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There are too many painful stories about individual and corporate retirement funds facing severe funding deficits due to historically low interest rates on bonds. As a consequence, many fund managers have turned to commercial real estate investments as one of the few assets classes offering attractive risk-adjusted cash flow returns.
While these investments offer yields at a premium to Treasuries and a lower volatility than equities, they do require thoughtful due diligence prior to investment and careful monitoring throughout the investment life. Whether you invest yourself or with a fund manager specializing in commercial real estate, consider the following guidelines to protect your commercial real estate investments and to survive multiple economic cycles.
Robert Kantor is founder and CEO of Headwater Capital Inc. He served as the chairman and CEO of a succession of real estate investment and development companies over the past 40 years. In this capacity, he has acquired and managed investments in excess of $500 million.
For example, invest with conservative loan-to-value ratio (LTV), ideally utilizing an interest-only (IO) mortgage. A conservative LTV of 50-60 percent will protect your ability to hold these assets in periods of rising interest rates. An IO mortgage ensures that cash flow is being used to meet interest payments, which are lower than amortizing loans. Excess cash flow, if any, can be distributed as a return on investment with significant tax benefits. This combination of conservative leverage, interest expense tax shield and depreciation deferred tax liability on cash flow offers a superior after-tax cash return.
Effective commercial real estate investment requires a prudent and thorough asset selection process, a process that must carefully analyze the demographic and economic profile of the region in which the property is located. This demographic assessment must validate the asset-specific profile of the property. The tenants should be providing essential goods and services to neighborhoods in which the property is located.
Such analysis, both macro and micro, must be vigorously maintained and updated in order for the investment manager to monitor the asset’s ongoing risk profile and relative value. Buy-and-hold cannot mean buy-and-ignore. All regions are vulnerable to the unpredictability of ever-changing economic conditions and a real estate manager must monitor selling opportunities as vigorously as it monitors purchase opportunities.
The market for commercial real estate assets is a highly efficient network of informed buyers and sellers. It is unlikely that a transaction occurs where the risk and return are not efficiently correlated. That said, asset managers are far more variable in their skills, efficiency and transparency. What kinds of returns are reasonable? It depends on the asset profile and the asset manager.
An ideal minimum current cash flow is 6.5 percent, plus the investment should have the potential for long-term growth in asset value that matches or exceeds inflation.
Liquidity risk can be carefully managed by assessing the property and demographic profile of the region while employing conservative leverage metrics. In doing so, we are endeavoring to maintain and grow wealth over time.
It is essential that the investors receive a preferred return prior to the manager sharing in the income or the profits from the sale. There are many variations, so make certain you or your legal or financial advisors understand the terms of any investment opportunity you are considering.
The investment manager's financial reward (other than reasonable overhead) must be based on success and outcome of the realized profits of the investment. There can be no hidden fees or undeclared expense allocations that direct cash from the investment to the investment manager. Transparency is essential to the integrity of transactions.
A final bit of advice: learn about the team that will manage your investments. Check and double check their professionally specialized experience in the subject matter of the investment. A wonderful manager of apartment building investments might not be able to provide similar results when investing in shopping centers. Most importantly, research the ethics of the people with whom you invest.
