SPECIFIC DISADVANTAGES RELATING TO REAL ESTATE Lack of Liquidity Liquidity in finance refers to the ability of an asset to be exchanged for cash without loss of value. Publicly traded stocks have good liquidity. (That is the purpose of having “stock markets.”) Commercial real estate investments typically do not. If you have invested in a small office building and the time has come to liquidate that investment, it cannot be done overnight, or, at least, it cannot be done overnight without great loss of value. Of course, much will depend on prevailing supply and demand conditions. It is possible that an investor will decide to liquidate in a period of high demand and short supply. In that case, a sale may be arranged in a few weeks. If the decision is made to liquidate, when market conditions are adverse, then arranging a sale may take months or years.
Difficulties in Determining Property Value This issue is closely related to liquidity. If real estate is inherently illiquid, that means it takes time to realize the property’s value. But what is its value anyway? This is certainly an area that it is easy to disagree on. When investors are selling a commercial property, they are really selling a stream of income. Valuing this stream of income requires two factors to be considered. First, one must quantify the stream of income itself, and secondly, one must determine the risk associated with that stream of income. When investors refer to the stream of income, what exactly are they talking about? It is possible that this refers to net income. Net income is a residual, resulting from taking all legitimate tax-deductible expenses from revenue and then subtracting the required tax from that sum. This may or may not be a good measure of the property’s value. One reason for this is that the calculation of net income results from including, as tax deductible expenses, both business costs and financing costs. While the business costs are likely to remain the same if ownership changes, the financing costs may not. This is because the new owner may use a different capital structure (mix of debt and equity) than the current owner. Thus, net income not only reflects the operating characteristics of the property, but the financial characteristics as well. As a consequence, some analysts prefer to use earnings before interest and taxes (EBIT) as a measure of income. This allows a focus on the purely business aspect of the property. The calculation of EBIT is closely related to that of net operating profits after taxes basically EBIT after taxes. The nature of the tax code is so arbitrary that taxes paid may, or may not, have something to do with firm performance. Using EBIT is preferable in measuring income in situations where the tax is going to be determined by considerations other than those pertaining to the property. NOPAT is preferable if the tax liability is systematically related to firm performance. Another problem with net income is that depreciation expense, one of the legally permitted deductions from revenue, is not a “cash” expense. Indeed, it is not paid to anyone but merely serves as a device to shelter income from taxes. The property owner retains this portion of revenues. As such, the sum of net income and depreciation is typically referred to cash flow. Cash flow is probably the most commonly used measure of income after net income. Cash flow should probably be used more commonly than net income as a measure of income because it makes greater economic sense. The reason that net income is more commonly used as a measure of income than cash flow is because real estate value is most commonly expressed in terms of income multiples. For example, it is very common to say, “That type of business will sell for five times earnings.” Thus, net income is the traditional measure of earnings in the real estate business. Yet another measure of income is possible. Real estate properties frequently require regular maintenance to preserve their value. Painting, patching, repairing, clearing drains, replacing worn elevator parts, and so on. The nature of these expenditures is that they may be deferred. While this may lead to a long-term deterioration of the property, such deference will have the effect of reducing the tax-deductible expenses and thus result in a larger net income figure. Consequently, some analysts prefer to take cash flow and deduct necessary maintenance expenses from it. This is a great concept, but in practice it is very hard to identify necessary maintenance expenditures. When this is done, however, such a measure of income is called free cash flow. An additional issue with respect to income is its level. We generally know a lot about income in the present, but less about income in the future. When it is said that the value of the property depends on the income it can generate the reference is to income now and in the future. In many situations, future income can reasonably be expected to grow. In some circumstances, decline is possible. The future level of income can be a very important element in determining income. The second element (after determining income) in determining value is determining the risk associated with that value. This risk has to do with the fact that the income anticipated might not occur, or its value may in some sense be diminished. The use of a discount factor is commonly used to adjust the cash flows to take this into account. Thus, discounting that income to its present value explicitly quantifies the risk associated with income. Equation (1.4) is the most commonly used framework to determine value. That is, the value of a commercial real estate property depends on how much income it will generate, the appropriate rate at which that income should be discounted, and how much that future is likely to grow in the future.
Overextended Borrowing Leverage is a good thing, but too much leverage can be a bad thing. Leverage increases the potential return on a project, while at the same time increasing the risk associated with that project. This is why it is better to optimize leverage than maximize it. Too much borrowing jeopardizes the success of a real estate investment as surely as too little leverage. It is a matter of balance to be decided by the investor’s taste and preference for the trade-off between risk and return.
Management Expertise Required Where ownership of the property is direct, the commercial real estate investor is going to need to be involved with searching for the project, evaluating the project, financing the project, and (if acquired) managing the project. Even where the commercial real estate investment involves a sale–lease-back arrangement and there is no property to search for, and the evaluation is cut and dry, the project will still not manage itself. There are always ongoing issues to be dealt with between the lessor and lessee. Commercial real estate investment is not a passive activity. It requires active, focused, intense participation or things are likely to go terribly wrong. Commercial real estate investment is not for the detached.
