Low interest rates on fixed income investments have led many fund managers to invest in commercial real estate as an asset class that offers attractive risk-adjusted returns.
While real estate investments offer yields at a premium to Treasurys and lower volatility than stocks, investing in commercial real estate presents its own challenges. Shielding these investments from economic cycles is one such challenge.
Don’t over-leverage: We all know that leverage is a double-edged sword. Keep the loan-to-value (LTV) ratio on the conservative side. An LTV of 50-60 will protect the ability to hold the assets when rates are rising, while an interest only mortgage can ensure that cash flow is used to meet interest payments. Excess cash flow can be distributed as ROI with considerable tax benefit. Taken together, these measures should foster a better after-tax cash return.
Keep an eye on your assets: To invest successfully in commercial real estate, the asset selection process needs to be prudent and exacting, particularly in terms of monitoring the demographic and economic profiles of the area in which the property is located. Micro and macro analysis should be ongoing to monitor to the asset’s ongoing risk profile and relative value. Moreover, given the unpredictability of economic conditions, remember to keep on eye on selling opportunities as well.
Be realistic about returns: The market for commercial real estate is highly efficient, and transactions where risk and return are not efficiently correlated are rare. The level of return considered reasonable by an asset manager can vary, but the ideal minimum current cash flow on commercial real estate is 6.5% with potential long-term growth that equals or exceeds the rate of inflation.
Make sure clients understand what percentage of the asset they own: Investors need to receive a preferred return before the manager shares in income or profits from the sale of the asset. Make sure your clients understand the terms of the investment clearly.
As always, the manager’s compensation should be based on the success of the investment: Your clients’ success is your success. Ensure that there are no hidden fees or undeclared expense allocations that direct cash to the investment manager. It goes without saying that transparency is the key to integrity.
For more information, please read:
Five Ways to Protect Real Estate Investments and Survive Multiple Economic Cycles | WealthManagement.com