SAN FRANCISCO—In modern portfolio theory, Alpha is the excessreturn of an investment above the market or benchmark return. Inthe capital markets, Alpha is the excess return of common stocksabove a benchmark like the S&P 500 Index or the excess returnof a portfolio of corporate bonds above the Barclay's CapitalAggregate Bond Index. The Alpha for REIT stocks would be the returnin excess of the FTSE NAREIT Index. In CRE, Alpha is the excessreturn generated by the investment owner/manager above a marketreturn like the NCREIF NPI Index. The Alpha return in CRE asopposed to stocks and bonds is primarily generated by theinvestment owner/manager through its control of the real estateasset. This hands-on control of the real estate asset, leases,income/expenses and capital structure enables the owner/manager togenerate an Alpha return.

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Each type of CRE, whether an office building, shopping center,industrial property or apartment complex has distinct income andcash flow properties. These properties primarily derive from thetenant leases that encumber the property. The type of lease,duration, rental rate, expense reimbursements and other leaseprovisions plus additional property income, determine the effectivecash gross income of a property. Cash property operating expensestypically include repairs and maintenance, real estate taxes,insurance, management fees, salaries, utilities and administrativecosts. The net of the effective gross income and operating expensesis the net operating income or NOI. NOI is considered one of themost important metrics in CRE and is used to apply thecapitalization rate to calculate real estate value.

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CRE owners and managers can adopt various policies andstrategies such as revenue enhancing capital improvements, alteringthe ownership and management structure and/or financial engineeringto realize incremental NOI and Alpha value. Some of the mostimportant policies and strategies to create Alpha for CRE arediscussed in the table below.

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Commercial Real Estate Alpha Strategies

Strategy

Description

Alpha Influence

Example

1. Capital Improvements.

Investing additional funds to improve the physical propertyabove and beyond normal and recurring repairs and maintenance.

Can have a moderate effect on NOI and property value dependingon the amount invested and direct benefit to tenants.

Renovation of an office building lobby or new appliances for anapartment project.

2. Capital Redevelopment.

Major physical change or redevelopment of a property due to highvacancy, outdated use, or severe disrepair, to attract or maintaintenants.

Can provide a substantial boost to NOI and value of a property,however, requires substantial new investment.

Complete rehabilitation of an older C apartment property into aB property or conversion of a vacant office building into ahotel.

3. Management and Leasing.

Selection of leasing/management agents and application of NOIenhancing marketing strategies.

There is a wide disparity in the quality of leasing and managingagents especially for apartments and hiring the right firm iscritical to creating value.

Changing the management and leasing agents on a property in asmall suburban market from one of the large global brokerage firmslike CBRE or JLL to a small local firm.

4. Lease Structures.

Changing the lease structure to increase base rents, shiftadditional operating costs to tenants or provide for inflationindexation.

Depends on the property occupancy, local market lease customsand tenant retention, but can have a very positive effect on NOIand value.

Include a CPI rent increase clause or change the lease structureto triple net from a gross lease.

5. Income and Expense Management.

This relates to the management function, however, betterincome/expense management can be beneficial.

Most popular and easiest to implement strategy that can achieve5%-10% increases in NOI.

Make investments in technology to reduce salary and leasingcosts at an apartment project.

6. Market Arbitrage.

This relates to the arbitrage opportunity available fromconverting CRE ownership to/from public (REIT) and privateownership.

This strategy can generate very high Alpha depending on thevaluations assigned in the public (REIT) versus the private market.The valuation of CRE is usually different in the public vs. privatemarkets due to liquidity risk, economic outlook, interest rates andthe availability of capital.

Converting a private real estate company or portfolio to apublic REIT, wherein, most REITs are currently trading atsignificant premiums to private net asset value.

7. Ownership and Advisor Change.

This requires a change in the property ownership or advisorrelationship. Some firms are just better owners/asset managers thanothers.

Many institutional real estate fund owners/sponsors do notpossess the best operating, investment, capital strategy andintellectual capital and therefore, realize lowerreturns.

A public pension fund replacing an underperforming advisor witha new firm.

8. Financial Engineering.

This involves the structure of the property capital stackincluding or the amount, percentage and cost of the first mortgage,mezzanine debt, subordinated debt, preferred equity, owner equityand securitization opportunities.

This is probably the riskiest strategy and a major contributorto the current 2007 CRE bust, however, can provide the highestvalue increase.

Selling the land under a major office building in a long termsale leaseback or capitalizing a project with only 5% equity,multiple layers of non-recourse debt and subordinate financing in adeclining interest rate environment.

9. Cap Rate Arbitrage.

This is similar to market arbitrage above and is usuallydependent on the level of interest rates, inflation and theeconomy.

A drop in cap rates from acquisition to sale can generate thelargest boost in value. A 1% cap rate decline from 6% to 5% canincrease a property's value by 20%.

Acquiring CRE at high cap rates and selling at low cap rates dueto the decline in interest rates or cap rate compression.

Joseph Ori is executive managing director of ParamountCapital Corp. The views expressed in this column are the author'sown.

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