Prescriptive advice for investors in commercial real estate

The world of finance in general and real estate in specific has become increasingly volatile over the past number of years. Events previously considered infrequent and negligible has become more significant if not more frequent. With the increasingly complexity of the world, neo-classic economic theory is being critiqued for its inadequacy of explaining real world events. Events are not, as the theory suggests, insignificant even if they are assumed infrequent.

For example, the 2008 U.S. subprime crisis serves as the latest reminder of an imperfect financial system. What made this crisis even more significant than a financial dip in the U.S. is the effect it had on other economies. Globalisation and the interconnectedness of economies make what happens in one country important and of concern to another.

An event like this usually, or rather should, prompt a fundamental questioning and inspection into what caused it and what possible changes to the economic-, banking- or financial system is required to avoid repeating it. This process of investigation and remediation will lead to either an improvement of the current system or a radical departure and changeover to a new structure.

In their report, A new paradigm for real estate valuation?, Wyman et al. (2011) argue the need for conventional valuation theory to include complexity economic theory and agent-based modelling to improve current day understanding of real estate price determination. This calls for a better understanding of how property price determination works in volatile markets.

The test of any theory is whether it explains real-world observations. If neo-classic theory states that events are normally distributed and outliers are insignificant, then a financial crisis should be infrequent and insignificant. However, in reality, a financial crisis might be somewhat infrequent but is most definitely not insignificant. If a theory does not match the observation, it calls for improvement or it stands to become redundant.

It is not the intention of this article to add to the criticism of neo-classical theory or to argue its redundancy; conversely, it is efficient, but only in a certain context. In turn, complexity theory is still very much in its infancy stage and real-world application is some time away. Although it is very efficient at describing certain real world events, especially volatile environments, it does not lead to prediction and never will. It is an abstract theory with allegorical utility.

Cape Value has conducted research aimed at delivering two outcomes. The first was to develop a reality matrix model aimed at contextualising the efficiency of the two opposing schools of thought (neo-classic theory and complexity theory) within a level of analysis (macro, meso and micro), however, this will not be addressed here. For more information on this, please contact us.

The second aim was to deliver a list of prescriptive advice on the identification of unexpected risks in the commercial real estate sector of Cape Town. By mapping a systems diagram on how commercial real estate in Cape Town works, through consensus of various market participants, it is possible to identify systemic risks when analysing the various loops in the diagram.

Twenty risks were identified and the research findings can be organised into four themes namely government failure, dependence on debt finance, natural disasters and market dynamics. This article will discuss one risk per theme together with possible mitigation strategies.

Government failure theme

Dependence on a single mode of transport can result in inaccessibility or sporadic high costs. The price of private vehicles can increase exponentially due to shortage of steel. The cost of fuel can increase unsustainably due to changes in the oil market. Taxi or bus drivers’ going on strike will require alternative transport arrangements that can be costly. Corporates dependent on flying executives and managers to various meeting points can be susceptible to high aviation costs or the unavailability of flights due to a natural disaster or a major accident on the landing strip.

Possible strategies are to ensure a familiarity with multiple transport systems and to create a technology backup solution.

Dependence on debt finance theme

Developers identify opportunities for development while investors identify investment opportunities or plan capital expenditure for renovations, refits or maintenance. This is all based on the implicit assumption that money or capital will be available from lending institutions. Occasions can arise where no capital is available and developers will be required to either halt new development or be self-funded, and investors cannot make an investment or expend on maintenance.

Possible strategies include various arrangements such as to maintain large cash reserves, change supplier payment terms (customer or supplier side), conduct an internal cash flow prioritisation and stacking of projects, sign rental agreements with the end-user while retaining ownership, or consider a formalised barter trading system.

Natural disasters theme

Weather changes can result in water shortage and rationing with accompanying levies for water-dependent or less water efficient buildings. Older, less modern commercial property will use more amounts of water than their counterparts (green buildings).

In addition, depending on the location, some sea front or riverbank commercial property can be susceptible to flood or storm damage, properties located in electric belts can be increasingly susceptible to storms, or properties located in on quarry can be exposed to landslip or shifting foundations. The challenge with insurance is not the traditionally known risks such as these, but the occurrence of events in areas not anticipated before. Unfortunately, it is not possible to know the where and the what of these events as the luck of the draw will be with those not holding property in an area that has become exposed to a certain event.

However, possible strategies include investing in the greening of buildings (design and technology) and to not invest in properties located on a river bed, sea front, quarry or mineral rich area.

Market dynamics theme

Socio-cultural changes also affect building use. The increasing popularity of shared workspaces is changing the traditional view of space market management. Individual freelancers or micro businesses require workspace on demand with fitted services such as internet connectivity, call filtering, or boardroom facilities. This requires a change in building configuration (types of services offered) and how income is managed (short-term contracts and marketing strategy for building).

The unique locational economic advantage of a commercial building can be a sustainable competitive advantage in relation to other competing properties. However, there is always the risk of an unrelated substituting risk driven by technology that can eradicate the economic edge. This should not be interpreted as the unilateral demise of physical locational advantage, but rather the increasing complexity and channel management of modern day business.

Therefore, the degree of desirability of a certain location attracts, ceteris paribus, a certain quality of tenant with higher quality tenants normally associated with good locations and vice versa. The quality of a tenant affects the quality of adjacent tenants creating a reinforcing loop spiralling either upwards or downwards.

Another aspect of managing a portfolio of investments is the security of income derived from the quality of tenants and associated lease expiry profiles. Building managers try to ensure a degree of uniformity in timing of lease expiry i.e. to not expire all at the same time, but this assumes the tenant’s ability to pay the agreed rental amounts. Rather than taking a historical view and analysing a tenant’s bank and credit history, Cape Value recommends that an investor should hold a deeper understanding of the tenant’s business model so as to manage the future security of income on your investment. Understanding each tenant’s business in terms of a network or system would deliver greater insight and lower the risk of income loss.

Possible strategies include the creation of a management and research team to continuously research and advise on the selection and tenant mix decisions focusing more specifically on the modelling and understanding of each tenant’s business in a systemic fashion.