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In order to be a savvy
and successful commercial real estate investor the investor has to learn
how to analyze the risks involved in the enterprise. Some risks
accrue to certain types of commercial real estate assets that requires
some special knowledge, but there are many types of structures and
securities that can offer the investor the opportunity to conduct due
diligence and make a decision based upon the available facts. A
large measure of these risks are the same risks every investment
presents, to wit:
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Market Risk.
There is always the risk that the business/project will, sooner or
later, experience a total systemic market failure (e.g.: the advent
of the automobile killed the buggy manufacturing industry).
This creates foreclosure and bankruptcy risk as a result if the
subject company has a high level of debt capitalization (e.g.: an
apartment building is financed 98% with debt and 2% equity is
at-risk).
-
Regulatory
Risk. There is the risk that the level of relative economic
advantage a business/project has (over its peers) is only temporary
because of potential changes in the law could result in the business
being "legislated out of existence".
-
Litigation
Risk. There is a risk that a legal claim be lodged against a
business (for whatever reason) that results in a judgment being
entered of an amount sufficient to bankrupt the business/project.
The savvy commercial real
estate investor undertakes a different kind of due diligence activities
before making a final judgment on investment participation because of
the key issue of liquidity:
-
What does the
investment represent? Is this an investment in a given
security (equity, preferred equity, debt or hybrid) or a real
property interest (tenants-in-common, joint-tenants, etc.).
Real property interests convey certain rights and responsibilities,
while investments in securities create other rights and
responsibilities. Your rights must be clearly
understood. Some securities leave you with no rights or very
limited rights, while some forms provide exceptional rights.
When it comes to real property interests, you hire a real estate
broker and the broker sells the real property interest in the market
for a price you dictate. This may result in market acceptance
or not (as evidenced by the price you finally deem to be acceptable
given the circumstances).
-
What does the market
say about this type of business? Since the investment
represents a lack of ready liquidity (which can be good and bad -
look at the bath shareholders in Bear, Stearns & Company have
had to endure because of the ease in which shares are bought, sold
and/or short-sold) the issue of market risk is the one area that has
to be carefully considered. In development finance, the first
thing that is done regarding a project proposal is the market
feasibility study (or market study). The more closely the
business is matched with surveyed and projected market conditions,
the more likely the business will maximize its own opportunity for
success. The market study provides all of the expected
revenues, operating costs and usage/occupancy levels of the
resulting project. If the pro forma financial presentation
does not use these findings as the baseline assumptions in the
forecast, the investor is placed at (potentially) grave risk.
-
What is the
experience of management? Are the sponsors of the project
presenting a team of individuals and/or companies that are providing
the key program management skills well-experienced in this type of
endeavor? The axiom seems to be to "stick to you
knitting" when it comes to putting together a project team.
-
What phase of
financing are the sponsors seeking to obtain? There are four
(4) levels of financing in a commercial real estate project that
represent different levels of risk:
-
Pre-development
phase financing represents the highest risk level and would then
require the highest level of speculative return because the
project is not defined (beyond a proposed business concept) and
requires the successful completion of the necessary due
diligence studies and reports to substantiate the project to the
point where additional capital may then be prudently added to
the transaction. The result of this state of affairs is
that the premium to be paid to investors is quite large (say
150% to 300%) for a comparatively short holding period (less
than two (2) years).
-
Pre-construction
phase financing represents the second highest level of risk, but
not as much as the pre-development phase because at least some
due diligence documentation has taken place that, to the
reasonable mind, constitutes a lower level of risk compared with
the pre-development phase. The expectation for
profitability and holding period are usually in the range of
150% to 250% for a holding period of up to five (5) years.
-
Construction
phase financing represents the next highest level of risk, but
not as much as the pre-construction phase presents because
virtually all of the due diligence documentation has been
undertaken and the risk of unknown factors or events potentially
impacting the transaction are smaller. The expectation for
yield is the same, but the holding period is typically 7 to 10
years to obtain the 250% to 300% total return.
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Post-construction
phase financing represents the lowest level of risk in the
commercial real estate investment envelope because investors are
entering the transaction after all of the essential risks have
been eliminated from impacting the transaction. The
expectation for yield is slightly greater than the corresponding
yield on SPRDs (12-month trailing yield) as a premium for
investing in a "done deal". The premium is
usually 25% to 50% higher than the SPDR's yield target and the
holding period is generally 7 to 10 years.
Now that we have
discussed yields, click here to return to the
overall discussion.
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