Table of Contents
The 6 Crucial Factors
- 1) Information is King
- 2) Requisite Knowledge and Experience
- 3) Adopting a Realistic Time Horizon
- 4) Calibrated Use of Levarage
- 5) Access to Deals
- 6) Strong Execution Capability
Real Estate Co-Investment as an Alternative
Real estate as an investment asset class is alluring for a number of reasons. In addition to being a tangible asset, real estate provides recurring a passive income, an effective hedge against inflation, as well as significant risk diversification benefits from the traditional asset classes including a potential appreciation in capital value. Yet, it is also an asset class where investment pitfalls and challenges can be underestimated, often to detrimental consequences.
The major role that real estate plays in our lives – whether at home, work, or play – makes properties highly relatable to just about everyone. Consequently, some might be lulled into thinking investing in real estate is relatively easy due to this familiarity. This is a dangerous misconception. In this article, we have distilled six critical factors from our years of practice in the institutional real estate private equity space that we hope can help property investors achieve better results. As it turns out, property investing is a lot more than simply “location, location, location”.
The 6 Crucial Factors
1) Information is King
Unlike listed stocks and bonds, real estate is an asset class that is relatively less transparent and never homogenous. In certain markets, data points are often lagging, incomplete, and not always a true representation of the current market. To illustrate the last point, while official government data are usually reliable, their scope may be too wide. Statistics tracking the entire office sector may not be best suited for the purpose of evaluating investments in specific segments of the market (e.g., there are limitations to using island-wide office data to assess the Grade A segment in the CBD of Singapore).
Compounding the matter further, information goes beyond just mere statistics. Per-square-foot price comparisons do not account for differences in build quality, efficiency of floor layouts and design. Headline transaction prices can also be distorted by wide variations in the terms of purchase such as rental guarantees, non-monetary discounts (eg. “free” interior design or furnishing packages) and deferred payment schemes. Gross rental levels may not reflect leasing incentives such as fit-up subsidies, rental guarantees and number of rent-free months.
By now, it should be clear that getting access to information, and the “right ones” for the matter, is hardly a trivial task even in the most transparent of markets. Yet this information asymmetry is often a critical factor that separates successful investors from the rest.
2) Requisite Knowledge and Experience
Assuming an investor is able to muster the data in the aforementioned point, he or she now needs to organise and process them into information which informs the investor of the likely future performance of each real estate opportunity.
On one hand, real estate serves the needs of space users (we call this the physical market). Rental levels and trends depend on a multitude of factors with significant overlap and interplay that eventually feed into demand and supply. These factors include, but are not limited to, the economy, demographics, government policies, local specific factors such as infrastructure developments etc. On the other hand, real estate is also an investment asset class (the capital market). Similar to any other asset classes, it is influenced by a wide range of factors including interest rates, capital flows, liquidity, macro asset allocation etc.
Navigation of both the physical and capital markets aside, the challenge is further compounded by several other considerations.
a) Real estate is a heterogeneous asset class. Every property is unique and influenced by many locational, historical and cultural attributes. Two properties along the same street can have vastly different capital values.
b) Property investing is very much a local business. Top-down and bottom-up analyses may not always corroborate. Investors need to take into account both approaches and interpret contradictions that arise.
c) The cyclical and dynamic nature of real estate markets require constant monitoring and active management.
Given the vast array of complexities, real estate investing is both an art and science that draw upon a requisite multidisciplinary skill-set and years of experience. Without sufficient knowledge, investors are putting a lot at risk, especially with the large capital outlays traditionally associated with this asset class.
3) Adopting a Realistic Time Horizon
Investors of real estate need to be prepared to take a relatively longer investment horizon as compared to some other asset classes for a range of reasons.
a) Depending on the underlying investment theses, market drivers (eg. improving infrastructure, changing demographics, increasing wages etc.) often take time to feed through to the real estate market. Value-creation strategies require time to execute as well.
b) Rental income yields are often an important driver of returns and it therefore makes sense to hold on to the asset for a meaningful period of time to benefit from the investment.
c) Crucially, there are significant costs associated with real estate transactions (e.g., brokerage, legal and administrative costs, statutory costs etc.) such that they significantly impact upon quick in-and-out or 'deal flipping' strategies.
It is for these reasons that close-ended real estate private equity funds serving sophisticated institutional investors typically have a fund life of at least five years, if not more. Being prepared for a realistic investment horizon can make the difference between a successful real estate investment and a disaster.
4) Calibrated Use of Leverage
Appropriate employment of financial leverage is absolutely critical to achieving success in property investing but it is a double-edged sword that can increase both winning and losing positions in an investment. Because the cost of debt is lower than the cost of equity, the inclusion of debt reduces the overall weighted cost of capital and amplifies any returns on capital. Further, the capital intensive nature of real estate investing may tempt investors to load up on debt in order to minimise their capital outlay.
But leverage comes with risks that investors need to appreciate. Payment of principal and interest is a regular commitment and therefore adds to investment risk. This risk gets magnified when the market is going through a downturn, especially if a property is leveraged to the hilt. Investors can easily find themselves in a negative cash flow situation where the rental income generated is insufficient to service the debt.
Even worse, there could be times when rental income is zero if the tenant leaves or goes into arrears. Cash flow issues aside, any adverse market movements triggering a fall in capital value of the asset could result in the loan-to-value (LTV) covenant being breached. In both aforementioned scenarios, investors would need to stump up more capital to either service the cash flow shortfall or make good the LTV ratio to avoid seizure of the property by the lender.
5) Access to Deals
When it comes to property investing, there is a natural tendency for investors to stick to their home markets due to home bias and the lack of familiarity with other markets. Yet, savvy investors consciously cast a wider net and do not restrict themselves to just one market for two main reasons. They understand the value of diversification especially as property markets undergo cycles. Equally important, having a larger opportunity set naturally translates into increasing the probability of landing a good deal.
Nevertheless, investors should not be tempted to plunge into overseas properties from the get-go without the requisite know-hows alluded to earlier in this article. Rather, investors need to devote considerable time and effort into acquiring the necessary knowledge and developing their deal flow channels in order to enlarge their investment universe. For investors looking to accelerate this process or are unable to afford the commitment, an alternative would be to invest alongside other experienced investors while ensuring all stakeholders’ interests are well aligned.
6) Strong Execution Capability
As opposed to equity or fixed income investments where the only options available to investors are the timing of entry and exit, successful direct property investment requires active asset management. From property management, deal negotiation, capital stack optimisation, securing of tenants, lease structuring, carrying out asset enhancement to the eventual divestment, there are many areas that property investors can play an active role to drive returns for their investments. Execution capability can significantly impact upon the eventual returns from property investments and is an important factor that separates successful investors from the rest.
Real Estate Co-investment as an Alternative
In conclusion, while real estate is an asset class that many find easy to relate to, it is dangerous to underestimate the pitfalls and challenges of direct property investing. Sustainable success in direct real estate investing entails the amalgamation of a range of critical success factors that we have hopefully summarised in this article. For all the benefits that the asset class yields, acquiring and building up the broad range of requisite skill-sets is a demanding and intense task.
Given these challenges, it is little wonder that real estate co-investment platforms have proliferated since their inception. Nowhere is this more salient than in the US where real estate co-investment has exploded despite the US having one of the most developed and deep REITs markets in the world. This impressive growth is testament to the value that such platforms offer investors. As an increasing number of real estate professionals with institutional backgrounds and established track record enter this burgeoning market segment, investors can now access the necessary expertise that were previously out of reach or would require considerable time and effort on their part to acquire.
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