Owning real estate for investment can take a little or a lot of work, depending on the type of asset you purchase. When considering purchasing real estate for investment, there are several different options to consider. These range from more passive investments, such as single-tenant, net-leased commercial properties, to more time-consuming, operational real estate.
The most passive type of investment real estate is a real estate offering managed by professional sponsors. These are typically “armchair” investments, requiring no ownership responsibilities on the part of investors once their capital is contributed.
Single-tenant, triple-net leased commercial properties also require little time and effort on the part of owner-investors. The tenant is responsible for payment for and performance of maintenance obligations, as well as payment of real estate taxes and insurance for the properties. Landlord responsibilities are generally limited to collecting rent, overseeing tenant performance (including ensuring that the tenant is maintaining the property and making the required tax and third-party payments), and keeping the property leased. When the tenant is financially strong with a long-term lease, this work is fairly straightforward.
In contrast, residential properties of all types—as well as commercial properties that have multiple tenants, or properties where the landlord has some maintenance, repair or improvement obligations under the lease—require a bit more effort on the owner’s part. These types of investment real estate include shopping centers, multi-tenant office buildings, properties with common areas that require upkeep and updating, and all kinds of apartments. Depending on the extent of services required, investors can still own these types of properties without extraordinary effort if they hire a professional property manager to handle daily operations.
Operational real estate properties, on the other hand, are among the more time-consuming types of investment real estate from the owner’s perspective.
Unlike the asset types described above, which depend on the credit of tenants signing leases (usually for a year or more), an operational property’s revenue is dependent upon the success of the property’s business.
Operational real estate properties include:
Their income stream is determined by a percentage of sales generated by the business rather than a fixed annual rental rate. As a result, very few investors choose to self-operate these types of assets, especially on a large scale.
Instead, it is most common for an operational property to have a lease in place with the operator of the underlying business. The rent is determined based on actual net operating income rather than a fixed monthly or annual rate. Rental income fluctuates with the property’s performance. Therefore, an investment in operational real estate is both an investment in the ongoing business at the property and an investment in the real estate itself.
Cash flow generated from operational real estate can vary greatly based on numerous factors, making distributable income uneven on a daily, monthly, or quarterly basis. When trying to project rents, operational real estate measures prospective income with financial reporting and metrics other than a rent roll. That can look very different, depending on the type of real estate.
Property managers for the above assets have the ability to offer customers a different rate from what they advertise online if the customer calls or shows up in person. Most operators use software designed to determine what rate should be charged based on up-to-the-minute supply and demand.
Senior facilities, on the other hand, take into account the level of care required for their residents. They could possibly move their clients to different areas within the property as their medical needs increase. Some operators require significant deposits prior to move-in, which may be returned in whole or in part if the resident passes away.
You should know and understand the metrics applicable to your particular type of operations before purchasing these types of investment real estate properties.
While there are a variety of factors affecting the bottom line in operational real estate, there are seven main factors to consider.
The normal business patterns of an operational asset presume that there will be availability for customers on an “as needed” basis. Consider, for example, a parking lot. The operator will adjust pricing based on demand. This may fluctuate significantly at different times of day and different days of the week. It is possible for several different users to occupy the same space in the lot on a given day. Fluctuations in occupancy are more likely to occur on a monthly, seasonal or annualized basis. Contrast this to a commercial building or apartment unit, where tenant turnover is comparatively lower.
Your success in owning operational real estate can also be affected by the weather. A hotel on the beach will have greater occupancy and can sustain higher rates when the weather is typically warm and dry. The occupancy and daily rate for the same room will be higher in prime season than it would be during hurricane season. Severe weather can also prevent guests from reaching their intended destination on time.
Special events, such as concerts, weddings, conventions and major sporting events, can generate business at times that would normally be less busy. They can provide a basis for elevated income during the time in question. School calendars, including breaks and moving seasons, can also impact business and cash flow.
Regulations and activities that encourage or discourage business or tourism in a particular location can directly impact the performance of an operational asset. A greater influx of people and businesses in a neighborhood can generate needs for parking, storage space and hotel rooms. A city with a robust economy is likely to attract a better and larger pool of workers to staff service-oriented properties like senior housing facilities and hotels, which can help improve performance.
In contrast, high crime in a neighborhood, taxes and other laws that make it expensive to do business in a municipality or county could make owning operational real estate a nightmare rather than a dream come true. A slump in an industry that dominates the region can also be detrimental to operating properties.
Your success in owning operational real estate is linked to the amount of discretionary funds people have available to spend, and people’s ability to travel. This point was clearly illustrated in 2020 when the global economy slowed to a trickle during the outbreak of COVID-19, causing many hotels and urban parking garages, as well as entertainment and other hospitality businesses, to notably suffer. In periods of recession (or a global pandemic), people are less likely to take vacations, or they plan less luxurious travel. Businesses may limit corporate travel or reduce participation in out-of-town conferences. People may opt for public transportation instead of driving their own cars, or vice versa, including occasions where transit workers go on strike.
Success also depends on how quickly the property’s clients with significant corporate accounts pay their bills. Businesses that rely on reimbursement from insurance companies, including Medicare, can be affected by government regulations and the availability of healthcare in the general marketplace.
Operational real estate properties are more rapidly and directly affected by competition than real estate with traditional leases. Tenants in offices, apartments, and retail centers must pay rent and honor their lease obligations during the prescribed term, regardless of whether their own finances are strong or struggling. There is little opportunity for an owner to adjust pricing until existing leases expire.
However, competing products (e.g., new or alternative hotels), changes in user lifestyle preferences (e.g., scooter and bicycle rentals, a growing market for gently used goods and clothing) and disruptive technologies (e.g., rideshare and carshare services, self-driving cars and home-sharing websites like Airbnb and Vrbo), coupled with a comparatively low price to cancel a reservation, can sway users away from an operating business on very short notice. This can result in less rent due to the owner of the property under the facility lease. Having an operator with high-quality customer service and a strong property location can help mitigate these factors.
Certain kinds of operational real estate have industry-specific challenges. For example, hotels and resorts have amenities that need to be staffed at some level, even during days or seasons when overall occupancy is low. Cash flow for senior housing facilities may be affected by the speed of reimbursement from insurance companies. Their operations may be impacted by government regulations as well. Construction or road closures in the vicinity of a parking structure may prevent drivers from leaving their vehicles at a facility.
Of all the challenges related to owning operational real estate, the skills and expertise of the people managing the property and handling day-to-day operations are the most critical. Good managers will adjust pricing and staffing levels frequently in response to market changes and business opportunities. They will hire employees who provide superior customer service. Good managers will also provide timely and detailed reports about the property’s performance to ownership. If you do not have substantial expertise in operating the type of property you are buying, you will be well-served by leasing to a strong operational partner instead of trying to self-manage the asset.
Because of these uncertainties, owning operational real estate comes with a higher overall degree of risk (and hopefully a correspondingly higher return) than more traditional types of investment real estate. One of the best ways to understand and manage that risk is to lease to companies with strong, proven experience operating the type of asset in question and reliable forecasting.
While the right team cannot protect you from losses due to forces outside of your reasonable control, like the weather or a global pandemic, they can help you literally weather the storms. Finally, you should always consult with your own personal financial and legal advisors before purchasing any real estate for investment, including operational real estate.
©All Rights Reserved. January, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Tracy is a Principal at Syndicated Equities where she 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…
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