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Commercial Real Estate: Value-Added Investing COMMERCIAL REAL ESTATE: VALUE-ADDED INVESTING by Colin Branch Real estate investment, like investments in commodities such as gold, oil and wheat, has traditionally offered and been regarded as one of the best hedges against inflation. Which is why real estate has traditionally been included in institutional portfolios. When you combine the hedge against inflation, with a favorable risk and return profile, real estate remains an excellent investment. So then, what is Value-Added investing? Value-Added: enhancing a product or service through time, sweat and/or money before offering that product for the use by a customer. In essence value added investing is taken something of less worth, improving it and selling it or generating income above the old value, plus the cost of renovation. While we all wish we had the “Midas Touch” the reality of value added investing is much harder than the theory behind it. This article will seek to explore the best ways to safely calculate whether a real estate asset is a good investment or not and the implications of doing proper due diligence. The very first thing a value added investor will be looking for is a commercial property that has a Net Operating Income (NOI) that has the potential to increase. It is important to understand NOI because all commercial real estate transactions depend on its value. In essence NOI is the difference between gross income and operating expenditures. To increase this value the asset in question needs to be a property that has an improvement need. Those needs can change from improvements on the structure, the land or other items that we will address later in the article. Without an improvement need the asset is not a value added investment. We would consider anything else to be opportunistic or stabilized investing. For our purposes we will not go into opportunistic investment, but stabilized investing is simply the exit strategy for value added investing. This comprises the senior debt loan or stabilized loan once the improvement has been made. The goal is to refinance out all the equity with a permanent stabilized loan that cashes the investor out of a cash flowing asset. In the traditional finance world of publicly traded securities and portfolio management by RIA’s (Registered Investment Advisor’s) and CFP’s (Certified Financial Planners) there is the quest to capture “the alpha”. This is betting on whether the asset you are investing in will generate significant gains to outperform the market. Either by investing directly into the asset or through some index fund. This is exactly what we are trying to do in value-added investing; beat the market. Value-Added investing is the quest to find something under-valued that has the potential to beat what is happening in the rest of the market. However, in real estate, there is ownership control over the asset which allows managers of the asset to change its value by the work they perform on the asset, which can make the return more complex than simply increasing “alpha” defined for public securities portfolios. The trick in hitting a homerun in value-added investments, however, is more complicated than this simple but accurate description of the value-added process. This leads us to naturally discuss the risks involved in value-added investing as we have quickly outlined that the return is more complex than our friends in the finance world who seek to capture “the alpha”. First consider the risks of making a value-added play. There are 3 really important categories of risks we will discover before learning how to increase our valuable NOI. The first group of risks is associated with the broad market trends that can affect the returns from a property. For the time being we will call this group “Macro Risks”. 1. Benchmarks – this is a new field which is strongly correlated to the new use of derivatives in the real estate market. The inception of real estate benchmarks through the derivatives market in 2007 has not gained enough traction yet to be a good indicator and needs some tracking errors to be ironed out. However, within a couple of years this tracking mechanism will be a great benchmark to measure returns. 2. Leverage – this is the debt to equity ratio used in real estate transactions. High leverage is a situation where there is very little equity and lots of debt. Whereas low leverage couples lots of equity with low debt. Recently with debt being offered at very low rates investors want projects with very little equity placed in the project which in-turn raises the potential return and the risk or volatility. If projects are highly leveraged and property values drop, developers or property owners can find themselves completely wiped out (as in the case of property owners during the late 80’s and early 90’s). 3. Capital Market Cycles – this is the risk involved in peoples affinity for certain types of real estate. Depending on the asset class the real estate is grouped, there could be great differences in the performance of properties in an asset class. One year an asset class could be envogue and the next year it could be out. 4. Demographic Trends – these are the aspects that deal with the changes or lack thereof the population for a given region or nation. They can have a profound effect on long term returns especially for different property types. 5. Real Estate Cycles, Interest Rate Cycles, Inflation Cycles, and Business Cycles – all of these have an effect on all asset classes of real estate and the returns from real estate investments. 6. Manager Incentive Risk – this is the risk associated with the managers desire to over perform by selecting properties to produce results well above the target for excess performance based fees. The second group of risks is activities and risks taken to outperform the market average. Some of this is speculative because one could underweight or overweight property return projections based on future expectations. 1. Property-Type Allocation Risk – even though all property types offer comparable returns to one another, the performance of those property types is considerable. For instance office properties are the most volatile while apartments are the least volatile. 