I’ve just got around to reading the findings of the IPF-commissioned An Investigation of Hurdle Rates in the Real Estate Investment Process carried out by a team from Cambridge and Aberdeen. Focussed on, er, hurdle rates, it provide a good overview of the challenges of applying mainstream financial theory to commercial real estate practice. An added bonus is the good contextual material on the institutional investment processes. Of course, they really should have referred to some outstanding previous work for the IPF that address similar topics 🙂
Different types of real estate asset were captured quite well.
Following Brennan and Trigeorgis (2000), there are effectively three types of investment projects. In the first, the investment manager is confronted with a project that has exogenous cashflows that cannot be altered by the manager in the future. In real estate, such a project would include some of what are called ‘core’ investments and would correspond to a fully rented building with long-term rental contracts. Corporate finance textbooks are very clear about the investment criteria that should be used for projects of this type. In the second type of investment project, future cashflows can be altered by the manager. In real estate, such types of project would include those that are called value-added or opportunistic, depending on the degree of flexibility that the project brings. A building with vacancies that can be filled or that has rental contracts that can be adjusted in the future would also be such a project. Another example would be a piece of land that the owner could develop in the future. The landowner knows today that she will wait for the best moment in the future and this makes the cashflows endogenous. Corporate finance theory prescribes that real option models provide the appropriate investment criteria in this situation. In the third type of project, strategic interactions between market participants play an important role. For instance, two developers might be interested in opening a new shopping centre, but only the first will be profitable.
This really chimes with something that I’ve tend to bang on about in our real estate asset management modules. There’s a lot of variation among real estate assets in their potential for active asset management or adding value (alter the cash flows). This is really due to variations among assets in building quality, intensity of site development, tenant numbers and qualities, (unexpired) lease terms, local market conditions, intensity of use, location etc.
There’s a strong relationship between asset quality/risk and active asset management/added value/real option opportunities. High quality/low risk (core) assets tend to have little potential to add value by asset management (alter the cash flow). Assuming that the core asset is fairly new, and high spec, tenants have strong covenants, best-in-class services are in place at competitive prices, weighted unexpired lease terms are long etc. It is pretty difficult for even the most brilliant asset manager to add value by changing the building, the tenant, the leases, the service offer etc.
In contrast, higher risk/lower quality assets often require upgrades and tend to have potential to add value by increasing density (extending or reconfiguring the building), using the building more intensively, upgrading and updating the building and the infrastructure, improving the service offer through efficiencies and/or additional services, improving tenant quality and mix, improving lease quality etc. In particular, where local market conditions are buoyant and leasing conditions are favourable, there can be significant rental and capital value uplifts from ‘re-positioning‘ assets.
Such real options tend to be easier to identify with hindsight and much harder to put a value on.