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.
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.
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.
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."
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.
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
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?
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.
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
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
• 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
• 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
NPV = $2,351,388
Calculation of internal rate of return
n cash flow
IRR = 52.08 percent
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.
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
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.
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.)
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.
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.
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
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
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.
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.)
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."
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
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
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