2. Metro Area Allocation Risk – these risks assume the differences in cities impact the returns on a property. For instance there can be differences in similar properties depending on whether a city exhibits growth, easy access to building permits and land entitlements. Other factors such as a cities dependence on a specific sector of business or particular economic drivers like banking, technology or manufacturing. 3. Property Selection – we all know that location is everything in real estate and there can be significant differences in the performance of properties based on location within a defined region. 4. Enterprise Risk – this is the risk associated with investing in any given group. Whereby the board of directors, staff and philosophy do not remain constant enough throughout the dangerous periods of over-performance. Many times when a group over-performs it will venture into more risky territory because of the lure of great financial returns (the mortgage meltdown is an example of banks having over-performed and getting greedier everyday). 5. Reinvestment Risk – this is simply the process of taking the good returns from one property and placing them in a satisfactory property. 1031 Exchanges are very popular to avoid paying capital gains taxes but investors must be weary of reinvesting in properties just for the tax benefit. The last set of risks is associated with active property management. Especially, when there is a need for re-development or even ground-up new development. This is of particular relevance to value-added investing. For our interests we can call these Property Risks. 1. Leasing Strategy Risk – vacancy changes due to changes in the leasing strategy of a building. 2. Market Analysis Risk – architectural design of development or re-development of buildings can have a dramatic effect on real estate value. 3. Construction Risk – there is an over abundance of construction risks in any project from errors in construction, strikes by employees, materials shortages, price changes and all other delays. 4. Joint Venture Partner Risk - having to deal with another company invested in the project brings in a whole new dynamic. Too many problems to discuss in this article but they can range from business philosophy to hands on implementation. 5. Environmental Risk – local, national or international economic changes and building cycles. 6. Liquidity Risk – cash is king and the lack of money can make it increasingly hard to find a partner to help finish a project. In the value-added game of real estate the risks most associated with returns are leverage, reinvestment, capital market cycles, enterprise, and property risks. If all things go well, these are the risk factors that will drive NOI in the proper direction for a project. Per each project individual characteristics can also increase NOI. The first are revenue generating events such as: · Re-tenanting, which may include increasing occupancy, increasing the lease rate, increasing lease term or increasing tenant credit. · Rehabilitating the asset should lead to increased demand, higher occupancy, higher lease rate, longer lease terms and better tenant credit as well. · Repositioning the asset or changing the assets use can add significant value to an asset. As well as significant changes in the submarket such as roads, new employment centers and large scale mixed use developments can increase NOI. It is good to note, however, that all these revenue generating activities are subject to the risks associated with value-added investing which we have covered. Even though applying any one or several revenue generating events to an asset should in theory drive value up, all real estate investing works within the constraints of the risks associated with the asset at hand. In closing, the numbers need to work. In regards to real estate investing, especially value-added real estate investing, all emotions need to be left at the door. Don’t let your emotions guide your decision making. Be as dispassionate as possible and let the matrix of numbers lead your decision making. If the numbers and risks outweigh the rewards then the deal is plainly a bad deal. Additionally, in all deals there are usually one or two main events, whether risks or rewards, that need to be managed properly to drive the exit NOI. Know what those main events will be and plan for every situation that may arise during that phase of the project cycle. Then after planning think of a back-up plan as well. Going into a real estate transaction there can never be enough planning and preparation because the more you do the front end of the deal, the better chance of success you will have. This requires accounting for all the basic information every good real estate transaction will have in order to make an informed decision. Such as: capital structure outline (debt and equity investments), sources and uses of that capital, the capital improvement budget (money in and money out should equal 0 by the end of the project), any historical data on the real estate involved, all tenant information, the project proforma, and lastly the exit value (Stabilized NOI/Exit Cap Rate). Just remember that now is the time to focus more on risk management because of the state of the economy and to avoid a catastrophe such as the one the world is in next time around. Therefore, the key elements will remain for many years to come the ability to control leverage (your debt to equity ratios), development/redevelopment risks, the types of property and regional areas investing, and the enterprise risk. While much of this article may be based on straight forward common sense, an aura of disillusionment tends to cloud judgment during times of double-digit returns. REFERENCES: Kaiser, Ronald W. (2008). Assessing and Managing Risk in Institutional Real Estate Investing. Journal of Real Estate Portfolio Management. 287-304. Moigne, Cecile Le, Eric Viveiros (2008). Private Real Estate as an Inflation Hedge: An Updated Look with a Global Perspective. Journal of Real Estate Portfolio Management. 263-264. |
