The Importance of Location Real estate properties are differentiated from most other financial or real assets by their uniqueness. No two hotels are exactly alike, no two pieces of undeveloped land are alike, no two office buildings are alike, no two shopping centers are alike, and so on. Commercial real estate is not a commodity. Each property is different because it is in a different physical location. This makes location one of the most important attributes of any piece of commercial real estate. The first thing to understand about location is that location is not an absolute. There is no such thing as a generically “good” location (or a generically “bad” location.) The desirability of a particular site is relevant only in terms of its intended purpose. A property that is good for a residential dwelling is not necessarily good for an apartment, an office building, a factory, and the like. Assessing the value of a property always requires the strategic perspective: What is the purpose intended for this property? Only in that context are the actual physical attributes of that site relevant. Physical attributes of a site would include the current use of the property, its location with respect to traffic patterns, relevant zoning laws, the contour of the land, the attributes and uses of adjacent or neighboring parcels of land (an otherwise desirable piece of land for a single-family residence might be made undesirable if the adjacent property were a mobile home park or a rendering plant), the effective marketing area or impact zone of the property and trends in adjacent, neighbor, local, or regional land use. Another factor to consider in the valuation of commercial real estate is the impact of subjective perception. Certainly, a piece of property has an objective reality. However, that objective reality may not be as important as the subjective lens through which that property is viewed. An objective reality might describe 50 acres of rugged land surrounding a dismal swamp located 20 miles from the nearest urban area. A subjective perspective might be to consider land as a nature preserve, featuring select executive home sites surrounding ecologically important wetlands, that provide protection for a living environmental laboratory. The objective reality might be a rundown hotel adjacent to a metropolitan central business district whose desirability is threatened by crime in the neighborhood. The subjective perspective might be that the (refurbished) hotel could become a badly needed retirement community for area residents that is distinguished by its access to urban amenities and its significant architectural and historic significance. An investment in such a property could be thought of as a beacon of successful urban renewal that could revitalize the neighborhood. It is all in the perspective. A lot of highly successful commercial real estate development occurs because someone is able to think “outside the box.”
The Importance of Diversification A key to successful investing, in general, is diversification. Specifically, diversification has that wonderful property of lowering risk without necessarily lowering gain (and often raising gain). We argue in this book that most investors should be diversified into real estate. We now wish to argue for diversification within the real estate sector for the same reasons. In the middle of 1984, the market for office space in the Baltimore– Washington metropolitan area had been moribund for two years, with vacancy rates averaging around 14%. Manekin LLC, a private developer and broker of office buildings was not doing well as a result. Rather than downsize its staff, the organization looked at the residential market that had been red hot the last three years and decided to get into this real estate sector. Richard Alter, Manekin LLC President was quoted as saying, “Going forward, depending on market conditions, we expect to see 40% residential, 50% office, and 10% retail.” Moreover, in this area (as in most metropolitan areas), land for developments of any size was becoming increasingly difficult to find. In addition, local planning and zoning boards were becoming increasingly demanding. It turns out that the trend among these regulators is towards mixed-use development. This makes diversification a natural fit for a company like Manekin. MIE Properties, a real estate development company that is also in the Baltimore–Washington metropolitan area, held about 2 million square feet of office space and 2 million square feet of retail space in 2004 and was in the same boat as Manekin. So, they began developing an 800-unit residential property that had a much brighter profit outlook. “We look at a piece of land and say, ‘What would maximize the value?’” said Ed St. John, MIE Properties President. “We’re not stuck with what we do. We do it all.” “If one end of the market takes a hit, you have something else to fall back on. It never hurts to be diversified,” says J. William Miller Senior V.P. at the commercial real estate firm NAI KLNB.
The Dynamics of Wealth Creation and Preservation Creating and preserving wealth starts with saving. Sad to say, there is no shortcut here. Those individuals who maxed out their credit cards in 2000 and 2001 to invest in the stock market paid an awful price for trying to go the easy way. Creating wealth is the classic example of the tortoise and the hare. To become wealthy, it is not necessary to make a onetime “killing.” A much better approach to creating wealth is to use the power of compound interest. One dollar invested for 20 years at 4% is equal to $2.19 (double your money), at 6% your money triples to $3.20, at 10% it increases to $6.72, and at 14% your initial investment will grow to a fabulous $13.74. No need to make a killing. All that is needed is patience and a sound investment strategy. Commercial real estate opportunities offer rates of return that will have big payoffs through the power of compound interest. The trick to remember here is that higher returns go hand-in-hand with higher risk. When you receive an offer to have more return with less risk, watch your wallet and run for cover. Still, opportunities with superior returns relative to the risk abound in today’s commercial real estate market and this situation is likely to continue for some time.
