Tuesday, October 7, 2008

All things considered, real estate still looks pretty good

Posted by: Scott Beggs
Investment Specialist
775 336 4644

Scott joined NAI Alliance in March 2008 to assist the company with investment sales. Previously, Beggs spent over seven years with Dermody Properties as Vice President of Acquisitions and Port Management.

Despite the meltdown in the financial markets, well-located, fully-leased commercial real estate remains an attractive asset class relative to the universe of investment alternatives. This may seem like an odd statement in light of the problems facing some commercial real estate investors, but generally speaking real estate cash flows have held up well, even in this difficult market.

One of the most important attributes of commercial real estate is long term cash flows. Over the short term, real estate cash flows are dictated by the terms contained in the leases. Leases are legal obligations of the tenant to pay rent to the landlord for a specified term. Provided the lease terms are long enough and the creditworthiness of the tenant high enough, there should be somewhat limited risk of significant cash flow declines for an asset. If an asset is well located and well built, there should be somewhat limited risk associated with the long-term cash flow for a particular property.

Historically, investors typically focused on long-term cash flows with some modest expectation for value increases over the long term. This was exemplified by the use of 10-year IRR calculations where a large percentage of the return was generated by current cash flows. In recent years the market became inundated by “Value-Add” and “Opportunistic “ investors with higher return thresholds and shorter holding periods. The shortening of the investment horizon and a greater reliance on capital appreciation (as opposed to cash flow) has skewed the decision making process for these types of investors.

Adding to the difficulty, the commercial mortgage backed securities (CMBS) market bought into this hype. Many conduit lenders were more than happy to originate loans at unreasonably high loan-to-value (LTV) ratios, and unreasonably low debt-service coverage (DSC) ratios. And investors were more than happy to oblige.

It would seem that the problems faced by many investors are not the result of poorly performing real estate; rather they are the result of a poor capital structure and overly optimistic expectations for values. In fact, real estate returns are much more stable and predictable than many other investment alternatives. The problem is that some investors purchased real estate as a short-term trading asset, not as long-term cash flow investment. Nevertheless, the abuses and excess of the past two years does not invalidate the merits of a well-located, well-leased, appropriately capitalized real estate investment.

So what should investors focus on when evaluating a possible real estate investment:

1. Focus on Current Cash Flow – While there will be opportunities to create value by leasing vacant property; this strategy is not for the faint of heart. Seasoned real estate investors will tell you that the timelines and cost associated with leasing up vacant property can spiral. Unless you have a coherent business plan focused on a value-add strategy and significant equity capital, then most investors are better off focusing on current return.
2. Credit is Critical – A long lease term is meaningless if the tenant goes bankrupt. Understanding a tenant’s current and future financial position is an important aspect of underwriting an investment.
3. Have a Downside Plan – Even with the most thorough underwriting, sometimes unforeseen things occur. Have a plan for an unforeseen vacancy. Know the likely cost of re-tenanting a space that may “go dark” and have a capital plan to employ the strategy (e.g. have some reserves)
4. Avoid Overleveraging – The use of debt is commonplace in real estate transactions, but recently debt has been abused. An appropriate amount of debt is a very reasonable means of enhancing your returns, but leverage is not a magic elixir. Leverage merely magnifies your return, both positively and negatively. Stress-test your cash flows under various downside scenarios so you can adequately plan your optimal capital structure.
5. Understand the Risks – If you are looking for a risk-free asset, buy US Treasuries. But if you want to earn an excess return, it comes at a cost – RISK. As long as the investor understand the risks and has a plan to deal with them as they arise, real estate risks should be manageable.

Some may argue that my insistence that real estate is an attractive investment is misguided. They quickly point to the distress some real estate investors are now experiencing. I would suggest that the problems these investors are experiencing are not necessarily the result of poor real estate, but rather the convergence of a poor capital structure with a historic credit crisis.

Real estate is obviously not the only asset class that is feeling the pain of this credit crunch and sharp decline in investor confidence. Year to date (as of October 6, 2008) the S&P 500 Index(^GSPC) was down 26.97%; Dow Jones Corporate Bonds Index was down 5.55%, and the US Treasury Index (^TNX) was down 12.17%, and the Financial Sector exchange traded index (AMEX:XLF) was down 37.24%. As you can see there is no safe haven for investors.

In light of the extreme recent volatility in the stock market and the expectation that this volatility will continue into the foreseeable future, fully leased commercial real estate looks pretty attractive on a risk adjusted basis. Even if cap rates continue to edge upward over the short term, real estate pricing historically has stayed within a relatively narrow range. Over the last 20 years, cap rates for fully leased real estate have generally stayed between 6.0% and 9.0%. Relative to the ever changing multiples in the equities market and the volatility of yields on fixed income investments, real estate still looks like a highly stable asset class. In addition to this stability of pricing, real estate has historically enjoyed the added benefit of increasing cash flow streams. In many instances rental growth is embedded in the leases and therefore contractual in nature.

So while excess returns cannot be achieved without incurring some amount of risk, the risks of commercial real estate can be investigated, understood, and to some degree mitigated. Given the balance sheet shenanigans that have taken place at some supposedly high quality companies, the risk/return tradeoff associated with real estate investing, doesn’t seem all that bad.

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