Exploring commercial real estate

No other investment category is as popular in the region as commercial real estate: many businesses, including some of the largest GCC corporates, typically have as much as 65 per cent of their investment portfolio committed to this sector. Yet the reality is that this can be a challenging and high maintenance option, where investors play a ‘probability game’ on the likelihood of good returns – which can be exceptional in a good economic climate. SME Advisor explores the opportunity…

First things first. Part of the appeal of investing in the commercial property market is the sheer size of the sector and the enormous choice of investment that it offers. According to the USA’s CoStar Group, worldwide, the total value of commercial property is estimated at USD71 trillion. Yet within North America – the world’s largest real estate community, with assets valued at USD11 trillion – more than US$160 billion of commercial properties are now in default, foreclosure, or bankruptcy. In Europe, approximately half of the €960 billion of debt backed by European commercial real estate is expected to require refinancing in the next three years (according to PropertyMall, a UK based commercial property news provider).

While the market is also distinctive for its volatility – with values climbing, according to Bloomberg, 280 per cent in the GCC between 2002 and 2008 – it is also arguably the best of all long-term investments, out-performing everything except top-quartile Gilt-edged stock over the last three decades (Forbes). This despite the fact that the down side of extraordinary growth was dramatic decline during the financial crisis of 2008-2011.

In many western markets, this decline was softened by a broad portfolio spread: – so for most corporate investment portfolios, only about 11 per cent of investments were held in the property sector. Typically, though, in the Middle East and Asia, the figure is much higher – up to 70 per cent is not uncommon. During the financial crisis, this of course had dire consequences for many investing businesses, especially in the SME space, where the spread of any portfolio is generally quite narrow, and risk concentration can be a major concern.

The investment opportunity

Ostensibly, investing in real estate makes good sense. Take, at the simplest level, the following example:  you decide to expand your office space to accommodate a growing business, so rather than look for rental offices, you decide to buy a small office complex and source a commercial mortgage. You will be able to rent the other units and cover about 90 per cent of costs – and in the meantime, you have an asset, the value of which will, in all likelihood, go up. In time, you will also be able to refinance the office block in order to boost cashflow or finance further investments – and while doing so, you will retain ownership of the development. There are only two apparent risks: either the value goes down, not up (as many investors experienced during the financial crisis); or once you have paid for the property you sit on a ‘dead’ asset and fail to release its cash value back into the business.

There are two other investment models:

• A commercial property fund. This entails either a one-off or regular payment into a ‘unit trust’ model that is an amalgam of many different properties. It gives you returns against a rise in their averaged price. While simple – working in the same way as an institutional pension fund, for example – the drawback is that you don’t have one specific property to utilise.
• Membership of a property syndicate. This lets you join forces with likeminded businesses and buy a share in a property that you would otherwise not be able to afford. You will have vote in what happens to the investment, and when. This is an instrument most frequently used by larger businesses (enterprise level) looking to build a property portfolio in niche market verticals with a high re-sell value.

What will you invest in?

There are five main types of commercial real estate, namely –

• Office Buildings – This includes single‐tenant properties, small professional office buildings, downtown skyscrapers – and everything in between!
• Industrial – This category ranges from smaller properties, often called ‘Flex’ or ‘R&D’ properties, to larger office service or office warehouse properties. It also includes the very large ‘big box’ industrial properties.
• Retail/Restaurant – Sites on high streets, single tenant retail buildings, small neighbourhood shopping centres, larger centres and malls.
• Land – This describes investment properties on undeveloped, raw, rural land in the path of future development. Or, infill land within an urban area.
• Miscellaneous – A bigger category than you might think and including non-residential properties such as hotel, hospitality and medical.

Each of these has its advantages and disadvantages. The deciding factor is likely to be entry-level cost – so for example, a custom-built hospital premises might be an excellent investment opportunity, but is likely to be well beyond the budget of a business with only modest sums to invest.

You might also be unlikely to invest in buying land as such unless you are a specialist developer, since this will involve all kinds of clearance, civic development and licensing issues far beyond the realms of a simple opportunistic investment.

How a direct real estate investment works

Properly managed, a commercial real estate investment can –

• Infuse a business with cash at key times, averting income shortfall ‘hotspots’ and boosting cashflow
• Provide collateral for future borrowing
• When sold successfully, contribute a significant lump sum
• Provide an additional working environment in a key location

But this means working with the basic dynamics successfully, eg, managing and understanding crucial factors like –

• Cash inflows
• Cash outflows
• The all-important timing of these fluctuations, which must run in opposition to standing costs and incomes in order to smooth balance sheet behaviour
• The need to appraise and mitigate risk

Cash inflows and outflows are the money that is put into, or received from, the property including the original purchase cost and sale revenue over the entire life of the investment. Cash inflows include the following:

• Rent
• Operating expense recoveries
• Fees: Parking, vending, services, etc.
• Proceeds from sale
• Tax benefits (where applicable)
• Tax credits (e.g., historical)

Whereas cash outflows include:

• Initial investment (down payment)
• All operating expenses and taxes (where applicable)
• Mortgage or loan payment
• Capital expenses and tenant leasing costs
• Costs upon Sale

The timing of cash inflows and outflows is important to know in order to project periods of positive and negative cash flows. Risk is dependent on –

• Market conditions
• Current tenants, and the likelihood that they will renew their leases year‐on year.
• Physical risks such as fire and flood
• Natural depreciation
• Security and theft issues

Businesses need to be able to predict the probability of the cash inflows and outflows being commensurate with the amounts predicted. Also, what is the probability that the timing of them will also be as predicted? What is the likelihood that there may be unexpected cash flows, and what would be their value?

These uncertainties – classic issues of management accounting – will also be impacted by economic shifts such as interest rate hikes and arbitrage/currency dilemmas in the case of a business operating across borders. In terms of commercial real estate investment, aspects of this kind can –

• Put renewed pressure on valuations
• Complicate loan refinancing
• Impede and delay debt servicing

The overriding factor to keep in mind is that once an SME starts to deal seriously in the realm of commercial real estate investment, it can prove to be a considerably labour intensive strategy. So, do you have the accounting and risk management expertise to move wholeheartedly in this direction? If the answer is yes, there is still no greater catalyst for growth and wealth creation.