Last spring, I spent a few weeks in Rome, Italy. As a history enthusiast, I enjoyed the city and its archeology, and like many tourists, I booked a Colosseum guided tour. There, I learned that one of the world’s oldest and well-known structures was built by Judean slaves to commemorate the Roman victory in the Jewish-Roman Wars (The Great Revolt). The Roman Emperor, Titus financed the construction of the Colosseum with spoils he had looted from the Jewish Temple in Jerusalem… Not many are aware of this historic fact! It appears that Israeli funding and staff, Italian architects and tough management can create impressive real estate that will last for many years…
Investment Update: In Sky Rock we’ve joined an acquisition of a $54 Million Class B Multifamily with 366 2BR-3BR units. The complex is located South of Washington D.C., a 25-minute drive from Capitol Hill and a 20-minute drive from Amazon HQ2 in Crystal City. The business plan includes extensive CapEx and upgrades that will allow for lease upgrades. Due to the rapid rise in rents in the area, new leases are already higher than the original plan.
In GREI we’ve completed the upgrade of two Multifamily properties with 64 units. The work consisted of interior upgrades, structural foundation repair to enable the rehab of 12 hard down-units and the installation of individual water meters.
When analyzing income properties, analysts usually conjecture two streams of income:
Cashflow from operations. This is a sound assessment based on past performance and comparing the property to relevant benchmarks in the area.
Revenue from selling or refinancing the property. This estimate is based mostly on speculations that range from realistic to hopeful, since no one knows what the market will look like in 4 or 5 years.
Since it’s more valid and current, investors should examine closely the cashflow from the operating income. Operating income stems mainly from rent. Therefore, it’s necessary to evaluate current and post-CapEx rental income. However, certain proceeds rarely get the necessary proper attention during the planning phase. It’s called Ancillary Income and it’s very important to the cashflow.
What are the main sources of ancillary income? According to the National Apartment Association, these are Application Fees, Admin Fees, Parking/Garage, Pet Rent, Security Deposits, Redecoration Fees, Trash, Storage, Utilities (regulations apply), Washer/Dryer, Pest Control, Short Term Lease, Early Termination, Damage Fees. There are obviously more.
Each item by itself isn’t a major expense to a single residential unit. But multiply a few items with a few hundred or thousands of units and you end up with serious injection to cashflow. In addition, undercharging for such items means that the expense is subsidized by the landlord. Unfortunately, this part often doesn’t draw proper attention. Responsible property management and analysts won’t overlook this income.
The real estate market was very kind to investors in recent years. Low interest rates and the availability of funding have led to substantial gains in real estate. Rising interest rates have created other, more liquid alternatives. This combined with the uncertainty about the economy, slowed the pace of investments during the first few months of 2019. Contrary to the grim outlook, the U.S. economy grew 3.2% in Q1. But recently, mortgage interest rates went even lower and the market began to sizzle again. Still, with the ‘right pick’, US real estate can be an attractive solid investment. The key here is ‘right’. What’s right for you?
The answer depends on the level of risk that you’re comfortable with. High risks can generate high returns and vice versa. Currently, a Risk Free 10-year USD treasury note yield is 2.00% annually. Less than that is an outright loss. Recent indications by the FED that interest rates won’t continue to rise have fueled the real estate market and cap rates took a dive again. The bad news is that nothing lasts forever, and investors should be aware of risks and how to limit them.
So, how to limit your real estate investment risks? One of the practices is to enter a Defensive Position. The term “defensive” refers to protection against any fluctuations. But most people only want to protect themselves against downward trends. No one really wants to protect themself against good scenario, except maybe for options and derivatives pros, right?
US Multifamily is traditionally a defensive/solid branch of real estate. It’s considered low risk (residential) and the returns are predictable according to the asset class. But it requires intensive care. This is contrary, for example, to the Office Market, which is generally considered less safe but also less complicated to manage. To avoid Multifamily headaches, you should team up with a good Property Management company.
Private Equity Funds also look for hidden treasures in “Value Add” properties. This term usually relates to a capital investment that may generate higher returns by physical improvement. i.e. interior upgrades or development. This way, a low-risk, low-yield investment, can upgrade itself.
An Aggressive Position, on the other hand, would be to invest in high leverage, ultra-luxury NYC condos. Such an investments should generate high returns but also a risk of loss. In such a case, expect many sleepless nights. But there’s absolutely no place like Manhattan for sleepless nights!
Interesting? Great! Let’s examine some traditional defensive tactics:
1. Spread: a customary "safe" tactic is investing in properties that are less susceptible to recession. For example, an office building with AAA tenants (strong) and NNN leases (tenant pays all costs). So, investing in a company that owns office buildings, rented by the US Government or a large bank, may be considered a defensive investment. In such a case, you can be assured that you have a large and strong tenant that will stay and pay. Rent is guaranteed and the investment is safe. Is it really?
