INVESTOR CONUNDRUM: (How Much) To Risk, or Not To Risk?

High Commercial Prices and Mortgage Woes Have Investors Re-Evaluating Risk in Their Holdings and Investment Strategies
Justin Mann, chief operating officer of Monopoly Trading Co. in Seneca, SC, has been taking a greater role in the family real estate business. Monopoly Trading owns a variety of properties, including a golf course, ranches, mobile home communities, single tenant and multi-tenant office buildings and retail centers, warehouses, storage facilities and undeveloped land. Like many investors with substantial real estate holdings, Mann has been watching the economy and analyzing his company's performance on a daily basis. He has evaluated each of its different entities and their respective markets and he has come to one conclusion. "We need to get back to our core businesses to strengthen the company," Mann said. "I absolutely feel that investors should tidy up and reduce the risk in their portfolios. The main reason being so that not only will they be able to weather a storm but they will be able to continue to grow -- and at record paces -- and produce record numbers by being able to acquire properties from owners that took on too much risk and have to sell short." Mann is not alone in re-evaluating his investment position. Top dollar commercial property values, falling housing values, escalating mortgage defaults, tightening credit and an agitated stock market have commercial real estate investors reassessing their portfolios and re-evaluating whether the strategies of the last couple of years can carry them through the coming years. Particularly, they are analyzing their risk exposure and more specifically whether they have relied too much on risk. Investors, both small and large, are reassessing. The California Public Employees Retirement System (CalPERS), the largest pension fund in the country with $230 billion in assets, being among them. CalPERS' Global Real Estate Investment Office notified the pension funds investment committee about it its planned strategic review of CalPERS' real estate portfolio and operations and development of a new investment plan for the coming years. It has been nearly 12 years since CalPERS completed its last strategic review of its real estate program. Since that time, the program has grown dramatically in size and complexity. "Given the drop in core return expectations and in response to market opportunities, the real estate program has shifted from a mainly domestic, core portfolio to a diversified, global portfolio with an emphasis on non-core initiatives," CalPERS Global Real Estate Investment Office explained to the investment committee. "For example, in 2000, non-core investments represented 24.5% of the real estate portfolio; by 2006, CalPERS had approximately 47% of its portfolio in non-core and REIT investments. During this same period, the number of investment relationships tripled." CalPERS' real estate portfolio was the biggest percentage gainer among asset classes last year, returning 27.6% for investments in office, retail, apartment, industrial, housing, land, and California urban properties. By comparison, the NCREIF industry benchmark earned 17.6%. CalPERS has retained Pension Consulting Alliance Inc. as a consultant to assist in the strategic review and the development of an investment plan. Over the next couple of months, CalPERS and PCA officials will be meeting with core partners. Among the key questions they will be asking is whether CalPERS should reduce the risk in its portfolio and where are the best places to invest on a risk-adjusted basis. CalPERS and PCA expect to have a draft of new investment plan ready to present to CalPERS' core partners at their annual meeting early this summer. And while evidence of portfolio re-evaluations are widespread, not everyone is concluding that it is time to lessen their risk exposure. In fact, many investors are becoming more comfortable with some form of risk. Robert Aigner, senior vice president of Harsch Investment Properties in Bellevue, WA, said he doesn't find investors afraid of risk. He cited Equity Office Properties sale to Blackstone and the subsequent sale of properties to regional players. "Risk is a function of return," Aigner said. "In order to address the cascading waterfall of returns on the above mentioned transaction, I see investors actually becoming more comfortable with risk (read lower cap rate) than previously believed. This is especially true for core assets and locations." Others are seeing a shift of investment types in which investors are willing to take a risk. "There's always risk, sometimes more and sometimes less. What's interesting is that one's own perception of risk can be very different than another party's perception of risk," said Terri Gumula, vice president, acquisitions of Real Estate Capital Partners in New York. "I'm seeing an increasing number of deal recapitalization come across my desk which can present some interesting opportunities." Recapitalization occurs when a new partner buys into an existing partnership or joint venture. "In today's environment, investors need to find ways to deploy capital without having to meet the market's pricing scale," said Gregory J. Nieder, principal, executive vice president, Foresite Realty Partners LLC. "Investing in opportunities through note purchases, taking subordinate debt positions or providing fresh equity in project recapitalizations can allow for strong returns while keeping one's basis low enough to justify the risks." In some partnerships and joint ventures today, the partners' initial expectations on returns are not being met, resulting in an existing equity partner's desire to get out of a deal and redeploy its capital to an investment with a higher return. Meanwhile, the local operating partner wants to keep the assets to take advantage of strong leasing demand and rising rents, such as are evident in today's office market. "While the scenario you mentioned is certainly happening, the recapitalizations we are looking at would typically allow us to come in with fresh equity for someone who has used up available funds in their capital stack," Nieder said. "For example, rising construction and leasing costs have caused some owners to run out of funds before finishing a redevelopment or leasing effort." "In those situations," Nieder said, "a new equity partner can come in and recapitalize the partnership with equity and debt to finish the project. Therefore, because it is not really a take-out of existing equity plus profit, you can keep a 'carryover basis' to some degree and even with the increased costs that went into the building, be in a better position than what the open market may dictate." "Also, generally the new equity gets a preferential return position vis-à-vis the original equity," Nieder said. "The reason why the original operating partner would stay in is exactly as you mentioned, to take advantage of the full creation of value through demand and rising rents." However, not even strong fundamentals in the office and flex rental markets are enough reason for some investors to take unnecessary chances. There just comes a point where prices are too high and rents won’t keep pace. "Despite the fact that construction costs, historically low inventories, and a strong economy make for the perfect rent spike environment, the fact remains that tenants pricing of the market is less elastic," said Frank L. Buckley, managing director of Ramsey-Shilling Commercial Real Estate Services in Los Angeles. "Occupancy costs are a percentage of revenue … [that] margin is sacrosanct." Even Justin Mann of Monopoly Trading, while he is not scared off by risk, prefers to sit on cash for a while. "I think strategies will vary for everyone depending on your company's strengths and weaknesses," Mann explained. "We are heavy in rental properties both multifamily and office properties. We are selling a lot of our land holdings to put our money in NNN leased properties. Our desire is to increase our monthly cash flow so that we can attack fewer projects but produce them with a much higher quality thereby creating a greater return on our investment." "With this money we are planning to take a certain percentage and invest it in higher risk projects, believe it or not, that we have the potential to see even greater returns on," Mann said, but adding, "the majority of it, however, will go back into more NNN properties to further increase our cash flow." COSTAR March 17, 2007 http://www.costar.com/News/Article.aspx?id=2154F78EEED207F9C55712E79AB68FA4&ref=100 For more information see www.houstonrealtyadvisors.net