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Re-Look at Real Estate Investment
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Article
By Daily Express, 02 Jan 19
clock 02-01-2019
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Sabah was a darling investment hotspot of property speculators – many of whom had gained in the past from flipping their bookings on real estate projects.

Then a downturn came along, or rather a period of cooling measures taken by Bank Negara on responsible lending on banks under its control, to avert a property bubble crisis.

The year 2018 was a serious year for some of the property investors to re-look their investment portfolios and the same goes for other more serious long-term property investors on their choices of property.


When talking of long-term property investment, the tragic tales of Star City and 1Sulaman continue to dampen outlooks of optimists as the regulator government was clueless.
Back in the peak of the commercial real estate market many investors bought properties with values underwritten by "pro forma" rents.

By "pro forma" rents, it was meant that properties were under-written based on projected lease rates, occupancy rates, and future increases as opposed to actual operating history of a property or a comparable property.

The obvious risk with this approach is that inaccurate assumptions can lead to dramatic swings in actual property performance.

To complicate matters, many lenders also underwrote deals based on these assumptions. Many of these assumptions added to the downturn that we've experienced.

With the downturn in the commercial real estate investment market, investors and lenders alike were forced to "get real" with the way they valued properties.

Property values were derived based on actual operating history which was a tough pill to swallow for those properties experiencing high vacancies. Essentially no value was being given to that square footage that was not leased.

Previously, for example, Wisma Merdeka and Centre Point Sabah hardly had any vacant ground floor shops, but now there are available units for rent without any tenants for months as landlords have high rental income expectations.

As for market vacancy – what is real market vacancy for such property? How has this property performed relative to the market historically? It is important to understand what stabilised occupancy really is.

On costs to obtain pro forma occupancy – if pro forma occupancy is realistic – there will usually be a cost in the form of downtime, leasing commissions, and tenant improvements to reach pro forma occupancy that must be considered in the analysis.

As for lease rate risk – it is imperative to make sure that projected lease rates are reflective of current market conditions for comparable properties.

It is too easy to say that lease rates "should" be higher when historically they have not been. It is also important to underwrite in-place leases to determine where those leases will renew at.

There are significant differences between sales and rental incomes especially for commercial properties, as more retail spaces are seen vacant without any tenants.

With more malls in the market what is the fundamental source(s) of revenue, and what are the risks associated with these sources?

Many people invested based on the promises of sales personnel of the developers projecting an attractive income stream or positive gain in resale value due to capital appreciation.


Further rental incomes are in many forms the terms of which are quintessential to the risk and reliability of cash flow projections.
Some real estate investments offer "other income sources" such as concession rights, and the portfolio of sources paints the big picture of what the investments is about.

These returns are based on current value of positive or negative cash flows over the course of time called the "planning horizon."

The horizon may be five to 10 years but it's the first three years that are the most significant.

Technically, sources of income are assessed at estimated contracted amounts. The broken promises of guaranteed rental income from the Oceanus mall fiasco is just a case in mind.

Values are often based on comparable properties and escalated over time along with escalating expenses.

Sources and uses are timed based on assumptions. Various "scenarios" are studied when evaluating risk, as are "sensitivities" of cash flows to key determinants such as commercial lending rates and other capital market conditions.

Projected returns are highly sensitive to the timing of these factors. Supply, demand, evolving capital market conditions, vacancy rates, absorption rates, lease terms, work letters, and other contractual events play significant roles in the timing of cash flows.

Timing often controls the financial outcome of any given pro forma scenario and investors need to carefully explore and understand the timing behind pro formas they are presented.

Gross income is the "top line" of a pro forma, and it is the sum total of all sales or rent rolls, or a combination.

Effective Gross Income (EGI) is gross income minus adjustments for risks such as vacancy and where absorption is accounted in the timing of gross revenue.

EGI is the "top line" from which expenses are deducted to project cash flows.

EGI is an adjusted gross revenue potential for rental properties at the current contracted lease rates and vacancy allowances, and forecasted with escalation factors into the out years.

Operating expenses is the grand list of all costs to be paid from EGI before paying returns to investors.

This includes all landlord and property owner costs such as broker fees, common utility charges and any property taxes.


There are surprises and landmines in the grand list that most new investors to real estate do not understand.
Sales and rent rolls must be sufficiently large and robust to cover expenses long-term in order for the real estate to be commercially viable, and scenario analysis may demonstrate there may be sustained periods of time when investors are not getting paid.

All pro formas that project positive returns assume a long-term balance between sustainable sources of income and a timing, nature, and escalation expenses in economic harmony.

Scenario analysis gives investors insight into worse case scenarios which are critical to understanding individual fit of an investor to the speculative nature of some investments.

Net Operating Income (NOI) is EGI minus Expenses. NOI is the key variable behind whether a real estate investment will produce positive or negative returns.

NOI can be reasonably accurate when based on existing operations. It is significantly more difficult to project NOI for a property that is yet to be developed, especially if the investor is not certain of how to maximise potential or does not fully understand the specific market and its cycles.

For this reason, NOI projections rely heavily on comparables, a comparison method which is a darling of property valuers, the so-called professional property consultants.

Projected returns to investors are expressed in different ways but all returns are based on NOI.

Internal Rate of Return (IRR) is an industry norm for returns. It is expressed as a percentage usually stated as a "leveraged" meaning the returns to equity investors assume some level of commercial debt was used helped to finance the investment on a long-term basis.

Therefore, the amount and terms of that commercial debt is key driver behind IRR.

Moreover, there are many assumptions and factors influencing any particular pro formas' outcome.

Underwriting studies scenarios and sensitivity of a pro forma to a range of risk factors that influence outcome.

Most such studies demonstrate ranges from negative to positive returns, and weighted averages are used by sophisticated organisations to compare one investment to another.

New investors to real estate often find themselves presented with a single pro forma or possibly even a "back of the envelope" analysis.

The investor needs to critically challenge and test the underwriting behind the pro forma along with its assumptions, and understand the risks they truly face.

Performance during the first 3-year is the most critical, as in the case of Oceanus mall. By itself a single pro forma showing a snapshot in time is out of context with the underlying risks of real estate in any particular location.

Yes, it takes time as some wise sages advise, but tell that to retirees who put all their retirement funds in Star City abandoned mall, now slated to be revived in 2019. - David Thien

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