Editor’s note: This is the second installment of a two-part series written by Joseph Ori, an executive managing director at Paramount Capital Corporation. Click here to read part one.
6. Perform a Systematic Review and Analysis of the 15 CRE Risks.
There are 15 risks inherent in investing in CRE as follows:
• Cash Flow Risk: Volatility in the property’s net operating income or cash flow.
• Property Value Risk: A reduction in a property’s value.
• Tenant Risk: Loss or bankruptcy of a major tenant.
• Market Risk: Negative changes in the local real estate market or metropolitan statistical area.
• Economic Risk: Negative changes in the macro economy.
• Interest Rate Risk: An increase in interest rates.
• Inflation Risk: An increase in inflation.
• Leasing Risk: An inability to lease vacant space or a drop in lease rates.
• Management Risk: Poor management policy and operations.
• Ownership Risk: Loss of critical personnel of owner or sponsor.
• Legal and Title Risk: Adverse legal issues and claims on title.
• Construction Risk: Development delays, cessation of construction, financial distress of general contractor or sub-contractors and payment defaults.
• Entitlement Risk: An Inability or delay in obtaining project entitlements.
• Liquidity Risk: An inability to sell property or convert equity value into cash.
• Refinancing Risk: An inability to refinance property.
All investors that own commercial real estate should perform a detailed and systematic review of the above risks and their potential effect on an asset or portfolio. An easy way to perform this review is to assign points for each property based on one of three risk levels that correspond with each of the 15 risks. For example zero points for no risk, one point for moderate risk and two points for high risk. The cumulative risk rating for the property can then be calculated. If the property is subject to all 15 risks and the rating is zero to 10, the property has minimal risk, 11 to 20, there is moderate risk and 21 and over is high risk. Once the total risk factor is known, ownership can take the necessary steps to mitigate or eliminate each risk.
7. Provide Capital to CMBS Issuers or Invest in the Securities.
The commercial mortgage-backed securities business is coming back strongly and the industry, which was virtually closed down from 2008 to 2011, is in need of new corporate capital and warehouse line to establish and grow the business. The volume of new commercial mortgage-backed securities during the last few years was $44 billion in 2012, $80 billion in 2013, and $90 billion in 2014. CMBS production for 2015 is projected at more than $100 billion. This sector is in dire need of new capital and loan originators. A growing and established commercial mortgage-backed securities market is critical for a healthy commercial real estate industry and will prolong the boom times.
8. Sell Class A Properties in Core Markets.
Owners of Class A properties in core markets like New York, San Francisco, Miami, Boston and Seattle should consider selling their properties at these historically low capitalization rates and reinvest the proceeds in second tier markets at higher risk adjusted returns. Profits can be recycled into smaller growth markets like Oak Brook, IL; Walnut Creek, CA; Tucson, AZ; Albuquerque, NM and others. These small second tier cites have solid demographics and offer higher risk-adjusted capitalization rates than the overpriced core markets.
9. Acquire Small capitalization Public and Private REITs.
There are more than 30 public real estate investment trusts with market capitalizations less than $1 billion that are trading at or less than their net asset value. These are ripe to be acquired or taken private by other REITs, real estate private equity firms or other institutional investors. It also may be possible to get control of the board of directors via a proxy contest. This was done by Corvex, a private equity firm that ousted the former management of Commonwealth REIT (NYSE: CWH) and gained control of the company.
Any acquisition or merger opportunity will have to comply with the tax rules, including the ‘five or 50 rule’ which states that five or fewer individuals cannot own more than 50 percent of the value of a REIT during the last half of the year. Also, more than two-thirds of REITs are incorporated in the state of Maryland which has broader liability protection, more flexible voting provisions for stockholders, easier bylaw amendment provisions, and better protection against hostile takeovers and easier stock issuance procedures. Notwithstanding a Maryland incorporation, there are still opportunities via a friendly acquisition or proxy contest.
10. Reduce Allocation to U.S. Equity REITs and Increase Allocation to International REITs.
The total returns of U.S. REIT stocks has been very good the last few years and all investors, individuals and institutions should have an allocation of 5-15 percent to these stocks. If interest rates begin to rise in the U.S., then investors consider selling some of the pricey U.S. REITs and reinvest the proceeds into international REIT stocks. International REIT stocks have generated an average annual return of 40.6 percent during the last five years. Allocating investment funds to International REIT stocks provides low correlation to the investment portfolio which reduces nonsystematic risk and increases returns.
Currently, there at 30 countries outside the U.S. with established REIT markets and stocks. Additionally, four other countries, including China, are considering establishing a REIT market. The table below shows the total returns and market capitalization of companies representing the U.S. REIT market by the FTSE NAREIT All Equity REIT Index and the non-U.S. REIT market by the FTSE EPRA/NAREIT Global Ex US REIT Index.