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AQUICORE RESOURCE LIBRARY
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Goals of Asset Management
Essential Financial Concepts
Commercial Property Lifecycle
Acquisition
Ownership
Disposition
Lease negotiations. Improving net operating income. Interfacing with property managers. Updating investors. There’s a lot to do at every stage of the deal cycle — and a lot of information in disparate places that you need to do it. To start making sense of it all, we like to go back to the basics by understanding what exactly asset management is, how it fits into the machine of commercial real estate, and the goals that drive every decision and power every interaction.
So, what is commercial real estate asset management? It is the process of buying, selling, and holding assets with the goal of maximizing a property’s value and return on investment.
The Difference Between Portfolio, Asset, and Property Management
The breakdown of roles and responsibilities in commercial real estate can be confusing. While there is often overlap between portfolio, asset, and property management, there are distinct differences between the three.
Portfolio management consists of high-level decision-making for and analysis of a portfolio of properties, typically 20-30 but this can vary by organization. Portfolio managers drive investment strategy; asking questions like: how do we hit our returns at the fund level or for the company and how do all of the cash flows of our properties work together to create the kind of returns we want for our company and our investor base? To find these answers, they run scenario analyses that involve the acquisition and sale of multiple properties and analyze year over year trends. Portfolio management also includes budgeting for the overall portfolio as well as financing.
Asset management consists of high-level decision-making for a subset of properties within a portfolio, typically eight to 12. Asset managers drive the business plan for these properties and oversee property management teams without delving into day-to-day operations. They are responsible for leasing, capital improvements, budgeting, and occasionally, financing.
Property management involves overseeing the day-to-day operations and maintenance of a building and often includes bookkeeping and accounting as well. Property managers oversee any onsite work and minor capital projects. They are responsible for reporting back to the asset manager and working closely with them to maximize operating income.
As you can see, asset managers are responsible for a lot of moving parts but their primary goals are generally always the same.
Goal 1: Maximize value of the property. When it comes time to sell, asset managers strive to secure high valuations and make properties as attractive as possible to potential buyers. They accomplish this through a mix of strategies that include expense reduction, curing deferred maintenance items, strategic lease structuring, and presenting a property’s upsides to potential buyers.
Goal 2: Maximize returns. Although you can maximize value, that doesn’t mean you’ve maximized the returns promised to investors. To measure this, asset managers use a metric known as the internal rate of return (IRR) which takes into account the time value of money. In other words, taking into account how long you plan to hold a property, the equity multiple (how many times over the investors have earned back their initial investment), and the cash on cash return (even if there is a large sale value, many investors expect quarterly or yearly returns). Asset managers accomplish this by determining optimal sale timing through conducting a hold-sell analysis; minimizing vacancy without sacrificing market rent; and closely monitoring a property’s construction budget.
Goal 3: Minimize risk. To minimize investor risk, asset managers must constantly monitor market conditions, be strategic when it comes to selecting tenants and build good relationships with them, stay ahead of lease expirations, and carefully balance maximizing occupancy with maximizing revenue.
To understand how these goals are achieved and measured, there are a few financial concepts you need to know.
Calculating Net Operating Income
Two factors contribute to net operating income: revenue and operating expenses. Asset managers tend to spend the bulk of their time working to maximize revenue, and that makes sense; revenue swings up and down quickly and sometimes dramatically in response to a building’s positioning, local market, and an endless list of other factors. By contrast, operating expenses are usually fairly consistent year to year, and even with a lot of work, there are hard limits on how much can be cut.
Understanding Capitalization Rates
The capitalization rate, often referred to as a cap rate, represents the anticipated return after one year as if you had bought with cash. Cap rates usually move slowly and are determined by factors external to the building, like asset type and neighborhood.
For example, a property with a higher cap rate will see a proportionally smaller gain in asset value relative to increases in NOI. So a 10 percent cap rate building would see half the gain of a 5 percent building. Another way of looking at this equation is to see cap rate as a fixed variable that expresses investors’ ROI. Because NOI is the only variable that can be directly controlled, we can think about it as determining the value of the asset.
Determining Asset Value
A commonly used valuation method combines income and the cap rate to determine the current value of a property being considered for purchase. In this method, asset value (AV) is equal to net operating income (NOI) divided by the asset’s capitalization rate (CAP). This produces the following equation: AV=NOI / CAP. This information will tell you if the property meets your cash flow and profitability goals and expectations.
When it comes to asset management, every commercial property falls somewhere on the buy-hold-sell continuum. During each phase of the property lifecycle, asset managers have different priorities and responsibilities but are ultimately responsible for ensuring that all aspects of the deal are going smoothly from acquisition to disposition as well as throughout the entirety of the ownership period.
To begin the acquisition phase, buyers start by establishing a comprehensive understanding of their target markets. Asset managers have their finger on the pulse of market dynamics and can provide acquisition teams with firsthand knowledge of trends, including rents, property taxes, insurance premiums, and other factors that affect real estate performance. Commercial real estate investments are typically evaluated by combining those market dynamics with the historical performance of a given property, and then comparing that to the purchase price.
Asset managers will often construct a business plan to increase the value of the property over time and generate stable cash flow for investors. A typical plan may include steps to assess local market demand, estimate the costs and revenue potential of certain property improvements, and evaluate opportunities for new management to enhance revenues or better manage expenses. As such, there are three main investment approaches that buyers employ when looking to acquire assets.