Risk and Danger Are Not the Same Danger is something to be avoided at all costs. A sign that says “Danger— Unexploded Ordinance” means keep away. Rational individuals do not trespass. Risk is different. Risk needs to be embraced by investors because without risk there is little, if any, return. All forms of investment are risky. Avoiding risk is not the issue. Getting compensated adequately for bearing risk is the issue. All commercial real estate opportunities have risk, just as all other investments have risk. However, as commercial real estate is underused as an investment vehicle, the returns relative to the risk tend to be larger than those available in more traditional investment vehicles. If Prudential Insurance has an AA-credit rating and its 10-year bonds pay 9%, what is wrong with doing a buildto- suit lease for one of their regional offices that looks to earn a return of 22%? In both cases the obligation is secured by the general credit of the corporation. Which is preferable to the knowledgeable investor? For investors the risk they are exposed to is not simply the sum of the riskiness of all their individual investments. Rather, it is the risk inherent in their entire portfolio. The risk of individual investments is not the same thing as the risk in the portfolio. This is because the risks of the different investments in your portfolio are more or less correlated with the risks of other investments in your portfolio. The effect of diversification among different types of investments is generally to reduce the risk of the overall portfolio without necessarily reducing return. This happens because the individual risk on one element in the portfolio may be largely independent of the risk of another element in your portfolio, so the risk of the portfolio itself declines. A property and casualty company’s portfolio of homes they insure for fire hazard may illustrate this concept. If the probability of one home burning down is 0.001 (one in a thousand) and the probability of another home burning down is also 0.001, then the probability of them both burning down is 0.000001 (one in a million.) So adding elements to the portfolio whose risks are independent lowers the risk of the portfolio itself, even though the elements are equally risky.
An important implication of this concept is that investors should not evaluate the risk and return on an individual investment in terms of the riskiness of that particular investment alone. Instead, the risk should be judged by the impact of that investment on the riskiness of the overall portfolio itself. This means that it is possible to add a relatively risky investment to a portfolio and have the total riskiness of the portfolio go down. This reflects the way in which the riskiness of that investment is correlated with the riskiness of the existing investments in the portfolio. Sometimes what is true for the individual is not true for the whole. Logicians call this phenomenon the “Fallacy of Composition.” If it is true that one person at a football game can see better by standing up, it is not true that everyone can see better if they all stand up. It turns out that what is not true for an individual investment—more return with less risk—may be true for your portfolio, that is, it is possible to have more return with less risk because of diversification. There are a lot of highly technical and mathematical ways to measure risk. All of them suffer from a variety of imperfections. Indeed, they are so mind numbing in their complexity, that the best approach to evaluating risk for the individual investor is common sense. The common sense approach to risk is that while diversification is generally good, it needs to be evaluated within a set of priorities focusing on the life style context of the individual and his or her family. A young family needs to invest in a home and life insurance before they think about stocks. A retired police sergeant and his dependent wife living on his pension have no need to diversify by investing in a risky stock market option. A 45-year-old professional, with a family income of $145,000 a year, a house with substantial equity, and $200,000 in mutual funds as his sole financial asset, should be thinking about getting commercial real estate. Diversification in this case makes sense if the goal is wealth creation. The whole point of this book is that an upper middle-class individual who today has a good job, is educated, owns a home, has paid off his or her credit card debt, and typically owns a fair amount of individual stocks or mutual funds, can probably stand to diversify into commercial real estate. Such diversification, if done correctly, can increase the individual’s overall (portfolio) performance and decrease its risk. However, commercial real estate is not an area to take lightly. Each type of commercial property tends to have unique attributes with which the individual investor should be familiar. Given this knowledge then, a financial analysis of a specific project must be undertaken to figure out exactly what the risk return parameters of the property are. Then, the time comes for the investor to step up to the plate or not, as he or she deems appropriate.
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