SUMMARY Many investors have an excessive concentration of equities in their investment portfolios. Whether such equities are directly held, the result of employer offered stock options or held indirectly through mutual funds, such investors can achieve significant reductions in risk without loss of potential return through investment in real estate. Indeed, the astute investor can often both increase return and reduce risk through real estate investment. This “magic” is accomplished through diversification and the power of compounding returns. The tried-and-true approach to building wealth over time comes from a portfolio of one-third equities and long-term debt, one-third real estate, and one-third liquid assets. Diversification minimizes risk and wealth grows by compounding earnings. This is a bedrock foundation for wealth building that will withstand the storms of adversity that are sure to come. Portfolio structures composed of trendy stocks are built on sand and inevitably collapse. Real estate provides a mosaic of opportunities and risks. No one sector is inherently better than another. Office buildings may be hot in California, but dead in New York. Residential housing can be going great guns in Arizona, but suffering from oversupply in Tennessee. The good news for investors is that the market is so complex and dynamic, there are always good investment opportunities to be found somewhere. Of course, not all real estate investments are appropriate for all investors. Investors will vary by their degree of expertise, their willingness to commit time and energy to an investment, their ability to use the tax advantages inherent in real estate, their need for liquidity, their access to capital, and their taste for risk. Still somewhere within this mosaic, the patient real estate investor will find the opportunity that is right for him or her. Table 1.1 presents a synopsis of the strengths and weaknesses of the different types of commercial real estate investment. Potential real estate investors should use this chart to find that combination of traits that are most appealing and then go to the relevant chapter to learn more about the area should use this chart. All strengths and weaknesses are rated on a scale of low to high. It should be noted that these are general rankings. Local market conditions, or unique circumstances characterizing a particular project, could alter this rating in that instance. These rating should only be used as a general guide. More detailed information is contained in the referenced chapters. Most forms of real estate investing permit or encourage a high degree of financial leverage. Greater financial leverage means an increased ability to fund a project with debt. The ability to use financial leverage in real estate investing is an advantage because financial leverage will give the investor a greater return per unit of equity capital. For example, a single-[ family residence is bought for $100,000 with $5,000 equity and a mortgage of $95,000 and the property appreciates 10% to $110,000 in one year. Then the investor’s gain is not 10% but 200%, that is, the $5,000 of equity has now become $15,000 of equity. Of course, financial leverage can also be a disadvantage because it implies an increased interest expense. Interest expenses are fixed and increase break-even points as a result. Operating leverage occurs when a rise in sales or revenues brings about a more than proportionate increase in profits. Almost all real estate properties have high-operating leverage because the bulk of real estate expenses are fixed. This property of real estate simultaneously makes real estate such an attractive proposition in terms of potential return and increases the risk of failure if those fixed costs cannot be covered by receipts.
Real estate properties are capable of functioning as an inflation hedge. That is, when prices in general go up, the rents or fees derived from owning real estate will also rise. This attribute of real estate combines with the use of leverage in real estate. Where the debt carries a fixed interest rate, the effect of inflation is to lower the value of the debt repayments. Under this scenario, creditors lose and debtors win. Real estate property may generate tax savings that augment the real value of the property. In general, tax advantages arise from the use of depreciation and the fact that interest expense is tax deductible. Many real estate investments are not profitable until the tax advantages are considered. Investing in real estate is not necessarily a passive business. Even if there are no operational demands on the investor, managing a portfolio of properties requires many administrative tasks that can amount to a full-time job. In addition, the investors may also elect to take on certain operational responsibilities with respect to the property owned. An office building owner may wish to take charge of the maintenance function, for example, or a shopping center owner may wish to find tenants on his or her own. Some investors may well consider the opportunity to support themselves by running their portfolio as their own business as a good thing. The framework used above treats the ownership attributes of a type of property as a good thing. One of the most important components of the wealth building process is the ability to compound earnings. As a general rule, real estate properties are very good for facilitating this process because of the opportunities naturally provided to reinvest in a property already owned or a similar property. In all real estate markets, there are times of excess demand. Converting the value of a property into cash by selling it is not a problem. Sadly, all real estate sectors sooner or later experience conditions of excess supply. Under these conditions, it can be very hard to access the value of a property through a cash sale. Frequently, the property becomes impossible to sell without significant reductions in price, or without some form of seller financing. Lack of liquidity constitutes a serious risk to all real estate investors. Because real estate properties tend to be unique as a result of location or the characteristics of the improvements located on that property, determining the value of that property may be difficult. Of course, “comps”—comparisons—can always be found, but frequently those comps are not really comparable for one reason or another. Valuation difficulty can create a liquidity problem. The manner in which these advantages and disadvantages impact the different property types are discussed in the referenced chapters. However, these advantages and disadvantages may be summed up in the “Suitability Index” shown in Table 1.2. Success in real estate investing is a function of the experience (knowledge and expertise) of the investor. The first-time investor should not go for an industrial or office building property unless very special circumstances are present. Success in this area comes best to the novice who starts small and simple and acquires the necessary experience for success over time.
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