Example of how things can go wrong: Assume that you’ve invested in a property rented by the Army for 20 years at a solid return of 4% annually. The Army is your partner and that’s as safe as they come. You can invest your entire retirement plan there. Right? But we know that Governments write their own rules and for such a good tenant, you may face a non-negotiable clause called Termination for Convenience. The Army may simply terminate the agreement. Even if you have a case, litigation with the Government can be long and expensive… And if, for example, your tenants are servicemen, they may also find themselves deployed, without warning, to the other side of the world. The families that were left behind still live in the property but may stop paying rent due to the situation. And so the property has no income, but the holding company owes money to local authorities and the banks. By the way, don’t even think of evicting and replacing non-paying families of an active serviceman. It isn’t only immoral, it’s illegal. Read the Servicemembers Civil Relief Act.
Another example: You’ve invested in a large office building, leased by one of the world’s largest banks. Everyone is envious and wants to be in your shoes. Right? You may want to check with Savanna – owners of the Citigroup Building (One Court Square) in New York. This famous tower has been associated with the bank for years. Recently, Citi took a decision to relocate. We don’t need to worry for Savanna, but I don’t think they popped a Veuve Clicquot when they heard the news!
The examples above demonstrate that even with safe and solid assets, you want to “buy insurance” in the form of spreading your investments over many properties. Most people don’t have the capital that enables them to buy tens/hundreds/thousands of properties and can only achieve this spread by investing in experienced and reputable real estate funds, that invest in many properties, or REITs that have a diversified portfolio, or buying shares in a large real estate holding company, etc.
2. Low Risk Profile: There are a few main categories of Income Generating Real Estate: Residential, Office, Retail, Industry, Logistics and Infrastructure. You may obviously add and break it down into many more segments, but these are the prominent ones.
Residential Real Estate is considered the safest because it’s considered resistant to bad times (not to be confused with Residential Real Estate Development, which is different and considered higher risk). Even in a fragile economy, people still need a roof over their heads. Rents may fall and vacancies may rise, but it’s unlikely that the property will become empty.
Offices, on the other hand, are more sensitive to economic conditions. Office landlords may find themselves without a tenant for long periods. U.S. office vacancy rates are now at 16.7%. This is equal to 2 months out of a year. Or more likely, every 5 years the office will be vacant for a year until a new tenant comes in with new requests and capital adjustments. Even WeWork, that came up with a flexible triumphal model, sustains 20% vacancies…
Retail was once an attractive category. But US malls are currently undergoing a serious crisis and store closures are on the rise.
Industry and logistics are different because the structure may be tailored to a specific long-term customer that will stay for a long time. But when they move, the property may end up empty for many years.
3. Low Leverage. Financing is the oxygen of real estate. They say “a banker lends you his umbrella when it’s sunny and wants it back when it rains!” In good times you can buy real estate with 10% down. But when ‘the rain’ comes down (i.e. Interest rates rise, cashflow isn’t enough, property is devalued, etc.), you’d be facing a tough banker who’d insist on receiving the monthly payment... Many investment bodies won’t leverage more than 70% of the property. In a defensive position, the LTV will drop to less than 50% to make sure that monthly payment would relatively be low and won’t jeopardize the asset even when revenues are unstable.
4. Personal Guarantee: In many parts of the world, it’s tough and Non-Recourse loans are reserved for strong public companies. Most mortgages are secured by a personal guarantee and additional collateral. In the US, Non-Recourse is more popular and if you haven’t been a Bad Boy then the bank won’t foreclose on your other assets.
5. Location: Real estate investments are safer in condensed urban areas. Governments spend money to convince investors to invest in remote frontiers for a good reason. In those areas, the yield must be much higher and reflect low demand and high vacancy. Urban areas generate a lower return, but so is the risk that the property will become vacant. Even run-down bad looking apartments won’t stay empty for a single day if located in the center of New-York, London, Berlin or Tel-Aviv.
These are just some of the ways that private investors may limit their exposure to real estate risks. Professional bodies obviously have access to other mechanisms, such as foreign exchange hedging, risk analysis, flexible leverage, timely reviews, fast response and agility, financial endurance, exclusive data, etc.
This publication is personal and not for general circulation. It does not form part of any offer or recommendation. It does not take into consideration investment objectives, financial situation or needs of any specific person. Prior to committing to an investment, please seek advice from a licensed professional regarding the suitability of the product for you and read the relevant product offer documents, including the risk disclosures, If you do not wish to seek financial advice, please consider carefully whether the product is suitable for you.
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