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owning operational real estate

Could Owning Operational Real Estate be Your Ideal Investment?

Exploring Owning Operational Real Estate

Owning real estate for investment can take a little or a lot of work, depending on the type of asset you purchase. Passive investments in real estate offerings managed by professional sponsors require little-to-no work on the part of investors. Single-tenant, triple-net leased commercial properties also require little time and effort on the part of the owner-investors. The tenant is responsible for payment and performance of maintenance obligations and real estate taxes for the properties.

This is in contrast to multi-tenant commercial properties.

The tenant is responsible for payment and performance of maintenance obligations and real estate taxes of the properties.

These properties include shopping centers, offices with common areas that require upkeep, and apartments. They will demand more attention from the landlord.

Examples of Operational Real Estate Properties

Owning investment real estate can be very time intensive, especially operational properties. Some examples include self-storage facilities, hotels, resorts, certain senior living facilities, and parking structures. An operational property’s revenue is dependent upon the success of the property’s business. The income stream is determined by a percentage of sales instead of a fixed annual or monthly rate. As a result, very few investors choose to self-operate these types of assets, especially on a large scale.

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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. Therefore, an investment in an operational asset is both an investment in the ongoing business at the property and an investment in the real estate itself.

Owning Operational Real Estate Means Tracking Cash Flow

Cash flow from owning operational real estate can vary greatly based on numerous factors. All these factors can act to make cash flow 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. Hotels, for example, look to occupancy, average daily rate, and revenue per available room to benchmark their performance. They check both independently and compare to other competitive hotels in the area.

Parking lots track their revenue not only on a daily basis, but also on an hourly basis. They monitor the duration of clients’ stays, as well as entry and exit times. Senior facilities 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. You should know and understand these metrics before owning operational real estate or properties.

Other Factors Affecting the Bottom Line

  • Fluid vacancies – 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. Contrast this to a commercial building or apartment unit, where tenant turnover is comparatively lower. Fluctuations in occupancy are more likely to occur on a monthly, seasonal, or annualized basis.
  • Seasonal variations – 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 will be higher than it would be during hurricane season. Severe weather can also prevent guests from reaching their intended destination on time.

    Your success in owning operational real estate can also be affected by the weather

    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.
  • Local economy – 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.

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  • Broader economy – Your success in owning operational real estate is linked to the amount of discretionary funds people have available to spend. The success also depends on how quickly the property’s clients with significant corporate accounts pay their bills. In periods of recession, 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.  However, self-storage facilities tend to flourish in challenging economies when people store their belongings as they downsize into smaller offices or residences. 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.
  • Competition – Operating 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.

    Operating properties are more rapidly and directly affected by competition than real estate with traditional leases.

    However, competing products (such as new or alternative hotels) and disruptive technologies (like rideshare services, self-driving cars, and home-sharing websites like Airbnb), 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.
  • Industry-specific challenges – 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.
  • Quality of management – Of all the challenges related to owning operational real estate, the skills and expertise of the tenant 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.

Circumventing the Risks of Owning Operational Real Estate

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.

Owning operational real estate comes with a higher overall degree of risk

While the right team cannot protect you from losses due to forces outside of your reasonable control, like the weather, they can help you literally weather the storms. Finally, you should always consult with your own personal financial and legal advisors before making any investments like owning operational real estate.

Read more: The Ups and Downs of Residential Real Estate Investments, 3 Real Estate Investment Types and Cash Flow Potential

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About Tracy Treger

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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