Asset Management Strategies

Mixing instinct and market knowledge can improve investment performance.

Through the acquisition, management, and sale phases of an investment property, it is up to the commercial real estate consultant to mix instinct and strategy for the benefit of the client. This can be a challenge in the hands-on environment of commercial real estate. It requires specialists to not only identify good properties based on market data and projections, but also to uncover the nuances of each individual client -- their backgrounds, family histories, work situations, financial resources, and management desires and capabilities -- all factors that shape the foundation of their investment objectives. With this spectrum of information in hand, however, consultants can confidently manage clients' investment portfolios to the highest level of satisfaction.

Although investors often have the best understanding of their portfolios, commercial real estate specialists who undertake the asset management process often can make suggestions based on experience and a broader understanding of the investment cycle that will help clients achieve their goals. Also, a professional's objective view of the market or a property can provide an invaluable perspective to clients who may not see the big picture.

General Guidelines

In most cases, clients looking for advice already are involved in investment and are seeking reactive-based information on their current portfolios. But once a relationship is established, consultants and clients should decide on a timetable for reviewing portfolio results. Typical time frames include monthly reviews of performance, quarterly reviews of returns against returns from other real estate product, and annual reviews against pro-forma expectations.

Determining how clients like to measure their portfolio performance also aids in setting a review schedule. For example, some clients like to use alternative investments, such as the 10-year Treasury Bill rate, as a performance barometer against which to measure the most common commercial property types.

Based on this data -- and since today's portfolio advice almost always revolves around capitalization rates -- advisers and clients easily can review portfolio results monthly. However, less-frequent meetings can be equally fruitful as long as the lines of communication remain open through e-mails and faxes.

"I meet face to face with clients as often as they want, but at least annually, to discuss significant changes over the year," says Charles G. Hold, CCIM, a broker with Inland Real Estate Sales in Oak Brook, Ill. He typically works with clients whose real estate portfolios range between $2 million and $10 million. "First, we talk from the client's perspective regarding property status, income status, and personal changes such as retirement, kids in college, or health. Then we talk from a current market analysis viewpoint as it relates to present and/or future investments. It's my job to share resources with them and know what information to rely on based on their needs."

Current Strategies

Investors must be proactive in their asset management and open in sharing knowledge about their portfolios and local markets. However, commercial real estate professionals also should provide timely and consistent market advice to the best benefit of the asset.

In a typical analysis of the investment cycle for a portfolio owner, or for an individual asset, the buy-hold-sell decisions will revolve around purchasing property to meet the required returns for the investor-owner. This criteria is different for each buyer and takes into consideration the expected holding period, cost of capital, and market forecasts including projections using absorption rates and rent expectations. In addition, for some properties, alternative uses are considered.

Finally, a determination is made of what point the overall investment market cycle is for similar property. For example, today's cap rates are historically low. Does the investor buy today, at the top of the seller's market, or believe that cap rates have peaked and will begin an upward trend? Where in the investment cycle is the market, and where in the investment cycle are the owner's objectives met?

During the hold period, there is a need for frequent communication to monitor progress against the initial expectations. The knowledge that each investor has unique perspective and plans -- and knowing what your client's expectations are -- provides the guidance needed. Turnaround investors derive their primary income from the increase in appreciation over a short period, demanding that capital dollars bring immediate results. Long-term holders usually require an improving expected return and long-term appreciation. Regardless, investment advisers should frequently consider the possible benefit of selling the property versus continuing to hold.

The selling decision effectively can be made through the marginal analysis of comparing the cash flow from a sale against the present value of the cash flows received over a holding period of any length. So, using this analysis, the proceeds from a proposed sale would be the original investment amount and the cash flows for the holding period consisting of the annual cash inflows in the analysis.

More importantly, commercial real estate specialists should be able to provide insight into applicable strategies to meet client performance goals. The following examples involve current methods for meeting portfolio objectives.

Hold Strategy. The asset manager provides the greatest value to the owner during the hold period. Whereas a traditional property manager concentrates on efficiently managing expenses, asset management provides value by analyzing property results with an ever-increasing emphasis on improving income. For example, a shopping center has a 40 percent vacancy, determined primarily to be the result of the functional obsolescence of 20,000 square feet of space located in the rear corner of the L-shaped center.

A decision is made to analyze the costs and benefits of changing the space to a medical use. Based upon analyzing the incremental cash flows and using the estimated sales price in the analysis (assuming a three-year hold), it is determined that the owner should spend $110 per square foot to convert and lease up the space. The analysis is based on the following assumptions:

• The increased income annually is $600,000, flat over the term.

• Any increased expenses will be paid for by the new tenants.

• The improvements and additional income will increase the sales price at the end of year three by $5,454,000. This increased price is based on "capping" the additional income using an 11 percent cap rate, which again is projected in three years: net operating income divided by 11 percent rate.

• The analysis assumes a marginal tax rate of 20 percent, capital gains rate of 15 percent, and straight-line depreciation for 39 years.

• The target discount rate for this risk level is 15 percent.

