Commercial Real Estate - Best Hedge against Inflation

Commercial Real Estate – Best Hedge against Inflation
According to the National Real Estate Investor website, the outlook for real estate investments in 2011 is optimistic. “An improving economy combined with a thaw in the capital markets and limited new supply led to a big spike in investor confidence in the fourth quarter” .

 Commercial 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.

Value-Added investing

Investors are rolling up their sleeves and getting involved in property improvements, management, marketing. Added value means enhancing a product or service through time, sweat and/or money before offering that product for the use by a customer.

Value added investors is take something of less worth, improve it and sell it or generate income above the old value, plus the cost of renovation. Television shows like Flip this House  give us the impression that with a little elbow grease, any of us could add value and make profits. The reality of value added investing is much harder than the theory behind it. This best way to safely calculate whether a real estate asset is a good investment or not is by doing proper due diligence.

In commercial real estate, Net Operating Income, or NOI is the difference between gross income and operating expenditures. The very first thing a value added investor will be looking for is an NOI that has the potential to increase. It is important to understand NOI because all commercial real estate transactions depend on its value.

Value cannot be added unless the property needs improvement. Without an improvement need the asset is not a value added investment. Anything else would be considered to be opportunistic or stabilized investing. Stabilized investing is simply the exit strategy for value added investing. A stabilized loan is put in place 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.

Publicly traded securities and portfolio managers work to capture “the alpha”. By investing in an asset or through some index fund, the goal is to invest in assets with gains that outperform 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.  Investors improve their position either by purchasing Bank-Owned (REO) properties below value or distressed properties with value-added potential. The owner/investor controls 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.

Like all investments there is risk. The physical part of creating added value means understanding property management and dealing with developers or contractors. These risks could be categorized as Property Risks.

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.

Environmental Risk – local, national or international economic changes and building cycles.

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.

 Leasing Strategy Risk – vacancy changes due to changes in the leasing strategy of a building.

Liquidity Risk – cash is king and the lack of money can make it increasingly hard to find a partner to help finish a project.

Market Analysis Risk – architectural design of development or re-development of buildings can have a dramatic effect on real estate value.

Macro Risks or broad market trends can affect the returns from a property.  The following risks fall into this group.

Benchmarks – this is a new field which is strongly correlated to the new use of derivatives in the real estate market. There are few useful tools in this area as most markets are highly dependent on local economics.

Capital Market Cycles – this is the risk involved in investor’s preference 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.

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. A prominent example is the growing population of Baby-Boomers, in need of Senior-Living or Care Homes.

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, and low leverage couples lots of equity with low debt. Investors want projects with least amount of 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 upside-down.

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.  This risk in not isolated to real estate investing, however it should be evaluated.

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.

Activities and risks taken to outperform the market average can be categorized as Market Risks. Some of this is speculative because one could underweight or overweight property return projections based on future expectations.

Enterprise Risk – this is the risk associated with investing in any given group. Many times when a group over-performs it will venture into more risky territory because of the lure of great financial returns, This resulted in the mortgage meltdown.

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 economic drivers in a metro area. Economic growth, easy access to building permits and land entitlements, or dependence on a specific sector of business are some examples.

Property Selection – There can be significant differences in the performance of properties based on location within a defined region.

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 more volatile than apartments.

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.

Property Risks  are the set of risks is associated with active property management. This is of particular relevance to value-added investing, especially when there is a need for re-development or even ground-up new development.

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.

Environmental Risk – local, national or international economic changes and building cycles.

Joint Venture Partner Risk – having to deal with another company invested in the project brings in a whole new dynamic.  Issues can range from business philosophy to hands on implementation.

Leasing Strategy Risk – vacancy changes due to changes in the leasing strategy of a building.

Liquidity Risk – cash is king and the lack of money can make it increasingly hard to find a partner to help finish a project.

Market Analysis Risk – architectural design of development or re-development of buildings can have a dramatic effect on real estate value.

In value-added investing, the risks most associated with returns that will increase NOI for a project might be:

• Leverage
• Reinvestment
• Capital market cycles
• Enterprise risks
• Property risks.

An investor or manager should consider these actions to improve NOI on a particular project:

• Re-tenanting – this 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.

Keep in mind, however, that these revenue generating activities are subject to the risks associated with value-added investing discussed earlier. 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.

Residential versus Commercial

Residential real estate is a completely different animal than commercial investment. Residential property values are determined by the market supply and demand, and may be influenced by subjective opinions. Some people like city views, others like ocean views. In residential real estate, comparable properties are used to determine value, whereas in commercial real estate, the value is based on Cost, Income, and CAP Rate.

An expert in the industry recently told me that it’s simple math. The numbers need to work. This may be true, but there’s more than that. You need to understand the real value and research, research, research!  There is a reason that the property fell in disarray. Understand the community before buying a property there. There may be undisclosed reasons for the low property values, such as environmental, economic, social, or other factors.

Also, every deal has its own merits and its own perils. 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.

Don’t believe the seller’s numbers. Audit the property and get a Broker Price Opinion (BPO) on the value.  Every good real estate transaction will have due-diligence with a Business Plan 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, any historical data on the real estate involved, all tenant information, the project Pro-forma, and lastly the exit value (Stabilized NOI/Exit Cap Rate).

 

Andy Sabo is the President of TOP 10 Funding, LLC.

TOP 10 Funding represents private lenders with access to $400 Billion to lend for commercial real estate projects, such as multifamily, assisted living, and office building purchases and refinance, business financing, new developments and construction in most cities in the US.

We have great relationships with DIRECT lenders for Commercial Real Estate.

There are no up-front fees and the application process is simple and fast. An executive summary and a two-page application will get you an answer in a few days.

Phone:             (808) 375-4845       Email: [email protected] Website: top10funding.com Andy’s Blog: http://top10funding.com/blog LinkedIn: linkedin.com/in/andrewsabo Facebook: facebook.com/andy.sabo Twitter: @andysabo808