Five Ways to Protect RE Investments Amid Multiple Economic Cycles

1. Don't over-leverage.

For example, invest with conservative loan-to-value ratio (LTV), ideally utilizing an interest-only (IO) mortgage. A conservative LTV of 50–60 percent will protect your ability to hold these assets in periods of rising interest rates. An IO mortgage ensures that cash flow is being used to meet interest payments, which are lower than amortizing loans. Excess cash flow, if any, can be distributed as a return on investment with significant tax benefits. This combination of conservative leverage, interest expense tax shield and depreciation-deferred tax liability on cash flow offers a superior after-tax cash return.

2. Closely monitor the asset.

Effective commercial real estate investment requires a prudent and thorough asset selection process that must carefully analyze the demographic and economic profiles of the region in which the property is located. This assessment must validate the asset-specific profile of the property. The tenants should be providing essential goods and services to neighborhoods in which the property is located.

Such analysis, both macro and micro, must be vigorously maintained and updated in order for the investment manager to monitor the asset’s ongoing risk profile and relative value. Buy-and-hold cannot mean buy-and-ignore. All regions are vulnerable to the unpredictability of ever-changing economic conditions, and a real estate manager must monitor selling opportunities as vigorously as it monitors purchase opportunities.

3. Be realistic about reasonable, secure returns.

The market for commercial real estate assets is a highly efficient network of informed buyers and sellers. It is unlikely that a transaction occurs where the risk and return are not efficiently correlated. That said, asset managers are far more variable in their skills, efficiency and transparency. What kinds of returns are reasonable? It depends on the asset profile and the asset manager.

An ideal minimum current cash flow is 6.5 percent, plus the investment should have the potential for long-term growth in asset value that matches or exceeds inflation.

Liquidity risk can be carefully managed by assessing the property and demographic profile of the region while employing conservative leverage metrics. In doing so, we are endeavoring to maintain and grow wealth over time.

4. Make sure the client understands how much of the asset they own.

It is essential that the investors receive a preferred return prior to the manager sharing in the income or the profits from the sale. There are many variations, so make certain the client understands the terms of any investment opportunity you are considering on their behalf.

An investment manager's financial reward (other than reasonable overhead) must be based on success and outcome of the realized profits of the investment

An investment manager's financial reward (other than reasonable overhead) must be based on success and outcome of the realized profits of the investment. There can be no hidden fees or undeclared expense allocations that direct cash from the investment to the investment manager. Transparency is essential to the integrity of transactions.

A final bit of advice: Do your due diligence. Just because you're a wonderful manager of apartment building investments doesn't mean you'll automatically be able to provide similar results when investing in shopping centers.