Fundamentals

In all of its ventures, LANDCO takes the perspective of a professional real estate owner-operator. We pay attention to the fundamentals of the real estate business

• when investing in real property, whole loans or CMBS
• when restructuring debt or equity
• when advising on management
  

Rent

Nothing is more fundamental to CRE than rent.

All economic benefits of commercial real estate (CRE) may be seen as “rent derivatives”.

The lender’s mortgage payment derives from rent, as does the CMBS bondholder’s distribution, as does the owner’s net income, the seller’s price and the builder’s profit. Even CRE taxes derive from rent.

This basic concept leads to several conclusions:

• CRE is a core business with core customers and core markets.
• Landlords are in an operational business with extensive functions of marketing, maintenance, customer service, risk-management, and compliance.
• Loans, bonds and other rent derivatives find their ultimate value in (a) the landlord’s competence in his core business and (b) the soundness of the relevant rental markets.
• CRE investment relies on the ability of a given asset and its management to generate rent efficiently over the holding period.

Location

Renters usually seek locations first, price and physical improvements second. Thus location often claims a higher value in the decision to rent.

Compared to physical improvements, good locations hold value much longer. Things that constitute a good location — transportation, public infrastructure, proximate employment & business opportunities, amenities, schools, shopping & convenient services — most of these things are difficult to reproduce and do not deteriorate quickly.

A landlord can do much to improve the physical condition of a property and to optimize its operations or capital structure, but the quality of its location is intrinsic.

Management History

Because CRE is an operational business, it is important to analyze prior operations and to measure future expectations against them. What have been the trends in revenue collection, utilities use or payroll? What insurance coverage has been deemed adequate? Is there a discernible renter-profile or target market? Dozens of questions must be addressed. Studying the operational history of CRE is among the most important jobs of an underwriter.

Economic Obsolescence

Rent is a payment for utility. The usefulness of a property, its fitness for purpose, is an important consideration in how much rent it can produce. In addition, operating cost is often higher when building components are obsolete. Energy efficiency is one of the newest considerations in this regard, but there are many more — for example, on-site amenities, fixtures and finishes, ceiling heights, clear spans & floorplates, handicapped access, fire & safety, parking, convenient public transport and many more.

Replacement Cost

All other things being equal, renters will pay more for new construction than old. Therefore, it is important for landlords to apply a discount against used property so that they can offer an attractive value proposition to tenants who have or someday may have newer property available to them.

Cap Rate

The best measure of the economic efficiency of CRE is cap rate: the ratio of net operating income (total revenue, less operating expenses before debt service and capital expenditures) to total asset-cost. For every dollar to acquire this asset, how much will it yield? Cap rate is a useful way to differentiate CRE opportunities and to compare them with fixed income and other investments.

IRR, Leveraged and Unleveraged, IRR Ratio

IRR is a measure of all returns from the property, whether from rent or from capital events such as sale or refinance, compounded as if available for reinvestment at the same rate. IRR may overstate the actual rate of return, because the reinvestment rate is artificial, but the measure is used so commonly in the real estate industry that it has become a useful rule of thumb.

Leveraged IRR is the IRR that derives from an investment with a mortgage, while unleveraged IRR derives from the same investment as if it had no mortgage. Unleveraged IRR will suggest whether an asset represents good value in itself, while leveraged IRR will suggest how much of its value depends upon the specific terms of financing.

IRR ratio compares the rate of return from rents vs. the rate of return from capital events (sale or refinance). A low ratio suggests that investment success leans heavily upon price-appreciation, while a high ratio suggests that the investment is more dependent on profitable rental operations. Because rent is among the prime fundamentals of CRE, a high IRR ratio is generally to be preferred.

There are other fundamentals that come into play when evaluating various CRE opportunities, but the foregoing make up a constellation of factors that LANDCO will look at immediately to determine the feasibility of investing in a particular asset, be it CMBS, a whole loan, or an income-producing property.

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