By Joseph J. Ori | Originally Published July 15, 2021 at GlobeSt.com
It is very difficult to buy properties at favorable cap rates and make appropriate returns on equity in the competitive CRE industry these days. Many property sectors, especially industrial and apartments are trading at very low cap rates, many in the sub 4.0% area. Other sectors are in some distress like retail and hotels and these property types have large bid/ask value spreads and exceedingly high risk.
Each of the four primary CRE types, office buildings, shopping centers, industrial properties, and apartment complexes have distinct income, cash flow and physical properties that drive their valuation. These properties primarily derive their revenue stream from the tenant leases which encumber the property, but all have similar operating expenses.
To create value in this tough environment, the owner/manager must adopt various policies and strategies such as providing best-in-class management programs, implement revenue-enhancing capital improvements, alter the ownership and management structure and/or increase financial engineering to realize incremental NOI and increased value. Let’s take a look at these value-added strategies.
- Management and Leasing
It is critical to have the best-in-class management and leasing personnel and policies when managing and operating a CRE asset. There is a wide disparity in the industry regarding the quality of leasing and managing agents and hiring the right firm or personnel is critical to creating long-term value. This is especially true with apartments that are the most management intensive of the four primary property types. The difference in the net operating income on an apartment property between a good and poor manager can be 10% or more, which will substantially affect the property’s cash flow and value. Many apartment owners/managers are currently refusing to lower the base rent for a tenant renewal, especially in blue cities with high vacancies and declining rents. They would rather have the tenant move and try to release a vacant unit and incur turnover costs of $6,000 to $10,000 or more, instead of lowering the base rent by $200 and losing a few thousand dollars, and keep a rent-paying tenant in place.
Leasing policies are also critical in this environment. I have seen many landlords who will not deviate from an overinflated base rent even with substantial concessions like free rent and above-market tenant improvements. These owners will often let an existing and long-term tenant leave a site rather than negotiate a lower base rent. In many instances, a tenant unwilling to renew at the higher rent, will close its doors and move to a lower rent location. If the lease was for a retail location, the landlord may have to wait years to obtain a new tenant and incur substantial revenue loss and lower cash flow. A new tenant will eventually lease the space, but most likely at a lower rent and the owner will incur substantial tenant improvement and leasing commission costs.
- Capital Improvements and Repositioning
Investing additional funds to improve the physical property above and beyond normal and recurring repairs and maintenance is another key strategy to increase and at least, maintain the value on a CRE property. Many of these strategies can provide a return on investment of 10% to 20% or more. Renovation of an office building lobby, new appliances for an apartment project and repurposing part of a Class C mail are all capital improvement and repositioning strategies that can greatly increase value. This has been especially true in the repurposing of many dying Class C malls, wherein the original retail square footage has been cut in half and new uses including industrial, hotels, residential, bowling alleys, skating rinks and other uses have been created. Many properties are currently being renovated for Covid related reasons with touchless entry systems, elevators and bathrooms and upgraded filtration systems. This would also be a good time for property owners to add additional revenue-enhancing capital improvements to their properties, including parking, storage, signage, and Wi-Fi service.
- Lease Structures
Changing the lease structure to increase base rents, shift additional operating costs to tenants and/or provide for inflation indexation can add to value enhancement. I believe the mall sector will see 30%+ of future leases structured with no fixed base rent and only a percentage rent. Although this will shift the volatility in lease income to the landlord, it will be good for the mall and retail sectors overall, as it will keep tenants in place and increase and stabilize occupancies. The tenants will also embrace a percentage rent-only lease structure as the rent expense on their income statement will correlate 100% with the store revenue.
- Owners and Advisors
This relates to a change in the property ownership or advisor relationship. Some firms are simply better owners/asset managers and advisors than others. The owner and advisor of CRE assets must make critical and strategic decisions on how the asset is managed, who will be responsible for the operations, the capital allocation between debt and equity and leasing and capital improvement policies. Many institutional real estate fund owners do not establish the proper operating, investment, and capital strategies and therefore, realize lower returns than their counterparts who are better owners and managers. Many large real estate private equity firms are more concerned with raising capital than operating the properties. They are not in the CRE investment business but are large marketing machines that excel at raising billions in capital, but are poor at operating and leasing the real estate assets.
- Financial Engineering
This involves altering the structure of the property capital stack including the amount, percentage, and cost of the first mortgage, mezzanine debt, subordinated debt, preferred equity, owner equity and securitization opportunities. Although aggressive financial engineering is persona non grata in today’s market, because of the defaults, foreclosures, and lawsuits from the Great Recession, it is still a worthwhile effort. With first mortgage debt ratios below 70%, owners need to consider a 10% mezzanine position to enhance their return on equity, while not over-levering the property. Owners should also consider participating loan structures and preferred equity positions to enhance the capital stack.
Joseph J. Ori is executive managing director of Paramount Capital Corp., a commercial real estate advisory firm.