Commercial Real Estate Funds- an Alternative Investment
by Ken Block and Brian R. Beggs, CFA, CCIM
In the late 1980’s and early 90’s, many described the commercial real estate market as excess development supported by investor speculation and tax abuses.
This is no longer the case, as many investment advisors agree that commercial real estate actually decreases an investment portfolio’s risk profile by providing a low correlation to other asset classes. Commercial real estate can be used as a building block for investors looking for diversification and a higher return on their investment portfolio. The term commercial real estate, as used in this article, means direct ownership of hard assets as opposed to investing in Real Estate Investment Trusts or REITS. REITS have had an excellent run over the past couple of years, but their returns tend to fluctuate with the equity markets as opposed to the commercial real estate market. Since most investors do not have the experience, time or knowledge to invest directly in commercial real estate, a real estate fund may be the solution. Most well managed funds provide the investor with a portfolio of properties that match the investment objectives of the fund and, at the same time, relieve the investor of the day-to-day activities that come with investing in commercial real estate. Not all commercial real estate funds are created equal and investors need to make sure the fund objectives meet their personal risk tolerance, time frame and return expectations.
Most commercial real estate funds are structured to acquire assets by using all equity or a combination of equity and debt. If a fund uses debt financing, or leverage, the overall risk increases. It goes without saying that the higher the leverage ratio, the higher the risk. Conversely, increased leverage can lead to higher expected returns. Leverage can be utilized in many ways such as fixed rate loans, floating rate loans, or interest only loans. Depending on the interest rate environment and future projections, each form of leverage can have advantages or disadvantages. Fixed rate loans eliminate interest rate risk since the annual debt service is known for the term of the loan. Amortization of the loan requires principal payments, which decreases short-term cash available for distribution, but may significantly enhance back end pay offs. As we have seen in recent months, interest only or adjustable rate loans can provide higher cash on cash returns but interest rate adjustments may turn a “cash cow” into something much less desirable.
The two most common types of real estate funds are income and value-add funds. Income funds usually have a lower expected return because the properties acquired have relatively stable cash flows from long-term leases and good tenants. They typically have a longer time horizon, or fund life, since the primary objective is wealth building and cash flow over the long-term. Value-add funds normally have higher expected returns since the overall strategy may entail more risk. As an example, these funds look to acquire empty or partially empty buildings or older buildings that can be converted to a higher use. Once they execute the strategy of leasing or repositioning the property, they try to sell the property and recoup the investment plus a substantial profit. If the strategy does not work, the investor may lose some or all of their initial investment. The time horizon for value-add funds range from a few months to a few years.
The fund management, or sponsor, is one of the most important aspects to evaluate when selecting a commercial real estate fund. The fund sponsor must have the experience and track record to successfully adapt to market conditions and make decisions that ultimately assure that the fund will meet projected expectations. Ideally, the sponsor should have leasing, management and construction teams in house or the ability to hire the best in the business. Sponsor compensation is also very important. Are the fees similar to other funds or are they excessive and unreasonable? The sponsor’s compensation should be more back-loaded so they do well if you do well. Finally, how much equity does the sponsor have in the fund? They should have enough “skin in the game” to feel the same pain you feel if the fund does poorly.
Ken Block is Principal, Block and Company, Inc. Realtors.
P | 816.756.1400
E | kblock@blockandco.com
Brian R. Beggs, CFA, CCIM is Director of Acquisitions, Block Funds.
P | 816.756.1400
E | bbeggs@blockandco.com