When considering real estate investment types, a variety of factors influence the stability of your cash flow. Those factors also influence your upside potential and overall projected return. One factor is the amount of property improvements necessary in the early stages of your investment to achieve your intended results.
Some assets have a consistent or long-term tenant base in place. Upon acquisition they may require minor or no improvements to preserve a steady cash flow. Properties that are undeveloped, or require substantial renovation or market repositioning, do not immediately generate distributable cash flow. However, they are more likely to appreciate significantly upon completion of the improvements. Existing operating properties that need some meaningful improvements to optimize cash flow represent a middle point in the range. Properties in every asset class fall into these categories, including both residential and commercial.
Stabilized cash-flowing properties are assets that have tenants in place. They do not need major repairs, replacements, or other substantial physical or operational improvements for the foreseeable future. Occupancy is high at the time of acquisition, at or near 100%. If these properties are also located in established markets, they are referred to as “core” investments.
From a financial planning perspective, these types of properties have the most predictable distributable cash flow. If commercial tenants have multi-year leases, the leases will specify your monthly or annual base rental income. The leases also indicate the nature and extent of reimbursement obligations for operating expenses. They specify each tenant’s real estate taxes and insurance costs through the end of the lease term. Absent a change in tenancy or modification of leases, you can calculate expected net operating income for several years.
You might hold the property beyond the term of the current leases, including residential properties where leases typically expire annually. Market data can help predict occupancy, real estate taxes, operating expenses, and rent increase for future tenants. As an owner, your primary focus is keeping the property leased, maintained, and properly managed. Core properties are among the more conservative forms of real estate investment.
You may also encounter opportunities to purchase property that requires some additional work to achieve stabilized profitability. Improvements could include the following:
These types of projects are “value-add” opportunities. The owner infuses capital and/or expertise to reposition the asset in the marketplace. Investors profit from the infusion of capital and energy in value-add projects. Depending on the nature and extent of the intended upgrades and on your capabilities, you may benefit from sweat equity. However, most investors rely on real estate professionals to manage and perform value-add projects for commercial and large residential properties. If you consider this type of real estate, vet the professional’s experience and track record. Look at his projects of similar scope in the same geographic region. Be sure to analyze the economics of the proposed improvements. Be sure you understand zoning requirements before changing the use of an existing property.
To project income from a value-add strategy, you will need to know the cost of intended improvements and corresponding rent increase or sale profits you are likely to realize after changes. Certain types of improvements can add curb appeal, an attractive first impression, But some are not good investments if you are unable to recoup your costs through increased rent or a higher sale price.
For example, natural stone vanities may be more durable and appealing than laminate. However, consider whether the demographics of your rental pool support a rental rate to cover the replacement cost. If the upgrade is unlikely to improve the tenant’s business, for example, the sink is used by employees rather than customers, you may not recover the cost when you sell. Additionally, consider the amount of time needed to do the work, especially if that will impact tenants’ use of the premises or your rental stream.
While value-add work is ongoing, distributable cash flow may be unavailable. Lender and owner reserves may be high.. Take this down time into account in your projections. A well-executed value-add strategy can pay for itself, generating higher cash flow and increased sale price when improvements are complete.
Development or opportunistic projects typically involve ground-up development or substantial construction at the onset. Net operating income in place at the time of purchase will likely stop altogether as improvements get underway.
Compared to real estate investments that provide early cash flow this type of investment requires special considerations:
These factors may significantly impact any real estate investment. Labor and materials shortages, for example, can affect even a stabilized property that needs employees. Market trends, such as increased flexibility to work from home and the need for services outside of central business districts, may impact performance across a variety of asset classes. The more development needed, the greater the effect of these uncertainties.
As a consequence, pro forma projections for an investment in a development project are speculative. They are shared with investors and lenders based on information available before the project begins and revised as circumstances change. The projections primarily illustrate financial milestones like financing, lease-up and rent stabilization. They consider the upside potential for the investment. They sometimes represent the sponsor’s best guess about when each milestone may be achieved and the corresponding economics.
Development project sponsors and investors focus on expected IRR (internal rate of return) and EM (equity multiple) rather than cash-on-cash yields. IRR measures the percentage rate of return earned on each dollar in a specific time period., EM measures how much cash the investor will get back in relation to the original investment. One measures the time value of the investment and the other measures absolute returns. These metrics reflect assumptions about the future value of the improved property as well as the anticipated market at completion.
Development investments will always deviate from original projections. They are not for the faint of heart nor for investors looking for a current or near-term income stream. However, they can be a lucrative use of funds if you are willing to forego current cash flow for potentially significant return. The greater risk can result in greater rewards.
In many instances, development projects assume that the project will sell when work is complete and operating income is stabilized. Stabilized means that tenants occupy most of the building. In other cases, the developer refinances or recapitalizes the property upon stabilization. The developer makes a distribution of proceeds to investors, and then owns and operates the property into the future. Investors should understand the intended and fallback strategies for anticipated exit, but be patient and flexible as to timing.
In sum, development projects can be a good way to add diversity and overall return to your personal portfolio. You have to be willing to accept the heightened degree of risk and be flexible. If you like predictability or want current cash flow, look for real estate investments in stabilized properties. Value-add projects offer a balance between providing a stream of income and obtaining meaningful profit from strategic improvements.
Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on July 8, 2019, and was most recently edited by James Howley]
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Tracy Treger is Principal at Syndicated Equities. Tracy helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas of…
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