Business 2K Blog Place

Investing in commercial property is well beyond the financial means of most people. Few can afford the large sums of money involved in buying commercial real estate. For most of us our investment in real estate is limited to where we live - our home.

But unfortunately our home doesn’t generate any income or cash flow. In fact it probably costs us money in maintenance, rates and upkeep.

Sure the financial incentive to invest in your own home is to offset the cost of renting or the capital gains you get when you sell your house if it’s value has gone up.

Most financial advisors will tell you the best investment strategy is to pay off your home mortgage as quickly as possible to reduce your debt.

But what about after that if you want to invest in property? You have a choice - invest in another residential property or a commercial property.

Residential properties can often provide a good cash flow from rent, but there are associated hassles with getting good tenants, poor tenants trashing your property and the ongoing cost of maintenance. If you like playing the role of the landlord and being involved in all those activities great! But what if you want a hassle free commercial property professionally managed.

An increasingly popular investment amongst smaller investors and retirees is through syndicated property trusts. This is known as direct property investment where smaller investors buy small parcels of a larger property through a prospectus. These projects are managed and marketed by licensed property dealers.

The prospectus is lodged with the Australian Securities and Investment Commission and the property and syndicate is professionally managed.

As of December 1999 there were 77 Property Syndicates operating in Australia with more than $1.45 billion invested. Nearly 60 per cent of these investments use borrowed money, known as “gearing”.

The benefits for investors buying into property syndicates is they can purchase relatively small parcels, for example as little as $10,000 and gain exposure to the commercial property market.

There is also the added benefit of the commercial property market often being in negative correlation with the share market so investors can spread their risk across their portfolio.

Another benefit provided is the regular income provided by syndicated property trusts, high yields and relatively low risk.

A typical breakdown of a property syndicate is the property management company buys a commercial building ranging from between $10 to $30 million and then they market this to around 300 individual investors who each have an equity subscription of between $40,000 and $50,000 each.

Simon Toovey is the Managing Director of Glenmont Properties a Perth-based property syndicate.

He says their main objective is to invest in properties that have quality tenants, long-term leases, strong returns and good potential for capital growth.

“The benefits of investing in a property syndicate are that it can enhance your lifestyle by providing a regular income, you can set and forget it,” he said.

Toovey gives the example of a typical investor profile of someone looking for secure, regular income rather than capital growth.

‘The most important aspects are location, lease, tenant and management. It’s no good having a lease when the tenant holding that lease is a $2 company. Ideally the tenant is either a government department or a major, “blue chip” corporation,” he said.

“Ultimately, it’s all about income. The right property investment should provide you with more income, income that will enhance your lifestyle, either now or in the future.”

Property syndicates may not be for all investors but they do provide an option for diversifying your investment portfolio.

Ten Tips for First Time Property Syndicate Investors

1. Set your objectives and work out a budget for how much you want to invest.

2. Understand the risk/reward tradeoff. The higher the return the higher the risk. Aim for syndicates with a return of between 8 and 10 per cent.

3. Understand the risks of property syndicates. These are a potentially unfavorable market when selling, rising interest rates, member liabilities and future potential tax changes.

4. Remember this is a long-term investment, usually around 7 years. It is “illiquid”; meaning you can’t take your money out of the investment during this time.

5. Identify investment syndicates with quality property in a good location with potential for capital growth. Ask for a copy of any independent investment and ratings reports.

6. Analyze the lease arrangement. Ask how much rent or income will the property produce, what the income growth is and how long will this continue?

Thomas Murrell MBA CSP is an international business speaker, consultant and award-winning broadcaster. Media Motivators is his regular electronic magazine read by 7,000 professionals in 15 different countries.

These and other problems have contributed to the “welfare mess” and have led to frequent calls to scrap the whole system. Reformers seek a simple structure that would get income into the hands of the poor without destroying the incentive to work. The solution suggested most frequently by economists is the so-called negative income tax (NIT).

