Create value in the current over-valued CRE market
It is very difficult to buy properties at favorable capitalization rates and obtain proper returns on equity in the competitive CRE industry these days. Many real estate sectors, especially industry and apartments, are trading at very low cap rates, many in the below 4.0% area. Other sectors are struggling, such as retail and hotels, and these types of properties have significant bid / ask spreads and extremely high risk.
Each of the four main types of ERC, office buildings, shopping malls, industrial properties, and apartment complexes have distinct income, cash flows, and physical properties that determine their valuation. These properties mainly derive their income from the leases of the tenants who burden the property, but all have similar operating expenses.
To create value in this challenging environment, the owner / manager needs to adopt various policies and strategies such as providing top notch management programs, implementing revenue enhancing capital improvements, changing the structure of ownership and management and / or increased financial engineering to achieve incremental NOI and increased value. Let’s take a look at these value-added strategies.
- Management and rental
Having the best staff and management and rental policies is essential when managing and operating a CRE asset. There is a great disparity in the industry when it comes to the quality of rental and management agents, and hiring the right company or staff is critical to creating long-term value. This is especially true with apartments which are the most demanding when it comes to managing the four main types of properties. The difference in net operating income on an apartment building between a good and a bad manager can be 10% or more, which will significantly affect the cash flow and value of the property. Many apartment owners / managers are currently refusing to lower the base rent for a tenant renewal, especially in Blue Cities with high vacancy rates and falling rents. They prefer that the tenant move out and try to vacate a vacant unit and incur rollover costs of $ 6,000 to $ 10,000 or more, instead of lowering the base rent by $ 200 and losing a few thousand dollars, and to keep a paying tenant in place.
Leasing policies are also essential in this environment. I’ve seen many landlords who won’t stray from an over-inflated base rent even with substantial concessions like free rent and above-market leasehold improvements. These landlords will often let an existing, long-term tenant vacate a site rather than negotiating a lower base rent. In many cases, a tenant who does not want to renew at the higher rent will close their doors and move to a location with the lower rent. If the lease was for a retail location, the landlord could have to wait years to get a new tenant and experience a substantial loss of income and reduced cash flow. A new tenant will eventually rent the space, but most likely at a lower rent and the landlord will incur substantial tenant improvement and rental commission fees.
- Capital improvements and repositioning
Investing additional funds to improve physical property beyond normal and recurring repairs and maintenance is another key strategy for increasing and at least maintaining the value of a CRE property. Many of these strategies can offer a return on investment of 10-20% or more. The renovation of an office building lobby, new appliances for an apartment project and the reallocation of part of a Class C mail are all strategies of capital improvement and repositioning that can greatly increase the value. This has been especially true in the reallocation of many dying Class C malls, in which the original retail square footage has been halved and new uses including industrial, hotel, residential, bowling alley. , skating rinks and others, were created. Many properties are currently undergoing renovations for Covid-related reasons with contactless entry systems, elevators and bathrooms and improved filtration systems. It would also be a good time for property owners to add additional income-enhancing capital improvements to their properties, including parking, storage, signage, and Wi-Fi service.
- Rental structures
Changing the lease structure to increase base rents, shift additional operating costs to tenants and / or provide for inflation indexation can add to the improvement in value. I think the shopping center industry will see over 30% of future structured leases with no fixed base rent and only percentage rent. While this will shift rental income volatility towards owner, it will be good for the mall and retail sectors overall as it will keep tenants in place and increase and stabilize the occupancy rate. Tenants will also adopt a percentage-only rental lease structure, as the rent charges on their income statement will be 100% correlated with the store’s income.
- Owners and advisors
This is a change in ownership or advisor relationship. Some companies are just better asset owners / managers and advisors than others. CRE’s asset owner and advisor must make critical and strategic decisions about how the asset is managed, who will be responsible for operations, the allocation of capital between debt and equity, and leasing and rental policies. capital improvement. Many institutional real estate fund owners do not establish the proper operating, investment and capital strategies and, as a result, achieve lower returns than their counterparts who are better owners and managers. Many large real estate private equity firms are more concerned with raising capital than operating properties. They are not in the business of investing in CREs but are great marketing machines who excel at raising billions of capital but are poor at operating and leasing real estate assets.
- Financial engineering
This involves changing the structure of the real estate capital stack, including the amount, percentage, and cost of first mortgage, mezzanine debt, subordinated debt, preferred stocks, equity, and securitization opportunities. . While aggressive financial engineering is persona non grata in today’s marketplace, due to defaults, foreclosures, and lawsuits from the Great Recession, it remains a worthwhile effort. With senior mortgage debt ratios below 70%, homeowners should consider a 10% mezzanine position to improve their return on equity, without over-leveraging the property. Homeowners should also consider participating loan structures and preferred equity positions to improve the capital stack.
Joseph J. Ori is Executive Managing Director of Paramount Capital Corp., a commercial real estate consultancy.