Most commercial real estate funds are structured to acquire assets by using all equity or a combination of equity and debt. If a fund uses debt financing, or leverage, the overall risk increases. It goes without saying that the higher the leverage ratio, the higher the risk. Conversely, increased leverage can lead to higher expected returns. Leverage can be utilized in many ways such as fixed rate loans, floating rate loans, or interest only loans. Depending on the interest rate environment and future projections, each form of leverages can have advantages or disadvantages.
Increased Leverage Advantages:
- Fixed rate loans eliminate interest rate risk since the annual debt service is known for the term of the loan.
- Leverage significantly enhances back end pay offs.
Increased Leverage Disadvantages:
- Amortization of the loan requires principal payments, which decreases short-term cash available for distribution.
- Interest rate adjustments may turn a “cash cow” into something much less desirable.
Income funds usually have a lower expected return because the properties acquired have relatively stable cash flows from long-term leases and good tenants. They typically have a longer time horizon, or fund life, since the primary objective is wealth building and cash flow over the long-term.
Value-add funds normally have higher expected returns since the overall strategy may entail more risk. As an example, these funds look to acquire empty or partially empty buildings or older buildings that can be converted to a higher use. Once they execute the strategy of leasing or repositioning the property, they try to sell the property and recoup the investment plus a substantial profit. If the strategy does not work, the investor may lose some or all of their initial investment. The time horizon for value-add funds range from a few months to a few years.
Finding Your Fund Management
The fund management, or sponsor, is one of the most important aspects to evaluate when selecting a commercial real estate fund. The fund sponsor must have the experience and track record to successfully adapt to market conditions and make decisions that ultimately assure that the fund will meet projected expectations. Ideally, the sponsor should have leasing, management and construction teams in house or the ability to hire the best in the business, like we strive to incorporate at Block Funds.
Even though there are no simple guidelines for asset allocation, a good commercial real estate fund may help balance the risk reward strategy for many investors. Keep in mind that like all investments, the basics remain the same --- sound management, strategy and execution.
Brian Beggs, CFA
Principal, Director of Acquisitions
Block Real Estate Services