September 2018 | 

Peeling Back the Layers of Commercial Real Estate Investing

Peeling Back the Layers of Commercial Real Estate Investing

A new program helps seasoned institutional investors and other professional financial advisors refine their ability to identify and manage the risks of real estate booms and busts — no matter what the market or the economy is doing.

The commercial real estate sector is attracting more interest among investors lately. A recent McKinsey report noted that today’s pension and mutual fund portfolios typically include real estate assets, which can add good diversification. Last year, institutional investors’ target allocations to real estate averaged 10.1 percent, edging up from 9.9 percent in 2016, according to National Real Estate Investor. Retail investors are even getting in (perhaps unawares) — real estate was recently added as a standalone sector in the S&P500 and comprises nearly 3 percent of that index.

Real estate often promises a stable dividend and some capital appreciation. But the down side of real estate investing is the potential for higher risk, and the difficulty of parsing it out. While some real estate investments compare favorably to conventional assets such as stocks and bonds, a glance at the headlines can also reveal troubled projects like the partially completed Exchange 106 — the tallest tower in Southeast Asia — from which $4.5 billion in state funding went missing, according to the Wall Street Journal. The reverberations of flubbed deals extend beyond the region: future Exchange 106 tenants include international companies such as British financial services giant HSBC.

Savvy professional investors realize that successfully investing in real estate requires special expertise. The sector has unique advantages and pitfalls, not to mention its own language, risk and return structures, and investment strategies. Plus, the term “real estate” covers a lot of ground (so to speak), according to Wharton’s Professor Todd Sinai, who is launching the new Assessing Commercial Real Estate Investments and Markets program to educate investors on the subject.

Real estate, Sinai says, can encompass very different kinds of investments, each with its own distinct risks and returns that can only be figured out by digging beneath the surface of the deal. Indeed, properties that physically look the same might actually have completely different investment risk profiles based on their location, current occupancy level, ownership/management structure, and existing debt. “You could have two office buildings in San Francisco right next to each other, one of which will get destroyed if there’s a real estate crash, and the other will sail through fine,” says Sinai. “And you wouldn’t have been able to tell by looking at them from the outside.”

Although the investment returns on real estate can be outsize for investors, knowing what to look for in an investment and how to mitigate risk is crucial. Sinai says a deeper understanding of real estate confers a substantial advantage on investment officers, fund managers, financial advisors, and others considering expanding their portfolios in the sector. The next time they encounter an opportunity or attend a presentation, these individuals need to be able to “see through the real estate prospectus to understand what are the drivers of the return they expect to get, and what are the risks they will be taking,” Sinai says.

Sinai emphasizes that real estate investors should be thinking about cash flow. “Some real estate may be pretty but may not actually deliver any value,” he said. “It doesn’t really matter what it looks like. It’s all about the cash you’re getting from it.”

A number of factors influence that cash flow. One consideration is location (as in the adage that what’s important about a property is “location, location, location”). So is the availability of potential tenants. Sinai illustrates with both a safe and a high-risk scenario: “If I have a building that already exists, in a city that’s thriving like New York, with a deep-pocketed tenant — let’s say Procter & Gamble — and they’ve signed a lease with me for 20 years, that is a really safe tenant cash flow.”

“On the other hand, if I’m looking at buying a half-empty retail mall in Kansas City with a declining department store as one of the few tenants, I would have to re-position it,” Sinai says. The investor might have to change it into some other type of asset, invest more money, or find new tenants, says Sinai. “Then the future cash flow is very uncertain, much more risky.”

Beyond the differences across individual properties, savvy investors understand the economic drivers of the real estate sector. “Demand for real estate is determined by economic growth,” Sinai says. “There is no need for more office buildings without employment growth, and there are no malls without shoppers.”

The hunt for growth also means that investors should be open to real estate opportunities globally. “A global approach increases the scope for finding opportunities,” Sinai says, “but it also brings a whole new set of risks. Investors need to think about currency exposure, counterparty risk, and whether their investment is protected by the rule of law.”

Sinai notes that investing in real estate isn’t limited to direct investment such as buying a building or a piece of land. Other options, he explains, include investing in public equities (such as a real estate investment trust, or REIT); lending to real estate developers or investing in real estate debt; or investing as a limited partner in a company or private equity fund that acts as the general partner in a real estate deal. “All those methods have their own pluses and minuses, pros and cons,” Sinai says.

The real estate sector can be volatile, but Sinai cautions that this program will not be about how to buy low and sell high. Instead, he says the program is designed to help seasoned institutional investors and other professional financial advisors refine their ability to identify and manage the risks of booms and busts no matter what the market or the economy is doing.

In Assessing Commercial Real Estate Investments and Markets, he gives these professionals a nuanced understanding of real estate cycles and the causes and consequences of those inevitable ups and downs. That way, he says, they are armed with a high-level strategy for success in this challenging but highly profitable sector.