A particular NIT plan is defined by picking two numbers: a minimum income level below which no family is allowed to fall (the “guarantee”), and a rate at which benefits are “taxed away” as income rises. The table considers a plan with a $6000 guaranteed income (for a family of four) and a 50 percent tax rate. Thus, a family with no earnings (top row) would receive a $6000 payment (a “negative tax”) from the government. A family earning $2000 (second row) would have the basic benefit reduced by 50 percent of its earnings. Thus, since half its earnings is $1000, it would receive $5000 from the government plus the $2000 earned income for a total income of $7000.

Notice in Table 37-4 that, with a 50 percent tax rate, the increase in total income as earnings rise is always half of the increase in earnings. Thus, there is always some incentive to work. Notice also that there is a level of income at which benefits cease-$12,000 in this example. This “break-even” level of income is not a third number that policymakers can select in the way they select the guarantee and the tax rate. Rather, it is dictated by the other two choices. In our example, $6000 is the maximum possible benefit, and benefits are reduced by 50 cents for each $1 of earnings. Hence benefits will be reduced to zero when 50 percent of earnings is equal to $6000-which occurs when earnings are $12,000. The general relation is:

Guarantee = Tax rate x Break-even level.

The fact that the break-even level is completely determined by the guarantee and the tax rate creates a vexing problem. To make a real dent in the poverty problem, the guarantee will have to come fairly close to the poverty line. But then, any moderate tax rate will push the break-even level way above the poverty line. This means that families who are not considered “poor” (though they are certainly not rich) will also receive benefits. For example, a low tax rate of 333 percent means that some benefits are paid to families whose income is as high as three times the guarantee level.

But if we raise the tax rate to bring the guarantee and the break-even level closer together, the incentive to work shrinks, and with it the principal rationale for the NIT in the first place. So the NIT is no magic cure-all. Difficult choices must still be made.

While economic activity is important for exchange rate determination in the medium run, “other things” often are not equal in the short run. Specifically, one factor that often seems to call the tune in determining exchange rate movements in the short run is interest rate differentials. There is an enormous fund of so-called hot moncyowned by banks, multinational corporations, and wealthy individuals of all nations, and amounting to well over a trillion dollars-that travels around the globe in search of the highest interest rates.

Thus suppose that British government bonds are paying an 8 percent rate of interest when yields on equally safe American government securities rise to 10 percent. British investors will be attracted by the high interest rates in the United States and will offer pounds for sale in order to buy dollars, planning to use those dollars to buy American securities. At the same time, American investors will find investing in the United States more attractive than ever, so fewer pounds will be demanded by Americans.

When the demand schedule falls and the supply curve rises, the effect on price is predictable: the pound will depreciate, as Figure 19-3 shows. In the figure, the supply curve of pounds shifts outward from S, S, to SzSz when British investors seek to sell pounds in order to purchase U.S. securities. At the same time, American investors wish to buy fewer pounds because they no longer wish to invest in British securities. Thus the demand curve shifts inward from D, D, to D,D,. The result, in our example, is a depreciation of the pound from $1.60 to $1,40. In general:

Holding other things equal, countries with high interest rates are able to attract more capital than are countries with low interest rates. Thus a rise in interest rates often will lead to an appreciation of the curreucN-, and a drop in interest rates will lead to a depreciation.

Most experts in international finance agree that this factor is the major determinant of exchange rates in the short run. It certainly played a predominant role in the stunning movements of the U.S. dollar during the 1980s. Early in the decade, American interest rates rose well above comparable interest rates abroad. In consequence, foreign capital was attracted here, American capital stayed at home, and the dollar soared. Then, in the mid-1980s, the gap between U.S. and foreign interest rates narrowed and the dollar fell.

In recent years, managers have become far more aware that what people know about their firms profoundly affects how firms function. They invest heavily in public relations, issue advertising, and reputational management, and actively promote favorable images to relevant publics. They use annual reports strategically to influence readers: A study of 18 firms over a 17-year period showed that managers of unstable firms claimed more attempts to control their environments than did managers of stable firms.

