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Part I - Commercial Investments:
This article is the first of a series of five comparing the advantages and risks associated with investments in commercial real estate, developments, residential real estate, and vacant land; the last article will establish a synthesis and a blue print of what might be appropriate for you.
We shall call "commercial real estate" buildings capable of yielding periodic revenues to their owners. Examples include a strip mall, an office building, a shop, houses or apartments for rent. For the purpose of this article, it will not include vacant land zoned commercial.
Without the shadow of a doubt, the current crisis has not affected commercial real estate holdings the way it has residential ones. Why?
The answer is both simple and comforting: commercial investments follow mathematical models which leave little room for hype and irrational behavior - two ingredients which have had their role to play in the current residential real estate mess.
In commercial real property, a sensible buyer considers four factors: (i) the cap rate, (ii) the likelihood of continued cash flow, (iii) the long term evolution of a geographic area, and (iv) the tax and financing benefits to the investor. The first two factors are property-specific, the third one pertains to a district, neighborhood or region, and the fourth one is investor-specific.
Armed with the right tools and the proper professional advice, an investor can make sensible decisions. This has been the back-bone of commercial real estate investments. Let us now review one by one the four factors presented in the previous paragraph.
The Cap Rate: the definition of the Cap Rate is very simple: "Net Operating Income generated by a given property during the first year of ownership, divided by the Purchase Price"; or, in more technical acronyms: NOI/PP. The Cap Rate is property specific, which means that it does not change with the investor. The buyer may pay cash, finance 100%, or be a pension fund, the Cap Rate for a given property will be the same. This is why it has become the standard measurement for commercial investment. The higher the Cap Rate (let's say, 12% or 0.12), the quicker the return to the buyer. The lower the Cap Rate (let's say, 6% or 0.06), the sweeter the deal for the seller. The link between net income and purchase price is direct. The rate will vary in function of the two following factors, and in function of the seller's and buyer's motivations.
The Likelihood of Continued Cash Flow: simply means that all tenants are not equal. Investors will prefer a strong publicly traded company over a Mom and Pop restaurant. Another twist in this chapter is the duration of a lease; a strong tenant with a lease ending in one or two years may not do too much good to the buyer of a property, which may thereafter sit vacant, or have to be rerented for cheaper, or have to be rerented to a poor credit tenant. This will affect the Cap Rate at which a buyer is willing to settle, hence the purchase price.
The Long-Term Evolution of a Geographic Area: is greatly a question of opinion; this is why hiring competent advisors is key. Customers supporting a shopping area may dwindle for many reasons - opening of a nearby mall diverting existing shoppers, closure of a factory employing many. On the other side, a new freeway, the relocation of a large employer or long term demographic trends may boost the revenue potential (hence, the value) in the short to medium terms. This will also impact the Cap Rate.
The Tax and Financing Impacts: are the last, yet equally important factors. A good move for one investor can turn out to be disastrous for another - this is why a good tax attorney and an advisor thoroughly familiar with financing options are key. Third party financing may offer the benefit of positive leverage, but at what risks? The current banking crisis reveals some of them.
Only a thorough review of the four factors outlined above will enable an investor to make a reasoned and sound move. The time involved in carrying out these reviews can be substantial. However, in real estate, time is always of the essence, and waiting too long to make a decision often means missing out on an opportunity. This is why investors should rely heavily on qualified professional help. This professional team should be willing to work overtime and to go the extra mile to provide quickly a dependable work product - one minute can make the difference between losing and making millions.
Posted by:
Olivier
Monod
Posted:
4/15/2008
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