For investors who want access to the benefits of owning privately held real estate, who find the potential risk-adjusted returns that those investments generate appealing, and who are willing to adopt a buy-and-hold strategy, responsible real estate investment opportunities remain available. Opportunities, however, depend on the property type and expected return on investment. The current real estate environment demands a patient, thoughtful approach to investing and requires investors to thoroughly evaluate the assets they are considering.
Privately held real estate assets have many attributes that may be evaluated to help predict the likelihood of strong overall investment performance. These include: evaluating the quality, or physical condition, of a property; determining the strength of a property’s location and the fundamentals of the local market; and analyzing the quality of its tenants. By analyzing these and other factors, an investor may establish whether a rational strategy exists that justifies purchasing an asset at the perceived plateau of the real estate market cycle.
PURCHASE QUALITY ASSETS
Purchasing the nicest building in a market is not a prerequisite for making a responsible, long-term real estate investment that could ultimately provide a solid return. Not every building can be an award winner, nor does a building have to be to cater to a subset of tenants that generate strong, long-term cash flow. But investors who chase yield at the height of a market by purchasing dilapidated properties with substandard attributes are putting their equity at risk. To avoid this pitfall, investors should evaluate a building’s physical condition, including:
- Functionality: Consider whether the property is functional or in jeopardy of becoming obsolete.
- Parking: Determine whether the parking is both sufficient for the building’s intended use and comparable to other properties in the market with which the subject building will compete for tenants.
- Capital expenditures: Evaluate elements of the building such as its roof and heating and cooling system to properly budget for repairs or replacement in the future.
- Deferred maintenance: Check to see if there is deferred maintenance that is jeopardizing any of the building’s systems or its structure.
- Environmental review: Verify that the site on which the property is built is not contaminated.
LOCATION, LOCATION, LOCATION
In a market environment where prices are appreciating rapidly, some investors sacrifice the quality of a building’s location in return for a lower price and higher, near-term yield. Such short-term thinking can hurt an investor over the longer term; the importance of investing in well-located property cannot be overstated. Although buying a property that is well located does not, in and of itself, ensure long-term investment success, buying poorly located real estate has the potential to sink an investment from the day the property is purchased. A few locational attributes to consider that help to enhance the likelihood of long-term investment success are:
- Conforming use: Is the building’s use in keeping with the character of the immediate area? If the building’s use is an anomaly or if the use conflicts with the uses of the surrounding properties, the long-term viability of the building may be jeopardized.
- Accessibility: Buildings should be easily accessible from major freeways and thoroughfares that make getting to the property convenient for the greatest number of people possible.
- Amenities: Buildings that are located near services (i.e., restaurants and other retail establishments) that cater to the employees who work at those buildings will more easily generate demand from tenants in the market.
Understanding where a commercial real estate market is in its economic cycle and how it has performed historically is as critical to examining the potential long-term performance of a real estate investment as is evaluating a property’s quality and location. Following are several fundamentals for investors to consider when evaluating a local real estate market.
- Rental rate: Investors should know the current market rental rate for buildings of comparable quality to the property that is being evaluated. It also is important to understand how the current market rental rate compares with historical rental rates in a given market at different points over an economic cycle.
- Vacancy rate: It is critical to know how much space comparable to a target investment is available in a market. As with the rental rate, it also is helpful to know how the market’s vacancy rate has fluctuated through economic cycles.
- Tenant demand/absorption: Investors should understand how many tenants in a given market are looking to occupy buildings similar to that being purchased.
- Construction pipeline: Know the amount of space under construction and the timing for delivery of that space. Construction deliveries will impact supply, could increase vacancy and will likely have an effect on market rents.
STABLE RENT ROLL
Revenue generated by a quality property that is well located in a vibrant real estate market is only as secure as the tenants from which that revenue is derived. Moreover, how a building’s rent roll is configured can have a significant impact on the leasing risk associated with an investment. Investors occasionally will accept a certain amount of credit risk related to a financially weak tenant, or leasing risk in the form of a rent roll with concentrated lease expirations and higher building vacancy, in order to purchase a property at a higher yield. Accepting this type of risk can be a mistake that could threaten the investor’s equity. Therefore, when evaluating a real estate investment’s potential to produce a secure, predictable and growing income stream over the long term, investors should consider the following with regard to a property’s rent roll:
- Creditworthiness of the tenants: Work with your advisers to review the financial wherewithal of the tenants that occupy a property to ensure the long-term viability of each tenant’s business and that each tenant’s lease obligation will be fulfilled.
- Occupancy history: Knowing the occupancy history of the tenants may help to establish the likelihood of a particular tenant remaining at a property over an extended period of time (beyond the expiration of the tenant’s current lease, perhaps). A rent roll that illustrates a history of tenant retention is an attribute of a property with a higher likelihood of strong, long-term investment performance.
- Staggered leasing risk: For properties with multiple tenants, a rent roll that spreads the risk associated with lease expirations over as long a period of time as possible is in many cases preferable to a rent roll with significant leasing risk within a short period of time. For single tenant properties, there is no way to stagger leasing risk. Therefore, for the long-term investor purchasing a building with a single tenant, it is likely that a lease with many years remaining on the lease term is preferable to a lease with a near-term expiration.
- Rental rate: Understanding where the contract rental rates are relative to current market rates is important. In most cases, it is desirable for contract rents to be at or lower than market rates than it is for contract rents to be in excess of the market.
It is difficult to determine whether we have reached the peak of the current real estate cycle and how the policies of the new Trump administration may affect the market. Nonetheless, through careful evaluation of a potential real estate investment following the four principles listed above, it still is possible for buyers to find commercial real estate investments with the potential to meet long-term cash flow needs. Work with your advisers and real estate professionals to determine whether properties you may have identified meet the quality, location, fundamentals and rental requirements that will make it a viable long-term investment even if markets begin to soften.
Adam Doud is vice president, real estate advisory specialist, at Wells Fargo Real Estate Asset Management.