RealTMOR Asset Mgmt LLC and RealTMOR Apartment Mgmt LLP
All real estate is not same just as all stocks or all bonds are not same. Commercial and residential properties ARE DIFFERENT!!!!
Commercial Real Estate–Multiple Asset Classes Rolled into ONE: Small/Individual investors typically group together distinct classes of commercial real estate.
- Offices
- Industrial (warehouses, factories)
- Retail (malls, stores, theaters)
- Hospitals and laboratories
- Hotels
Commercial Real Estate at “Discount” to Residential Real Estate in Same Area: Often, in an area, “stores/offices” are available at a discount to “apartments”. Lower unit pricing provides better yield/per sqft price dynamics. Hence, people believe, it’s a BETTER investment. That’s NOT the whole picture!!
Commercial Real Estate Inherently Riskier than Residential: Higher risk is why commercial real estate trades at a discount to residential.
- Prime Area Risk: An area’s Commercial Attractiveness tends to be fickle. For businesses, real estate “expense” is managed to optimize profitability. If business real estate costs increase significantly then “business-area” center of gravity shifts.
Nariman Point, 20 years ago, was Mumbai’s “prime” business area. Over time, due to reasons like cost optimization/commute efficiency, “prime” area(s) shifted to BKC/Lower Parel. Resulting in prices/rents of offices and stores being adversely affected, the negative impact on South Mumbai apartments was less. This isn’t an isolated incident and 20 years ago a similar phenomenon happened in NYC. When I started my Investment Banking career “on Wall Street” (late 90s), my office was located in Midtown Manhattan. There were no more than 3 major Wall Street Firms on “Wall Street” (Downtown Manhattan). In the 70s/80s, Downtown was the “commercial” hub of NYC. By 1990s, most firms operated from Midtown which became the “new prime” business hub (again owing to cost optimization/commute efficiency). Commercial properties in Downtown suffered while apartments blossomed. A case could be made that commercial decongestion increases an area’s “residential” attractiveness.
- Business Cycle/Inherent Business Risk: Previously, I was fundraising for a US Residential REIT. During the roadshow, the CEO shared an insight……. “commercial property investing requires understanding risks associated with ‘tenant businesses’”.
Owning a theater and not understanding the movie business could result in poor decision-making thus adversely impacting income/value. Previously, many mills in Central Mumbai were shut because Indian textiles encountered adverse/unrecoverable business events. The mill (property) owners that could foresee the adversities and react adequately did better. The shuttered real estate was later resurrected by a booming “residential realty market”. Business downside could result in “non-productive” assets in the portfolio for a while. For resurrection, one would need to wait for events outside one’s control.
- Reconfiguration Risk: This risk is underestimated but is critical. Reconfiguration of commercial properties between tenants could be expensive and time-consuming.
The “office” requirements of law-firms are different from those of doctors’ practices. Often, landlords have to reconfigure the premises during tenant changeover periods. If these expenses are passed onto the tenant then, invariably, a downward adjustment of rent ensues. In many cases, renovation cannot be performed during tenant acquisition times because of lack of visibility of tenant type. Many retail malls in Mumbai are languishing because appropriate “anchor tenants” are absent. Finding an anchor tenant is CRITICAL but time consuming and entails extensive/expensive reconfiguration and major compromise to manage tenant needs.
- Zoning/Regulatory Risk: Changes in governmental regulations is a “real” risk for commercial properties. Industrial real estate is prone to emissions, safety-standards and other changes.
Route 130 in New Jersey was a booming biotechnology hub in 2000s. This highway housed facilities of many members of the NASDAQ Biotech Index. NJ laws changed and it became expensive to comply with state laws (regulations on emissions/safety and taxes). The stock markets crashed in 2008 and it became harder for smaller companies to raise cash. Resulting in bankrupting some and forcing relocations to cost-efficient states. Today, there are “To Let” signs all over the area and prices/rents have been irreparably damaged.
- Locational Risk: Location of commercial real estate is critical for type and quality of tenant.
Store-fronts require certain location dynamics while office-spaces need different features. Residential properties, with unattractive locations, can be rented by reducing price because the tenant universe will decrease marginally. For commercial properties, unattractive location dynamics results in the tenant universe to shrink to miniscule proportions. No business wants to be “obscured” to save rent.
- Tenant Credit Risk: Credit risk of a tenant is ability/intent to pay rent.
Residential tenants rent a “home” and invest in the community. Additionally, there is a stigma/pain associated with being evicted from one’s home. Tenants try hard to maintain “stability of home”. No such compulsions for businesses, default risk is a feature of doing business. If things change and businesses can generate cost-savings on the “rent expense” they will surrender the keys and move. During financial distress, the landlord is the last constituent that businesses seek to pay.
- Price Risk: People cite potential of long-term leases with commercial tenants as providing earnings visibility. This could be double-edged sword.
Long-term leases typically require a tenant-discount to compensate for stability. During strong rental markets the landlord may be unable to leverage rising rents. If the lease is signed during weak markets, the base rent could be low and future rent raises inadequate. Cost increases in rental real estate cannot be easily passed onto tenants. .
- Legal Risk: In cases of residential landlord/tenant disputes, often, parties try to settle matters. The motivations include lack of will to waste time and resources.
In terms of commercial disputes, there is a propensity towards escalation and using the legal system (businesses have better legal resources). This could result in significant waste or an untenable situation for the landlord.
All these risks are inherently priced into commercial real estate. Although it may appear attractive, on a risk adjusted basis, commercial properties may not be appropriate for small/individual investors. It may not optimize “personal” money for future needs. This domain is best left to specialized/professional investors (REITs etc.) who are compensated to analyze/manage these risks.