Managing Real Estate Investments in a Volatile Economic Environment. July 2012
In this special report
Prepared by,
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Time to review your real estate investments
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Exercise discipline at all times
Bill Nimmo, VP, Wells Fargo Real Estate and Specialty Assets.
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Maximize income and reduce expenses
John P. Bailey, CCIM, SVP, Strategic Business Segments.
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Take advantage of improving capital markets
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Reinvest in your properties and consider new investments
Editorial Review,
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Evaluate real estate as part of your overall portfolio
Sarah E. Douglass, ASIP, SVP, Publications.
Managing Real Estate Investments in a Volatile Economic Environment
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As economic and credit market conditions improve, we are seeing a change for the better in commercial real estate markets. Market activity has increased, reflecting opportunistic buying by pension funds, Real Estate Investment Trusts (REITs) and other institutional buyers that have capital or have been able to raise money in the financial markets. In addition, we are seeing a significant rise in competition for some types of loans. Healthy banks are now looking at commercial real estate loans as an avenue to generate loan production and income and we are seeing renewed lending by life insurance companies. Meanwhile, traditional financial markets (stocks, bonds and other liquid markets) are extremely volatile and the outlook for investors in these markets is uncertain. Interest rates are historically low, but many financial professionals believe that the Federal Reserve’s current highly accommodative monetary policy combined with the potential failure of politicians to address the U.S. fiscal deficit may eventually lead to rising inflation and higher interest rates.
Time to review your real estate investments. In this kind of economic and political environment, we believe that portfolio diversification and exposure to hard assets (“real assets”) is increasingly important for wealthy investors. In our view, an exposure to real estate can offer investors a number of important benefits. In addition to helping provide an income stream, these benefits may potentially include: Q
Increasing portfolio efficiency and often improved total portfolio return
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Inflation protection
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Growth
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Diversification to potentially reduce portfolio volatility
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Tax benefits in some cases
If you already hold real estate investments in your portfolio, now that capital markets are improving, you may want to look at repositioning any underperforming real estate assets. Now that there are more lending options available and interest rates are low, it may be worth thinking about debt refinancing. Other factors to
consider include selling any underperforming property, tax and succession planning, and property renovation to help maintain the competitiveness of your real estate portfolio and to help prevent it from becoming obsolete.
Exercise discipline at all times While conditions may be improving, we would caution that the commercial real estate sector still faces a number of challenges. These include: Q
High unemployment
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Improved but still high vacancy rates in many commercial sectors, specifically office and industrial buildings
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High levels of outstanding debt that you may not be able to refinance even though credit conditions have improved
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Extraordinary market volatility
In view of such challenges, it pays to proactively manage your real estate investments. Often investors treat real estate as a passive investment that does not need ongoing review and scrutiny. We feel that, even in a more benign market environment, passive management can be a mistake and taking such an approach in today’s environment can be particularly risky. Instead, we would like to offer a number of suggestions to help you stabilize your portfolio and position yourself to take advantage of potential investment opportunities when they arise.
Maximize income and reduce expenses. As you navigate this economic environment, you may want to consider taking steps to maximize income and reduce expenses.
Maximize income. Q
Reach out to tenants early to renew their leases if you have invested in a market where conditions are still soft. Concessions are often cheaper earlier in a down cycle than at the bottom of the cycle. Be prepared to offer concessions to those tenants that may enhance the value of your investment over the longer term and help make it easier to refinance any outstanding debt on favorable terms.
July 2012 | Managing Real Estate Investments in a Volatile Economic Environment
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Creatively look at alternative uses and different types of users or tenants for your real estate, especially in regard to properties that have struggled with occupancy and turnover. Tenant technology and other needs are constantly changing and one of the best ways to help with a steady stream of long-term rental income may be to improve and reposition your properties. This may require reinvesting cash flow in property improvements so that your portfolio is “state-of-the-art” and less at risk of becoming dated or possibly obsolete in certain respects.
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Maximize other revenue generators, such as percentage rent and expense recovery clauses to recover recent increases in operating expenses, including real estate taxes, common area maintenance and insurance costs.
Reduce expenses. Q
Review the business practices of your competitors in your local market to see how they are charging tenants for operating expenses. Some recovery methods are more favorable and can reduce risks.
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Re-bid service contracts such as janitorial, landscaping and property management services. You may find that it is easier to get a better deal on such services in a competitive economic environment, helping you to reduce expenses.
