Merits and Challenges of Real Estate Equity Investments

by Susan L. Stupin

June 8, 2005 - With more investors - whether institutional or individual - seeking alternative forms of investment, commercial real estate has proven to be an increasingly attractive option.

Commercial real estate offers opportunities along the risk spectrum that investors can tailor to specific return objectives and risk tolerance levels. Investors can further fine tune their goals with respect to current returns, capital appreciation, and preservation of capital.

Commercial real estate investment opportunities range from the lowest yielding, lowest risk core investments to the highest yielding, highest risk opportunistic investments, with each different category offering a unique risk-reward mix that meets a variety of investor goals.

Core investments appeal to long term, passive institutional or individual investors seeking a secure return, largely generated from property cash flow.

Classic core investments include properties with long term net leases to strong credit tenants; first class or "trophy" office buildings in major urban markets, such as New York and Washington, D.C.; premier multi-tenant buildings with limited lease rollovers; and assets with a modest level of leverage (40 percent to 50 percent) relative to value. While overall returns (or IRRs) in the core category can range from 7 percent to 10 percent in the current market, it's still offering an attractive premium relative to other asset classes, like stocks and bonds .

The core plus market is a variation on core investing, offering slightly higher returns of 9 percent to 11 percent overall due to slightly less current cash flow versus residual value, somewhat more releasing and/or tenant credit risk, or slightly higher leverage (50 percent to 60 percent).

Investments in the value added category offer institutional or individual investors opportunities for a balanced mix of current cash flow and future appreciation.

These properties may be located in recovering markets such as Atlanta and San Francisco, or secondary markets, like St. Louis, Cincinnati, and Minneapolis, and may offer some re-leasing risk when existing rents are at below market levels.

Value added assets can potentially benefit from a change in marketing, operating or leasing strategy, as well as a new capital structure.

Moderate leverage (60 percent to 70 percent of value) can enhance yield while still allowing for healthy debt service coverage. Investing with experienced local operators that can closely manage the asset also mitigates risk associated with this type of investment. Overall value added returns are currently in the 11 percent to 15 percent IRR range.

This type of investment appeals to savvy investors who seek an enhanced return in exchange for a somewhat higher level of operating risk.

Opportunistic investments tend to be growth and development oriented, with high overall returns (IRRs in the high teens and above), with a significant portion of the equity return typically achieved upon sale or refinancing.

Opportunistic investments often involve assets or operating entities that offer "turn around" potential resulting from a new strategic direction, new or innovative product types, new development, or entry into unproven or international markets such as Korea, China, or Eastern Europe.

Players in this market sector tend to be large, sophisticated, and well capitalized real estate opportunity funds, hedge funds, and others who have a high risk tolerance and are comfortable with high levels of leverage.

Opportunistic investors can make significant bets on broad market trends and are often able to spread their investment risk across a pool of investments and use hedging techniques and derivatives to mitigate risk.

Investors who can clearly define their investment objectives can pursue highly individual investment strategies in the current real estate marketplace.

This variety of options, at all points in the investment risk spectrum, contributes to real estate's continuing appeal as an asset class and the explosive growth in new investors and investment vehicles , operating in the commercial marketl nationally and internationally.