Education & Workforce Development and Real Estate & Retail

VOICES FROM THE INDUSTRY: Learning the basic categories of investment real estate Property type New development or existing Risk of landlord responsibilities

February 21, 2005

Baby boomers, the wealthiest generation in the history of our country, are getting richer. Much has been written about the extraordinary transfer of wealth that will take place as the boomers take over the estates of their parents.

As their assets grow, many are get ting more directly involved in the management of their money.

Rather than sending all their cash to Wall Street or their bank, an increasing number of investors are allocating a portion of their portfolio to private equity real estate investments. These are investments directly in property instead of through publicly traded securities.

Some invest individually, choosing to provide all the equity needed for a property acquisition and handle management of the asset themselves. Others become owners as part of a small group of investors through single-purpose limited liability corporations, which are typically created by real estate development or investment organizations.

Those new to this type of investment vehicle can be overwhelmed by the new, unregulated world where there are no securities brokers, national-name firms or analysts providing information and education. Novices may be easily intimidated by the stories of woe that are so plentiful in the world of real estate: The friend of a friend who got burned, lost everything, never saw a dime.

Many of these stories date back to the 1980s and tax-driven real estate partnerships, in which most of projected return was based on hefty tax benefits from accelerated depreciation. In the middle of the game, politicians in Washington decided they just could not stand the idea of rich people saving on their tax bills-even though investors were just playing by the rules the politicians had made up a few years earlier.

The result, in what still seems to be an unconscionable act, was that Congress changed the rules related to the ability of investors to benefit from tax losses on their investments.

Millions of real estate investors in the 1980s were severely punished for playing by the rules, and real estate investment values plummeted.

Today, there is less risk of investors getting hurt by politicians tinkering with the rules. The tax benefits of real estate have been minimized, so values today are driven not by tax-related issues but by basic fundamentals of pretax cash flow.

So how does an investor differentiate the several real estate investment options available today? There are three basic categories:

Is it retail, office, industrial, multi-family or land? There are others, but these are the general classifications for investment opportunities.

This may be the most important question. Normally, there is much more risk and greater return associated with new development vs. acquisition of existing, well-leased property.

Responsibilities of the landlord vary wildly. Some require that services be provided on a daily basis while others place all responsibilities on the tenant, even up to replacing the asset if it is destroyed.

Investors should be aware of how various property types tend to affect risk and return. Retail property requires relatively little of the landlord. Tenants maintain their space and normally are responsible for the cost of improvements. Industrial properties tend to be the same, with not much expected of the landlord other than perhaps some contribution to the cost of improvements.

Office space is a different story. It is a high-risk game in terms of cash flow because landlords are normally responsible for the cost of tenant improvements, which may exceed $20 per square foot, potentially causing significant fluctuations in cash flow.

Unlike office, industrial and retail property where tenants sign long-term leases, apartments require the highest level of property management. The responsibility for leasing never ends, as short-term leases expire regularly.

Land purchased for investment is at the other end of the management spectrum, as there is not much to do but wait for the right time to sell-which, of course, may be years away.

New development involves the creation of an asset and normally includes lease-up risk. Purchasing a well-leased existing property eliminates much of the risk of investment, although future leasing will be required as leases expire.

For those who choose to be actively involved in private equity investments, it is critical to understand that not all real estate investments are alike.

When considering risk and return, it is important to understand the type of property, whether it exists or is to be created, and the responsibilities and risk borne by the owner.

The returns available in the private equity investment arena make it worth the effort.



Funke is president of Providence Partners, a locally based commercial real estate investment and services company. Views expressed here are the writer's.
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