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Consider a cost-segregation analysis for newlypurchased properties or recently renovated properties to find ways to accelerate depreciation on improvements and capital-type expenditures and thereby help save on taxes.
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Protest, protest, protest. Falling property values could mean lower property taxes. Determine how your taxing jurisdictions allow for disputing taxable value and negotiate.
Real estate markets are still recovering and you can purchase assets at prices well below the cost of new construction. Solid new investments made in today’s environment could provide strong income for years to come. they were even a year ago. Educate yourself about the refinancing alternatives now available and plan accordingly. It is not too early to consider your options, even if your loan does not mature for a couple of years. Q
You may want to use any remaining time you have before your loan becomes due to plan for a capital infusion that may be required in order to refinance or extend the loan on your property. Interest rates and lender equity requirements could require you to put cash into the investment. Use the time now to plan how to accumulate more cash if this is necessary. You may be able to take the cash you save to capitalize on a buying opportunity if it turns out that you do not need it in connection with refinancing or extending your debt.
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Another source of financing that you may want to consider is using unleveraged properties with consistent cash flow as a source of cash through a financing or sale/leaseback.
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Interest rate swaps may be an attractive way to lock in fixed rates on properties with variable rate debt.
Reinvest in your properties and consider new investments. Q
If you have cash available for property or tenant improvements, you may find that such improvements offer you an advantage over competing projects. As mentioned above, by reinvesting in your properties, you can help your portfolio stay competitive in the future thereby helping to maximize occupancy and strong rental rates.
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Look for buying opportunities. Real estate markets are still recovering and you can purchase assets at prices well below the cost of new construction. Solid new investments made in today’s environment could provide strong income for years to come. Most institutional buyers have focused exclusively on
Take advantage of improving capital markets. In our view, one of the best courses of action you can take in this volatile economic environment is to consult with your private banker on your entire leverage position. Your banker can potentially offer you suggestions on ways to help manage your debt that you might not have considered. Q
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Banks have been much more active lenders recently, and they now hold many more loans on their own balance sheet. As a result, the ease and availability of credit has improved in the past six months and your financing alternatives may be radically different than
July 2012 | Managing Real Estate Investments in a Volatile Economic Environment
“Class A” multi-family assets, and office and retail properties in large and often coastal markets, leaving a large supply of opportunities available in other commercial property sectors and numerous other markets for buyers to consider. Q
New construction levels are historically low, which may lead to increasing rents in the future and the ability for real estate to act as an inflation hedge in your portfolio.
Evaluate real estate as part of your overall portfolio. We suggest that you avoid looking at your real estate investments in isolation. Instead, we recommend that you assess the risks and opportunities of your real estate holdings in the context of your entire investment portfolio. Questions that you may want to ask yourself are: Q
Do I need short-term cash?
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How do these investments correlate with my other investments and overall wealth goals? (Generally, real estate has both a low correlation to financial equity investments and short-term price volatility. It can be a moderate hedge against inflation. However it is highly illiquid in the short term.)
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Do my real estate investments allow for more or less volatility in my investment portfolio?
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Should I consider adding real estate to my portfolio for potential income and growth?
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Or, am I too overweighted in real estate to meet short-term liquidity goals?
As you evaluate your real estate investments, ask yourself if the particular investment meets your investing goals. Also, consider whether your current investments meet your time and lifestyle needs. For instance, an office property investment may offer a higher yield than a net leased single credit tenant building with a long-term lease. In this instance you are trading the increased yield for stability of cash flow and low intensity of your time investment in managing the asset. We recommend that you meet with your Wells Fargo Relationship Manager to conduct a full review of your investment portfolio and to discuss any adjustments that may help you meet your financial goals. Acting proactively to manage any issues that may arise in your real estate portfolio may help reduce your short-term risk and better position your investment portfolio for long-term growth.
July 2012 | Managing Real Estate Investments in a Volatile Economic Environment
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Disclosures.
Wells Fargo Private Bank provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. Credit products are subject to credit qualifications. The information and opinions in this report were prepared by Wells Fargo Private Bank. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Private Bank’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Private Bank does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. This information is provided for education and illustration purposes only. Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the strategies mentioned. The strategies discussed or recommended in the presentation may be unsuitable for some clients depending on their specific objectives and financial position. Real estate investments carry a certain degree of risk and may not be suitable for all investors. ©2012 Wells Fargo Bank, N.A. All rights reserved. Member FDIC. NMLSR ID 399801 WM ( /)