Do you have an exit strategy? Planning how to get out of an investment is as important as getting into an investment.
The old adage, "sell when the market is right," can be difficult to determine. In fact, if an owner waits until it "feels right" to divest, the asset's peak value may have already crested, and the owner will have to wait until the next cycle to reap the same rewards.
Owners should understand the properties they're investing in and the investment classes they intend them to be. They should set goals for the property as soon as possible; establish benchmarks that need to be reached; and be prepared to pull the trigger when the parameters of their financial plan are met.
Additionally, it's important that real estate managers recognize their owners' investment objectives, so they can help owners meet their exit strategy goals.
* A STRATEGY'S CORE
Real estate investors typically pursue one of two basic investment strategies--core and non-core. Core investments are typically described as institutional grade, low risk/low yield assets, whereas non-core investments involve greater risk.
Core properties include "Class A" products located in quality, stable locations that require little new capital investment. A core investment is typically purchased based on replacement cost, minus discounts such as risk and market volatility
Investors are willing to accept lower returns (9 to 11 percent leveraged) in return for stable cash flows to distribute to the partnership. Core purchases are typically held for longer periods, like 10 or more years, and are called institutional grade properties.
Core-plus investors are willing to take on an element of risk in order to achieve higher returns than those investing in core strategy properties. Core-plus properties are the next level below investment grade. They are likely more than 10 years old, but are situated in excellent locations. The hold period for core-plus investments is typically 7 to 10 years.
Non-core investments involve medium- to high-risk strategies that target higher levered returns (14 to 18 percent) than the core strategies. Non-core investors aim to add value through capital or management improvements and then sell the asset to lock in the gains.
The typical hold period for non-core investments is 3 to 7 years. The shorter hold period is indicative of the owner's need to sell the asset immediately after the net operating income increases because extended time periods drop the yield per year.
THIS CHART DESCRIBES THE RETURN AND LEVERAGE CHARACTERISTICS OF THESE STRATEGIES. INVESTMENT STRATEGIES LEVERAGED RETURN EXPECTATION LEVERAGE CORE STRATEGY Core 9-11% 50% Core-Plus 11-14% 60% NON-CORE STRATEGY Value-Add 14-18% 70% Opportunistic 18-30% 75%+
* DOING DUE DILIGENCE
Keeping in mind that investors should be thinking about selling their assets even at the time they are buying them, they need to perform due diligence to ensure potential investment properties will be able to fulfill their exit strategy goals.
For all investment grade properties, the due diligence team should utilize a checklist to determine the physical condition of a property or its systems.
This analysis should include areas of physical obsolescence like roof replacement, siding and carpets, as well as plumbing, HVAC and any mechanical systems. An estimated life for each item should be plotted on, at minimum, a ten-year capital project schedule.
Evaluating non-core assets must be taken a step further, taking into account value-add opportunities. This type of process is a bit trickier. Investors must determine which areas or systems can be improved to achieve rent premiums or to reduce economic vacancy.
This analysis might lead to enhancing common areas, amenities, landscaping, or perhaps even management systems. Improvements should be justified by achieving a higher effective gross income level following the enhancements via rent increases or reducing the vacancy and/or concessions at a property.
Submarket rent studies must be completed to determine the appropriate rent positioning for a property after the improvements are complete. Ideally, newer assets in the submarket will establish a clear rent ceiling, as well as other communities of a similar vintage that achieved rent increases for similar improvements. A demographic trend analysis should be included in any value enhancement strategy.
Unfortunately, determining this will be akin somewhat to crystal-ball gazing. An accurate, well prepared marketing plan that demonstrates what similar properties are receiving in increased rent for the aforementioned improvements can help, though. Demographic trends and the subsequent predictions of future needs should be included when interpreting the future for any marketing trends.
Finally, another capital cost has recently been thrown into the mix in real estate, which entails "going green." Although some green initiatives may have a simple payback, most do not provide enough savings to justify the investment. Government subsidies, changes in renters' expectations and demands, and investors' attitudes toward green initiatives can make these investments more economically feasible.
* WHEN TO LET GO
Part of the due diligence process is mapping out the right time to exit--whether that means selling or changing the strategy.
Core investors should consider exiting an investment when they have achieved or outperformed their expected return levels and can lock in performance fees; the capital cost to maintain the "Class A" status is unfeasible due to functional and/or economic obsolescence at the property; and if an opportunity to convert the property to a higher and better use arises, such as converting apartment units to condominiums.
Core-plus investors should consider selling or refinancing their investments when they have achieved or outperformed their expected return levels. They should also consider exiting if major capital projects are forthcoming but will not realize an increase in rent because of changing market conditions, like a flattening or drop in revenue projections.
Because non-core assets are usually held for a short time anyway, the exit strategies for such investments are typically less about when to dispose of a property and more about how to quickly create a higher value for the property--often through conversion.
Investors often consider conversion of multifamily rental apartments to condos or specialty uses like student housing, senior or assisted living, or another alternative real estate use that creates economic value.
Prior to three years ago, the most successful and common exit strategy was condominium conversion, whereby investors prepare an analysis of what they can sell the apartments for, given various scenarios of upgrades; determine their expenses; and then forecast their profit.
Investors must determine the projected sales price they might obtain from another investor or converter, and whether doing the conversion themselves would be most profitable or even possible, considering their skill sets. Sale velocity is one of the major risks when completing a conversion. The slower the sale velocity, the higher the carry costs or interest expenses, which decreases profits.
* ACROSS THE BOARD
Regardless of investment class, investors contemplating an exit of the market always need to be cognizant of the economy, particularly in their region, and how it might influence their profit margin. They should consider having a backup plan in case economic factors like new supply; interest rate spikes; or a recession hurt their net income.
Empirical data, along with experience and gut instinct, should be used to accomplish a profitable exit strategy. Divesting real estate is similar to knowing when to get out of the stock market: There are no absolutes but you can make logical conclusions.
Greg L. Martin, CPM[R] Emeritus, vice president, Draper and Kramer, Inc. [left] Michael Gilmartin, assistant vice president, Draper and Kramer, Inc. [right]
Draper and Kramer, Inc., is a property and financial services firm in Chicago.
If you have questions regarding this article or you are a member interested in writing for JPM[R], please e-mail Mariana Toscas Nowak at firstname.lastname@example.org.
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|Comment:||Do you have an exit strategy? Planning how to get out of an investment is as important as getting into an investment.|
|Author:||Martin, Greg; Gilmartin, Michael|
|Publication:||Journal of Property Management|
|Date:||Jan 1, 2011|
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