4:Real Estate Performance Evaluation

4:Real Estate Performance Evaluation

4.1Introduction

Performance evaluation (PE) is necessarily both the first and last thing to be done if one wants to effectively manage anything, particularly, Real Estate (RE). For example, information on performance will help one to select a car. One’s own evaluation of the car’s performance during its ownership will inform the decision when to buy the next car.

Before any strategy can be devised & implemented, there is the need for performance of RE in its function as the following to be explored & understood at an earlier stage:

-RE as an operational asset

-RE providing space for the core operational activities of business

-RE as core business producing return directly

-RE as a cost base

The performance of RE in all these functions has to be explored and understood again:

-During the implementation of the strategy; and

-After the strategy has been implemented

This is necessary if the iterative process of management are to be applied. But what are the relevant issues that need to be considered in RE PE?

Data issues in RE as core business

-Data required for the assessment of performance of RE as core business include the following:

• Full rental value (FRV) and the rent passing
• Capital value and management costs
• Yields
• Physical characteristics & tenure

-Evaluation questions that need to be asked include the following:

• Is the RE being used in a way that maximizes revenue regarding investment return?
• Are there identifiable ways of improving the performance of the RE?
• Is the RE appropriate within the overall portfolio?

4.2PE of RE as core business

The issues being examined for the purposes of PE can be linked to the three roles that RE plays in any business:

-Asset base

-Cost base

-Trading base

Each role has to be considered in the PE of RE whether RE is held as core business or as an operational asset. While investment objectives have routinely been acknowledged, the performance of RE as core business was not widely monitored until the late 1980s and early 1990s. The RE market crashes of 1974 and 1990 were significant drivers behind the increase in the availability and quality of data as it became clear that RE markets were increasingly volatile and invested with capital sums so substantial that poor decisions could have an impact on the whole economy.

Obviously, extensive analysis will be required, if investors, banks, and RE companies were to develop any thorough understanding of how and why they had become so overexposed to high market risk. The major RE companies increased their research output and publication of consistently collected and analysed market data.

Today, companies like Jones Lang La Salle, Knight Frank, King Sturge & Co. and Investment Property Databank (IPD) all produce regular updates on the markets, focusing on rental levels, yields, capital values, available space, etc. For investors, the overall objective of investing is to maximise returns whilst minimising risk or at least keeping it at a level appropriate to the investor.

Looking at the three roles RE plays within the achievement of business objectives, PE of RE within the investment portfolio must be assessed in the same way - that is:

-As a cost base,

-As an asset base; and

-As a trading base

4.2.1 Evaluation as a cost base

Whilst it is anticipated that RE will produce a return directly, it will inevitably have costs associated with it as well. The costs will be incurred in a variety of ways:

-Negotiations with existing tenants – this can be very time consuming if the RE is multi-tenanted and are required for:

• Rent reviews, lease renewals, and break clauses
• Surrenders and dilapidations
• Enforcement of insurance/repairing obligations

-Collection of rents & service charges

-Legal pursuit of defaulting tenants or guarantors

-Marketing and re-letting

Some prime RE may have quite limited management costs, being blessed with:

-Occupiers of impeccable covenants and standing;

-Reasonably long leases with 5-yearly upwards-only rent reviews; and

-No landlord repairing obligations

A multi-tenanted RE in a secondary location of an unfashionable but prosperous town may actually reap quite substantial rewards as an investment and will require less initial capital outlay. Even though, it may have higher management costs associated with it good active management can pay substantial dividends. This is particularly the case if good management systems are in place, for instance:

-Data requirements are identified and collated

-Familiarity is developed with the location, local development control, local authority policies and the tenants themselves

-Opportunities to increase the rental return through surrender and renewal of poorly structured leases are identified

-The tenants’ business objectives and possible opportunities are understood

-A forward thinking approach is taken to possible development opportunities

Active management can increase the performance of even relatively weak investment portfolios. Active management will be crucial to ensuring satisfactory performance of portfolios dominated by non-prime RE. The strategy has to be to strive to reduce costs as a proportion of revenue whilst maximising revenue as a proportion of capital invested.

4.2.2 Evaluation as an asset base

Rental data

To evaluate performance of RE as an asset, basic information regarding actual and potential income must be collected. Rent passing will be relatively straightforward to determine, but must be placed in context:

-Has the rent been recently set or it is historic?

-What were the market conditions when the rent was set?

If it was set during the period of very high demand and low supply and the current market reflects the opposite conditions, an upcoming rent review may not result in any increase in rent. For a standard lease with an upwards-only rent review clause, the rent will not go down but there may be no guarantees of an uplift.

It is important to be aware of the context provided by the external factors. It might be that the RE has moved from being prime to secondary due to:

-Functional obsolescence

-Locational obsolescence

-Demographic change

-Fashion

-Economic change

It is equally possible the RE can move from being secondary to prime. Any external factors such as urban renewal & regeneration initiative, the relocation or development of a road, rail, or other transport link will affect the rental value of RE.

Terms of occupation

Regarding occupation, it could be that the tenant does not want to renew on the lease terms being offered because of more favourable conditions (regarding leases) are available elsewhere. The current rent generated from the RE is a direct product of the lease conditions under which it is occupied and so this information is also required. The standard commercial lease term in the past has been 25 years with five yearly upwards only rent reviews. However, lease patters have to reflect the requirements of the both the investor and occupier and things have changed over the years. Thus long leases are no more the norm and occupiers now prefer much shorter leases.

Yields

The risk-return ratio (RRR) is the basis of portfolio performance and cannot be adequately evaluated without careful attention to the requirements of the investor. Thus, the return on capital invested required by the investor has to be established. It is difficult to generalise regarding the target or RRR as it will vary from investor to investor. However, the RRR will reflect:

-The return available on relatively lower risk investments such as gilts

-The potential for income growth

-Depreciation

Once the RRR is established, the yield produced by the RE within the client’s portfolio can be evaluated. All the costs associated with the RE should be allowed in the computation of the yield so that the value of the RE will not be overstated. The yield may rise with increases in the rental income. Thus ways of improving on rental income should be looked at in order to maximise the return it is producing. For example, rents could be improved by ensuring that rent review notices are served correctly. The return the RE is producing should be based on the current capital value & not simply on the initial sum invested. This is necessary to make informed decisions as to whether the RE should be retained or sold. It is when the current market value is known that it is possible to realise the opportunity cost (whatever the RE is worth today is capital that could have been invested elsewhere) of the capital invested in the RE.

4.2.3Evaluation as a trading base

The RE should be assessed in terms of whether it should be traded in for something else. In the light of this, each unit of RE within the portfolio has to be evaluated in terms of:

• Existing investment return
• Potential return
• Open market value
• Potential size
• Portfolio spread
• Geographical spread
• Returns available on alternative investment vehicles

This enables informed decisions to be made regarding the trading of the investment. The demand and supply side of the RE investment market need to be compared with other investments.

4.2.4Benchmarking

Performance measurement can be made more effective if:

-There is an opportunity to compare the performance of the organisation’s RE with others.

-The recognition of the value of this type of comparison has led to the development of benchmarking as a growing activity within RE

4.3 PE where RE is an operational asset

This is where RE is not the core business of an organisation. It is used as an operational asset to support the core business activities of the organisation. PE of RE in this case is to ensure that the RE effectively supports the core business activities at minimal costs in order to enhance the return from the core business activities. Thus RE is also considered as an asset and a cost base and the overall object is to minimise costs and at the same time ensure that RE effectively supports the core business.

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