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The Laurex Process:
Investment Selection
Commercial Real Estate Opportunities
By Ray Alcorn
A recent
column on the front page of The Wall Street Journal titled "Real Estate
Takes On An Unaccustomed Role," written by Dean Starkman, provides much food
for thought.
I love the first line of the article: Commercial real estate has a
reputation for being the drunk driver of economic highways, the sector whose
periodic crackups wreak havoc on other industries.
What a line! What an analogy! You can bet that my attention was sufficiently
focused on what that article had to say which, by the way, was very
complimentary of the metamorphosis that the commercial real estate industry
has undergone since the roller coaster of the eighties and early nineties.
In fact, the point of the article is that commercial RE is now positioned as
a brace of support in a weakening economy, rather than making things worse.
I will quote some further excerpts from Starkman's article, and then explore
some of the possible ramifications for those of us involved in the
commercial real estate sector:
Why are things different this time? The '80s real
estate story was written more by the government than is perhaps widely
understood. The 1981 Economic Recovery Act drastically cut depreciation
schedules, providing huge write-offs on even small real estate
investments. The next year's Garn-St. Germaine Act opened the thrift
coffers to risky investments such as commercial real estate.
....By the time the 1986 tax bill revoked the incentives and regulators
finally and zealously clamped down on thrifts, the country had yawning
vacancy rates ready to greet the big employment slowdown that came three
years later.
....The 1990s brought changes. Thrifts and Japanese investors are now
gone. Commercial banks have reduced their appetite for construction
lending and apply much more stringent underwriting standards. And
publicly traded real estate investment trusts [REITs] now own more than
15% of all US income-producing property, while commercial mortgage
backed securities [e.g. conduit loans] provide about 19% of the real
estate industry's debt. The two industries, insignificant or
non-existent a decade ago, have spawned a small army of analysts
watching the industry's every move.
"Real Estate Takes On An Unaccustomed Role," The Wall
Street Journal, 2 April, 2001, Sec. A: page 1.
What does this mean for us, the average commercial real estate investor, as
we look into a somewhat murky crystal ball?
Actual Risk vs. Perceived Risk
I've heard a number of questions from investors lately about where we may be
headed in this suddenly uncertain economy. My own opinion is that real
estate investors are somewhat insulated from the wilder swings in property
values and performance of the past, precisely for the reasons outlined in
the article.
The particular magic of commercial real estate derives from the perceptions
of risk inherent in the game. It is an accepted financial axiom that when
one takes higher degrees of risk, then the potential and real returns must
increase as well. High Risk = High Return, Low Risk = Low Return. But
assessing the degree of actual risk vs. perceived risk is a very subjective
exercise.
Risk, it seems, is often in the mind of the beholder rather than based in
any concrete evidence, skewing the perception of actual risk, and hence the
value of the investment.
This skewed circumstance can also work in reverse. The recent NASDAQ
experience is a glaring example of risk perception gone awry. In that case,
people ignored the signs of real risk, allowing the perception of momentum
to mask the danger.
Commercial real estate is now in the opposite situation. The stabilization
and lowered uncertainty provided by the large players in the industry has
lowered the actual risk, but the old perception persists.
High "Perceived Risk" Creates
Opportunities
Those who understand the fundamentals of income-producing real estate know
that this gap between the generally held perceptions of risk in commercial
RE, as compared with the real risk involved, has substantially widened in
the last ten years, creating an opportunity to capture higher,
perception-based, risk-adjusted returns without the concomitant actual risk.
The end result is that we are now in a climate in which we have the
opportunity to gain a risk premium from activities that have in fact become
very stable.
When a deal makes good economic sense (i.e. real positive cash flow not
dependent on tax losses), then all involved can and will benefit. A properly
diversified portfolio can be assembled that is just about recession proof if
the basic fundamentals of deal structure and leverage are properly applied,
and once assembled it will compound and pyramid wealth at rate unmatched by
almost any other investment.
Does this mean there is no risk? Absolutely not. There is always risk in any
investment activity that goes beyond government bonds. But as the massive
run-up in the REIT's portfolios and the increased involvement of the
securities markets through conduit loans attest, properly managed real
estate investments yield very profitable returns.
Follow the Money
Always follow the money folks... and remember that while money doesn't care
who owns it, it despises uncertainty and will always flow to where it is
best appreciated (used). There is a reason for these guys (the REITs and
Wall Street bankers) pouring such a gargantuan amount of funds into
commercial real estate. That money is present in the product by design, not
by accident.
The reason is obvious. Commercial real estate has one of the biggest bangs
for the buck across the whole spectrum of investments.
I often rant against the bureaucracy that has been created by the
sub-industries of the REITs and the conduit lenders due to the increasingly
Byzantine criteria for underwriting and analysis. But even in the midst of
my frustration, I have to appreciate the resulting stability that now
characterizes our industry, and admire the concentration of wealth produced.
In many ways it has made it possible for me to be doing what I am doing
today. Most certain is that this skewed circumstance of real vs. perceived
risk in commercial real estate has created a window of opportunity from
which we can all profit.Ray Alcorn is the
Chief Operating Officer of Park Real Estate, Inc., located in Blacksburg
Virginia. Park was founded in 1953 by Ray's father as a real estate
development and investment firm. The firm owns a diverse portfolio of
commercial investment properties, presently including a hotel, a mobile home
park, several apartment buildings, a shopping center and two bowling alleys.
Plans for the future include the acquisition, divesture and development of
additional retail and hotel properties in the southeast.
Article Provided by:
Ray Alcorn
Park Real Estate, Inc. |
