When investing in real estate, there are a variety of factors that can influence the stability of your cash flow, as well as your upside potential and overall projected return. One such factor is the amount of property improvements necessary in the early stages of your investment to achieve your intended results.
Operating assets with a consistent or long-term tenant base in place may require minor or no improvements upon acquisition to preserve a steady cash flow stream. Meanwhile, properties that are either undeveloped or require substantial renovation or repositioning in the market do not immediately generate distributable cash flow. Existing, operating properties that need some meaningful improvements to optimize cash flow represent a middle point in the range. You can find properties in every asset class that fall into these categories, including both residential and commercial.
Stabilized cash-flowing properties are assets that have tenants in place and are not in need of major repairs, replacements or other substantial physical or operational improvements at the time of acquisition or in the foreseeable future. Occupancy will be high at the time of acquisition, at or near 100%. When the properties are also located in established markets, these assets are also referred to as “core” investments.
From a financial planning perspective, these types of properties have the most predictable distributable cash flow. If you have commercial tenants with multi-year leases, the leases will specify your monthly or annual base rental income. The leases will also indicate the nature and extent of operating expense reimbursement obligations for each tenant through the end of the lease term. Absent a change in tenancy or modification of the leases, you should be able to calculate your expected net operating income for the first several years.
Market data can help you make predictions about occupancy, real estate taxes, operating expenses and likely rent growth for future tenants if you plan to hold the property beyond the term of the current leases, including residential properties where leases typically expire annually. As an owner, your primary focus will be on keeping the property leased, maintained and properly managed. Core properties are among the more conservative forms of investment real estate.
You may also encounter opportunities to purchase property that requires some sort of additional work to achieve stabilized profitability. The improvement could be one of the following:
These types of projects are commonly referred to as “value-add” opportunities because the owner infuses capital and/or expertise to reposition the asset in the marketplace.
Value-add projects allow investors to profit from the infusion of capital and energy. Depending on the nature and extent of the intended upgrades and your personal abilities, you also may be able to benefit from your own sweat equity. However, most investors will rely on real estate professionals to manage and perform value-add projects for commercial and larger residential properties. If you are considering this type of real estate investment, you will want to understand the professional’s experience and track record with projects of similar scope in the same geographic region. In addition, you must analyze the economics of the proposed improvements.
To project income from a value-add strategy, you will need to know both the cost of the intended improvements and the corresponding rent increase or sale profits you are likely to achieve after the changes are made. While certain types of improvements can add “curb appeal,” or an attractive first impression, they are not good investments for a rental property if you are unable to recoup your costs through increased rent or a higher sale price.
For example, natural stone sink vanities may be more durable and aesthetically appealing than laminate, but if the demographics of your prospective rental pool do not support a high enough rental rate to cover the replacement cost, or if the upgrade is unlikely to improve the tenant’s business (for example, if the sink is primarily used by employees rather than customers), you may not be able to recover the cost of that improvement when you go to sell or refinance. Additionally, you should consider the amount of time needed to do the work, especially if it will impact either tenants’ use of the premises or your rental stream while the project is underway.
It is common for cash flow distributions to be suspended, and for lender and owner reserves to be high, while the value-add work is being planned and ongoing. However, a well-executed value-add strategy can pay for itself by generating higher cash flow and an increased sale price once the improvements are complete.
Development or “opportunistic” projects typically involve ground-up development or other substantial construction at the onset. Any net operating income in place at the time of purchase will likely stop altogether as improvements get underway.
This type of real estate investment requires special considerations compared to real estate investments that provide early cash flow:
As a consequence, the pro forma projections for an investment in a development project are intended to be speculative. They are typically prepared and shared with prospective investors and lenders based on information available before the project has even commenced. The projections primarily serve to illustrate the significant financial milestones for the project (i.e., financing, lease-up and rent stabilization) and the upside potential for the investment, along with the sponsor’s best guess about when each milestone may be achieved and the corresponding economics.
Additionally, sponsors and investors in development projects will focus heavily on expected IRR (internal rate of return) and EM (equity multiple) rather than cash-on-cash yields. While the IRR measures the percentage rate earned on each dollar in a specific time period, the EM measures how much cash the investor will get back. One measures the “time value” of the investment while the other measures absolute returns. These metrics reflect assumptions about the future value of the improved property as well as the anticipated market at the time of completion.
Development investments will always have deviations from the original projections. They are not for the faint of heart, and they are not 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 a potentially significant return on your investment. The greater risk can result in greater rewards.
In many instances, development projects assume that the project will be sold once the work is complete and the operating income is stabilized (i.e., that the building is substantially leased to and occupied by tenants). In other cases, the developer will refinance or recapitalize the property upon stabilization, make a distribution of proceeds to investors and then continue to own and operate the property for years into the future. Investors should always take care to understand the intended and fallback strategy for the anticipated exit, but also 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 if you are willing to accept the heightened degree of risk and be flexible with timing. If, however, you like predictability or want current cash flow, look for real estate investments in stabilized properties. Value-add projects can offer a good balance between providing a stream of income and obtaining a meaningful profit from strategic improvements.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Residential & Multi-Family Real Estate, Focus on Single Asset Real Estate and Investing in Commercial Real Estate.]
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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