Realty investing is not solely an art form

Over the years I have met many investors who have made a fortune in real estate. They have often stressed that investing in the sector is an art and they have always taken a view on an opportunity when making decisions.

Historically, with lower capital values and higher acquisition yields (for developed assets), the above has worked reasonably well. However, with a maturing of the market in the region, we are now witnessing investors undertake a more scientific approach, especially when it comes to acquiring developed assets.

Less than a decade ago, acquisition values for property followed a rule of thumb of 10 per cent of income. The level of due diligence that was undertaken was limited, as arguably even if things didn’t turn out well, there was enough “juice” in the deal for the investor to make a reasonable return. With yields now close to 7 per cent and with higher transaction costs, investors undertake significantly more due diligence, similar to the levels observed in mature markets.

It is here that consultancy firms bring in some “science” to the “art” of investing in real estate by helping to ensure that the returns are not compromised post-acquisition due to change in any of the parameters that could have been assessed prior to the acquisition. My role in advising potential investors is to conduct a thorough review of a transaction, that identifies and allows for a mitigation of those risks within the control of the purchaser.

It’s often said that “the best deal you do, is the one you don’t”, and a solid understanding of the potential risks is key to making better decisions. Four broad areas of due diligence are recommended as a minimum in assessing the acquisition of any potential operating asset; these cover the commercial, technical, legal and accounting aspects.

Commercial: Undertaken at the beginning of any potential acquisition, this should focus on arriving at a true market net income for the asset so as to arrive at the true net yield. Areas of particular focus include ensuring that the asset is rented “at market” and all tenancies are “arm’s length”. The quality, length and escalation in the leases should be reflected in the acquisition yield, as longer term stable income reduces investment risk. Another measure is the cost of redevelopment of the asset, based on current construction costs and land values.

Technical: Undertaken post-agreement on the commercial terms by an engineering consultant. This is particularly important if the asset is over 10 years old, as by then the structural warranty will have lapsed. The objective is to assess if the building is in a good state of maintenance and if any major refurbishment or repair is likely to occur within the next three to five years.

In case of acquiring hotels, importance needs to be paid to whether a maintenance reserve has been built up, which could impact upon the appropriate transaction value. Additionally, the prudent investor should seek information on the development and evidence of the quality of work undertaken during construction.

Legal: A qualified legal counsel should undertake a review all ownership documents and commercial agreements signed by the owner. The objective is to ensure the asset has no ongoing liability as well as to assess legal standing of agreements with third-parties. The counsel also plays a role in drafting and negotiating the legal clauses of the sales and purchase agreement, especially for matters related to representation and warranties offered by the seller to the purchaser.

Accounting: Used to validate that the full value of the income is reflected in the books of statement and bank accounts. This also assists in defining any adjustment to the transaction value, due to advance collections of revenue, pre-payments of expenses and treatment of cash or cash equivalents. A “locked-box” model is often used in case of hospitality assets to arrive at an adjusted transaction value.

While the above due diligence typically costs less than half a per cent of the transaction value, it potentially creates savings of over 5-10 per cent. It saves future losses of much larger quantum when the investor chooses not to pursue a transaction that has too many due diligence issues. Since these run concurrently and usually within a period of three to six weeks, it provides a potential investor with timely insight on whether the transaction is the right one or not.

Real estate investment will never be an exact science, but the use of a more scientific approach will help reduce the pain associated with decisions depending entirely upon the art of “gut feel”.

The writer is head of capital markets at JLL Mena.