Property Investment and it’s Terminology

As one of the 3 primary investment asset classes, property nearly always commands a high level of investor interest. Unquestionably, property can and does provide investors who build a diverse portfolio of property interests – a relatively stable and higher income potential. With a direct involvement in our 22 current property investment groups, we are widely exposed to:

• The vagaries of this asset class and,
• The responses or reaction of investors to changes as they occur during the life of any individual property.

To assist investors grow their comfort with property and to understand the importance of building a diversified portfolio we seek to answer some of the “typical” queries and concerns presented to us over time.

What is capitalisation rate (Cap Rate)” ?

Applying a Cap Rate is a common or standard way of arriving at a property value. To arrive at a value the rent is divided by the required return percentage e.g. $10,000.00 annual rent, with a required rate of return or Cap Rate of :

8% = 10,000 /.08 = property value $125,000.

Issues affecting the Cap Rate that should be applied are complex, but include the trade-offs occurring between, location, building age and quality, building use, tenant quality, lease quality and residual unexpired return, current market perception and level of risk premium (that is the extra return above a risk free rate of return an investor should expect for the riskiness of a subject property). Net or Gross (or partial Net) leases provide one of the biggest traps when buying property as at least one major NZ syndicator found this year, to the detriment of its investors.

Wat affects my distribution?

Property ownership is a business. Whilst it may have relatively stable cashflows compared to other business operations it is not immune to fluctuations.

The causes of variations in cashflows are:

• Rent increases or decreases due to market forces.
• The cost of physical alterations to the property to meet tenants requirements.
• Tenant failure, rent arrears or temporary financial incapacity of the tenant.
• Repairs, maintenance, alterations and refurbishment’s.
• Vacancy levels are commonly over 5% in the commercial property market. Commercial property can be more specialised than residential property, so there may be long vacancy periods while waiting for the user that fits a unique facility offered by a specialised type of property.

The above factors comprise the normal causes of variable cashflow and are common events that can reasonably be expected to occur over the life on an investment. * If debt funding is used, interest rate and repayment rate changes affect residual cashflows to the investor.

What affects the value of my investment and why there has to be a “Risk Premium”?

Investment assets are valued on the basis of the cashflows produced by the asset during the holding period and the final value of the investment on disposal. The timing and certainty of these expected cashflows are significant variables. In the property context the cashflows are: rents received, repairs and maintenance and alterations, refurbishment’s, rates, insurance and service costs, debt servicing costs and proceeds from sale of the property.

Overall economic conditions and investors confidence and demand determine the market value of an investment asset at any given time. Major factors being interest rates, inflation rates, expansion or contraction of the economy. The future expectations for these variables are considered. The lease entered into between a property owner and the tenant determines the cashflow from rents. The financial strength of the tenant, the terms of the lease, the length of the unexpired lease term and expectations regarding ease of lease renewal or a new letting are the factors that determine the certainty of future cashflows and consequently affect the investment value of the property. The more the certainty, the higher the value.

What happens when debt is included?

Whilst the use of debt (financial leverage) can significantly increase investment potential, it’s use must be understood. Debt alters the return characteristics of an investment. Where the interest rate on the debt is lower than the property yield the effect is to increase the cashflow return on the investors cash input (equity). If the interest rate is lower than the property yield cashflow return is decreased.

In the event of vacancy / tenant failure debt servicing becomes an expense additional to rates and insurance which must be funded. This can cause great difficulties for investors at this time.

Debt financing also magnifies changes to the investors equity resulting from movements in the capital value of the property.

Overall the use of debt increases the variability of cashflows and capital gains and losses, effectively increasing the riskiness of the investment and of course the debt has to be repaid sometime.

Currently debt financing is being used to increase the cashflow in most non – Guideline property syndications being promoted. Investors needs to be aware of the higher level of risk associated with these offerings compared to debt-free offerings.

Gross & Nett Yields

Investors need to ensure they are comparing “apples with apples” when comparing quoted returns (yields, when a property is advertised by a real estate agency as producing a certain return this is usually based on the rent received by the investor (after rates, insurance and services charges) expressed as a percentage of the price being asked for the property. In this instance the purchase price of the property does not include legal costs and any other costs incurred effecting the purchase (and in the past stamp duty). Likewise the rental return does not include any allowance for property management costs, non-recoverable compliance costs, sinking funds, vacancy etc. These are all costs which will occur over a realistic investment time-frame.

The Net result is that the advertised return overstates the actual achievable “Net” disposable cash return to the investor.

Changes in the Investment Property Market

Due to business competitive pressure with increased focus on costs and adoption of new practices to achieve greater efficiency commercial property is a more dynamic investment than previously. Property becomes obsolete more quickly, tenants are more conscious of their accommodation cost, tenants have less financial strength, their business changes quickly. This increased competition also applies to the supply of property. Any increase in demand for accommodation is quickly supplied by new development thus constraining rental growth due to demand pressure and hastening the obsolescence of lower grade property as tenants upgrade their accommodation, often at no cost, to fill vacancies created by new development.

Our view is that the overall effect of these trends are that property is becoming a higher risk investment than it previously has been.

This increases the need for diversification hence the increase in syndicates, trusts, listed companies and other vehicles allowing for a greater spread of investment for a given financial outlay. These trends also increase the need to seek ways to:

• reduce riskiness associated with any debt and,
• Increase relative before debt returns.

These intermediary vehicles affect the way the investment will perform in the hands of the end investor. The investor needs to be aware of the characteristics of the investment vehicle rather than just the underlying property. Professional advice is a must, as is experienced and proactive management if values are to be optimised over time.

When the economy is bad and property values are falling and everyone wants to be a seller, buy well located real estate and hold on to it. Don’t sell whatever the critics, the cynics and the losers might say. That way you will end up very wealthy

– John Paul Getty III