• The cost of sale is $100,000

Calculation of net present value
n cash flow
0 ($2,200,000)
1 $600,000
2 $600,000
3 $600,000+$4,838,592

NPV = $2,351,388

Calculation of internal rate of return
n cash flow
0 ($2,200,000)
1 $600,000
2 $600,000
3 $600,000+$4,838,592

IRR = 52.08 percent

Based on the assumptions and calculations, since the NPV is positive and the IRR is greater than the 15 percent factor, an asset manager should counsel the owner to perform the improvements.

Geographic Price Differences. The growth of net-leased property offerings has widened the investment market geographically and increased the choice in selling and buying options. Currently, investors have the opportunity to diversify portfolios by selling in a low cap rate market such as California, where cap rates are 4 percent and 5 percent and buying in a higher cap rate market of 8 percent or 9 percent. The geographic difference in cap rates is a function of supply and demand in local markets, possibly caused by additional capital in this increasingly populated region.

For example, a semi-retired couple used this strategy. "Following the sale of their Los Angeles apartment building, I traded them into a corporate-leased Jack-in-the-Box in Orange County at an 8.5 percent cap rate and with seven lease years remaining," says Hooman Ghaffari, a Sperry Van Ness vice president in San Fernando, Calif. "We negotiated a lease extension in 2003 and sold the property in 2004 at a 6.2 percent cap rate using the new income figures. Taking advantage of the spread in cap rates, the final leg was a purchase of a similar property (Burger King) on the East Coast. That building was purchased at an 8 percent cap, almost tripling the cash flow from their original investment."

Rising Interest Rates. Another big factor in the current investment climate is the affect of rising interest rates. For example, Mr. Hannah owns a 95 percent leased office building in a Chicago suburb. The leases are relatively new, with an expected turnover of 25 percent in 2005 and 2006. The net income for the building is $900,000 that, at an estimated cap rate of 8.25 percent, would produce a selling price of approximately $10,909,000. The basis in this property is $4,000,000, resulting in a taxable event of $886,000.

At current capital gains rates (and disregarding depreciation recapture), the tax liability would be $1,036,000. By making assumptions about interest rate fluctuation and its effect on cap rates, the client's adviser can assume an approximate 4 percent spread using T-Bill rates and suburban office cap rates. (See Effect of Interest Rate Fluctuations.)

In this case, even a 1 percent interest rate increase reduces the property's value by $1,179,000. Since one of the biggest objections to selling properties today is the issue of taxation, even with capital gains rates as low as 15 percent, one way of looking at the prospect of selling now versus later is to consider that, if it appears cap rates will be increasing, selling now effectively gets the seller a "premium" with which the tax liability can be offset. The bottom line remains; waiting to sell in a period of rising interest and cap rates will always result in a lower net profit. As such, the current market value of Mr. Hannah's property would more than offset his tax liability and the best advice would be to sell.

Another conclusion, although not as easy to calculate, is that value will be affected by demand, which is generally greater in periods of lower interest rates. The suggested course of action for the investor involves discussions of many of the factors previously discussed: risk aversion, personal situation, future opportunities, as well as finally determining the probabilities of each rate change and outcome.

Transaction Matrix. When it comes to selling a property, a consultant must have a solid grasp of the client's goals and the threshold of the market. They must conduct comprehensive pre-planning, implement an aggressive marketing strategy, and use concise evaluation materials to make a sound sell decision.

These elements were present when the partnership of Thompson and McGuire dissolved and needed to sell its industrial flex building, a portion of which the company occupied.

The proposed listing price was generated from a cap rate based on the current NOI, an assessment of local comparables and the current investment market, a recent appraisal, and the purchase price from two years prior, plus improvements and lease costs. The resulting list price was $3.2 million, which represented a cap rate of just below 9 percent.

Within two weeks, listing broker Kevin M. Lynch, CCIM, in Arlington Heights, Ill., received five legitimate offers. After initial negotiations, Lynch created a transaction matrix to help the seller evaluate the multiple offers. (See Transaction Matrix.)

"I like to organize the thought process for the seller, but also for myself," Lynch says. "It is easier to be objective when data is charted according to different sales scenarios. I share the matrix with my clients, we discuss the alternatives and they make their decisions."

Ultimately, the transaction went under contract with the second buyer. The due diligence period was shortened considerably by work performed upfront, such as obtaining electronic versions of all leases and tenant documents, choosing potential buyers who agreed to not have a mortgage contingency, and accepting some of the seller's information, including a recent Phase I property report.

A Final Thought on Clients

Most clients who engage investment consultants are seeking objective advice and usually take action. However, some clients do not take action. Consultants should realize this as a fact of business life and move on.

Occasionally the use of analogies can get a client's attention. Lynch often uses one that compares the commercial investment market with a thrill ride. "Imagine the roller coaster at your local amusement park climbing that first ascent, ready for the expected drop into the rest of the ride. Now, imagine that the hill is the real estate market and the cars are owners and investors holding their real estate portfolios. It's been a nice rise to the top, but the first car is starting to descend. Where do you want to be in your investments? First car? Middle? Probably not last, right?"

The ultimate investment decisions are not usually in the hands of investment advisers, but if they never delve deep enough or plan diligently enough, their rate of success will be equally low. However, if they move forward with honesty and knowledge, the intentions will show through and client portfolios will benefit


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