After a property has been identified and is under contract, due diligence occurs. Asset managers work closely with acquisition teams to ensure that assumptions about revenue, expenses, and occupancy are realistic based on experience and comparable properties in the market. Physical inspections of the property also occur.
Once the deal has closed, it falls to the asset manager to ensure a seamless transition from one ownership group to the next. Asset managers must ensure that the property is operational from day one. This includes getting the property management team up to speed and transferring ownership of all utilities and regular service contracts (or putting new ones in place).
Ownership is at the heart of asset management. It is the period in an asset’s life cycle where asset managers and property teams can have the most impact on improving performance and increasing NOI.
Operational Improvements
In a world full of macromanagement, it’s easy to overlook the details, like operational costs in favor of the overall market or a building’s positioning. This is a trap you’ll want to avoid. Small changes in operating costs result in large swings in asset value thanks to the way that net operating income affects value. The result is that a project that seems marginal, but that will reliably decrease expenses over the long term may result in important returns on investment across a portfolio.
Before you can begin executing any performance optimization program, you’ll need to collect building data for your portfolio. And for that data to be useful, it must be centralized, accessible, and accurate. Experienced property teams will be familiar with common energy optimization strategies but won’t be able to act on them without the right set of tools. The right analytics software will help you collect data, uncover operational improvement projects, coordinate action across property teams, measure the impact of your efforts, and allow you to easily report your results.
Leasing Options
Leases serve as the primary income stream for commercial properties and typically dictate who pays what expenses within a building. Asset managers are responsible for negotiating the terms with tenants and making strategic decisions about which tenants will ultimately be the best fit for a property. At the highest level, gross and net leases are the two main types you’ll want to be familiar with. With pros and cons to each, it’s important to determine which will be the more beneficial to all sides of the agreement, as well as your building itself.
A gross lease allows the tenant to pay a single flat fee for use of the space. Under this agreement, the landlord covers taxes, utilities, insurance, and, often, repairs. That is, they cover any and all expenses that may come with the property, while the tenant simply pays to use the space. Landlords who plan to make energy efficiency investments in their property may prefer a gross lease. Because the landlord is paying the utility costs and passing on a fixed cost to the tenants, he or she can easily recoup these costs. Because the tenant will continue to pay the same, agreed-upon rate even after the cost of utilities goes down, the tenant effectively subsidizes the cost of the upgrade.
On the other hand, a net lease is the complete opposite of a gross lease. Tenants under these arrangements will typically cover operational costs as well as the cost of using the space. A triple net lease, the most common type of net lease, dictates that tenants cover taxes, utilities, and operating costs in addition to renting the space itself. Triple net leases are often determined by square footage of the commercial building space or through submetering. What a tenant loses in control when leasing by square foot, they gain in the equitability offered by submetering, paying only for what they consume. Shouldering utility costs often motivates tenants to be more environmentally conscious; thus a triple net lease can be a great choice for energy efficiency and the burgeoning green market.
Going Green
Of course, standard choices are never the only options. In some cases, you may find yourself considering a green lease. A green lease can be either gross or net, depending upon the needs and goals of landlords and tenants. Both parties will likely have to discuss these needs and goals in-depth during a negotiation before signing a green lease. A green lease simply implies those interested are aligned for energy efficiency.
A unique aspect of green leases is the cost-sharing clauses available. For example, unlike a standard triple net lease, landlords under a green lease may allocate parts or even all of the costs of energy efficiency investments upon the tenants, providing benefits to both sides as well as significantly helping the environment whilst raising the value of the building by readying it for a green market.
Potential partners might consider entering a green lease for various reasons. One factor, for instance, may simply be that contemporary trends are pointing toward green buildings, with about 35% of clients looking to lease or buy commercial space with significant green stamps. This is why, alongside lowering operating costs, a green lease may help increase property values. But how, then, do you ensure your building is ready and able to compete within a green market?
First, verify that your building is LEED-certified, therefore meeting specific requirements for lower energy consumption and higher air quality. Similarly, make sure you have the best and most current Energy Star-rated equipment available, thus helping your building run efficiently. Even small changes can have a large impact, so little things like turning off all lights at night or changing the thermostat based on the building’s capacity may go a long way. Understand the policies and regulations of green buildings, as this may help you make a switch to alternative means of energy like solar panels. Not only will these actions help the environment, but you may find your building reaping rewards such as tax incentives and an increase in tenant interest by choosing to go green.
There are several reasons to sell a property. The ownership group may want to free up capital for other investments or rid themselves of a property plagued by management headaches or partnership issues. With some properties, the internal rate of return may drop after a certain number of years, meaning there is greater risk in holding on to it compared to selling. Often, shorter hold periods can magnify IRR.
There are three main strategies when it comes to exiting a real estate investment.
While asset managers have an important role to play in all three of the scenarios above, selling a property outright requires the most operational savviness. Prospective buyers will look back at least 12 months of operating statements and make assumptions about how the property will perform going forward. Ideally, you will have been optimizing building performance throughout your entire hold period but if not, you must begin to 12-18 months before your property hits the market. Demonstrating that a property is operating efficiently is critical to securing a high valuation when you go to sell.
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