INVESTING IN COMMERCIAL PROPERTY - PT 2
DECISIONS: INVESTORS VS. USERS Investors want to attain predetermined objectives. Therefore, needs assessment is primary no matter whether objectives involve an expected rate of return, a stated period to hold an investment, the tax shelter opportunities arising from a purchase or a long term strategy to diversify real estate holdings through leverage. Armed with needs knowledge, the salesperson then applies risk analysis. Lastly he or she assesses whether a specific offering can achieve anticipated return on profit given inherent risks. In the case of users, individual needs factor heavily into the buying or selling decision. How the property satisfies buyer/tenant requirements is uppermost. Too often however, registrants fail to realize that risk and return are never far from the user’s mind. While user groups are academically distinct from investor groups, investment objectives are interwoven in the decision-making process. UNDERSTANDING NEEDS A great deal of commercial activity surrounds the issue of needs. What does the user intend to do with the property? What investment return is he or she seeking? What is the user attempting to do, both generally and specifically? Can the salesperson clearly articulate those goals? What about a definitive statement of investment motives that set the stage for property selection and showings? Needs generally fall into three general categories: 1. Investor/User Objectives: General goals of the buyer including type of property being sought, investment return (if applicable), lease vs. own, type of ownership, etc. 2. Physical Requirements: Specific needs; e.g., HVAC requirements, transportation, site characteristics, etc. 3. Financial requirements: Amount of capital, other financial resources, credit standing, financial history, etc. RISK IN DECISION MAKING The element of risk applies to all investment decision. Risk refers to the uncertainty, chance, exposure and vulnerability imposed on an investor, with particular regard to any financial loss that may accrue from an investment. Risk, for all real estate purposes, centers on fluctuations in the income stream and the vulnerability of that stream to external influences such as market trends, availability and suitability of financing, degree of positive or negative leverage, and overall economic conditions. Risk is typically viewed as a primary consideration in any real estate investment. The ability to forecast and in some way quantify the impact of various influences on an investment property is broadly describes as risk analysis. Complex risk analysis models and related computer programs do exist, but often go well beyond the practical needs of commercial brokerage. In reality, reliance on intuitive sense, personal experience and historical market trends in more commonplace. Types of Risk • Financial • Market • Business • Building risks General and Specific Risk Each segment typically contains both general and specific elements. Financial risk, for example, refers to the ability to preserve principal while ensuring a return on that principal. From a general perspective, the ability of finances in the marketplace may dictate ultimate return. However, from a specific perspective, the particular leverage used within an individual project will also affect financial risk. With market risk, the property is subject to general risks given the ups and downs of the real estate market, while the property itself attracts specific risks given its particular use. Most theorists agree that entrepreneurial ability is a vital dimension in all risk analysis. In other words, the investor’s level of sophistication and his/her investment strategy directly affects risk. Financial acumen when securing suitable financing, also with the tax status of the investor, also have a direct bearing on risk. Risk can be reduced through effective business strategy. Obviously, selection of investment properties and proper portfolio diversification can impact risk. The limitation of liability and insistence on prudent contracts are further positive forces in reducing risk. Risk is also a factor in determining value. Risk in any investment property is ultimately reflected in the value of that property in the marketplace. Appraisers, real estate registrants and investors should be particularly sensitive to the type and class of investment opportunity and associated risk. In fact, the discount rate applied when determining the value of a particular property typically includes a risk component, referred to as a risk premium. RETURN Return is the yield realized on an investment. Expressed as a percentage, it can be either positive or negative. Investment real estate is driven by yield and various measures are used to assess that yield. Yield lies at the heart of real estate investment analysis. In real estate, as with other investments, risk and return are intrinsically tied. Generally, the higher the risk, the higher the return.