Commercial Real Estate as Investment

by Dan Nillen

RealEstate_1113Across the country, commercial real estate companies are finding that managing a portfolio is a particularly challenging task in today’s economy. The following best practices demonstrate that effective portfolio management starts with the development of a thorough review process that allows a business to respond to opportunities in the market.

Frequent Reviews Are Critical

Although many in the real estate industry feel they have their fingers on the pulse of their portfolios, at the heart of any successful portfolio management program is a thorough review process. Regular reviews — at least quarterly — can help companies consider different investment approaches, monitor interest rates and, in the end, apply effective credit management techniques to minimize market risk and maximize profits.

One of the most important reasons to frequently review a portfolio is to stay nimble in a rapidly changing interest rate environment. Beyond interest rates, other issues demand regular analysis of real estate investments, including market fluctuations and how a portfolio evolves.

Tenets of Review Process

Because interest rate shifts can ultimately boost risk exposure, it is essential that real estate developers examine a portfolio’s risk factors and how they impact a balance sheet. Primary considerations in the review process include:

Interest rate risk. Even a small interest rate increase or decline can significantly affect real estate portfolios with millions of dollars in primarily floating-rate debt. To mitigate risk on rates, the real estate developer may want to consider purchasing an interest rate swap, cap or collar, or look into rolling into a fixed rate.

Debt maturity. It is vital to look at maturity dates within a portfolio. As loans mature, it may be necessary to recalibrate the portfolio with new and different financial instruments. The preferred effective practice would be to stagger maturities to avoid overburden on staff, and, therefore, have ability to adjust to the market.

Plans for a property. What are the plans for a particular property, and how will it be used? An investor who aims to retain an asset over the long term has different needs from one looking to sell within a year or two. The use of liquidity comes into play on where the investor wants or needs to place his cash over the coming 12 to 24 months.

Portfolio make-up. Apartments and retail spaces have entirely different cash flow models. An apartment complex likely would provide predictable cash flow due to the surging rental market, but the retail establishment may prove highly variable — depending on whether it’s leased or empty. Being overweight in any asset class may make a portfolio susceptible to market risk, but adding asset diversity (multi-family, retail, office and industrial) can help offset some of that risk. The end goal is to match the debt to the property.

Focus on Liquidity

In many instances, matching debt to the property means turning to a combination of loan instruments that include fixed and variable rates — as well as interest rate swaps, collars and caps. Swaps allow the synthetic conversion of interest-sensitive loans into fixed interest rates. Caps establish a ceiling for future interest rates through the payment of a premium. Collars are hybrid structures that establish both an interest rate ceiling and floor, and allow the rate to remain interest-rate sensitive between these two parameters.

These devices offer a high level of flexibility and a range of options in all interest rate environments. They also can help an investor build a portfolio that provides liquidity at strategic points to help commercial real estate companies realize other business goals.

Unfortunately, this holistic approach to investing is too often overlooked. Consequently, a developer may lack essential capital 5 or 10 years down the road. To avoid this scenario, an investor can ask the following questions when building a portfolio: What are my plans for this property now and at various points in the future? Will additional projects or properties demand liquidity? What is my overall tolerance for risk, and how can specific properties, as well as the entire portfolio, affect this?

In the end, it’s important for portfolio managers to make sure all of the business partners they work with thoroughly understand the industry and how to best approach commercial real estate investments. Portfolio management is a critical element of an overall business plan that successfully minimizes risk and maximizes profits.

Dan Nillen is regional senior vice president and director of BMO Harris Bank’s Commercial Real Estate division for Arizona.

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