Executives try to sway the business press and mass media by sending position papers and sponsored reports free of charge to reporters. Company representatives often testify before congressional subcommittees. Managers also distribute information and business propaganda to the educational system and routinely supply valued executives to universities and governmental agencies for internships. Finally, everyone tries to co-opt government in order to diffuse its power to influence their competitiveness. Many studies document how often regulatory agencies have become captives of the industries they monitor. Regulators rely on information provided by the industry to make decisions, and agency personnel frequently move in and out of line positions in the industry.

In the booming 1980s, managers also conducted extensive public relations campaigns. Recent mergers indicate that public relations firms themselves are not unaware of their need to develop a presence in government: In 1986, public relations giant Hill & Knowlton acquired a Washington-based lobbying company. Within weeks, the world’s second largest public relations agency, Burston-Marsteller, announced that it too was acquiring a Washington lobbying firm. Not surprisingly, firms invest considerable sums on legal staffs to represent them to government regulators and in the courts. Corporate lawyers regularly prepare amicus curiae (friend of the court) briefs to influence judges’ opinions. Senior managers directly lobby legislators and executive staff on behalf of their firms, their industries, or sectors of the business community.

If the prolonged court attack on the tobacco companies has nearly always ended in dismissal, it is undoubtedly because tobacco firms have made vast investments in legal and medical research, in countertestimony at court trials, and in adroit congressional maneuvering. Declining domestic sales recently catapulted exports by U.S. cigarette makers and shifted the playing field to Europe and Asia. The proindustry Asian Tobacco Council, for instance, has helped companies lobby foreign governments to prevent them from adopting measures as strict as Thailand’s, with its high import duties, cumbersome customs clearance procedures, and ban on cigarette advertising. Already, exports of U.S. cigarettes to East Asia have grown from 18.4 billion in 1985 to 75 billion in 1990.

To an extent, savvy managers manipulate public opinion through deliberate, albeit veiled, relationships with trade press, public relations advisors, management consultants, investment advisors, and lawyers. By assisting competing firms and communicating through elaborate networks within industries, they enhance the spread of information about firms’ activities, problems, discoveries, new product ideas, and innovations. They also help both to build up and tear down firms’ reputations in their industries. One investigation of Fortune 500 firms found that the financial markets and the media relied on quite different kinds of information in assessing firms: The stock market and institutional investors assessed firms principally on the basis of profitability and risk, while the media were more attentive to large firms and firms donating more to charitable causes.

To maintain their firms’ reputations (and, frequently, the stock’s price on an exchange), managers have become more involved in negotiating with their stakeholders over the impact of firms’ activities on their welfare. Special interest associations representing labor, consumers, communities, or issues increasingly challenge managerial prerogatives and question the legitimacy of firms’ activities. So firms in highly visible domains face higher levels of stakeholder conflict, whether because they deal with contested product-market domains (tobacco, biotechnology), raise questions of national public policy (aerospace, defense, oil), or rely on risky technologies (nuclear power, chemicals). The more power a stakeholder group can marshall to draw attention to its concerns, the more likely companies are to incorporate stakeholder objectives into their decisions. More than ever managers are seeking to appear socially responsive and environment-friendly, whether through charitable contributions, affirmative action, recycling, following the Sullivan principles, or promoting representative stakeholders to positions of influence, for instance to their boards of directors.

To determine the marginal tax bracket, it is important to know precisely the levels of taxable and nontaxable income. Equally significant is determining which types of income are included and excluded from taxation. In this context, four types of income should be taken into account.

Ordinary income. This includes wages and interest which are fully taxable.

Capital gains. Income is taxed only on 40% of the reportable gain if an asset is held for a minimum of six months, when acquired after June 22, 1984, and before January 1, 1988. Assets acquired before or after these dates require a holding period of one year. To be eligible for capital gains treatment, an asset must be held for investment, or be categorized as a certain type of business asset.

Tax exempt. Income from some sources-notably, interest from municipal securities-is exempt from taxation.

Return of capital. No tax is paid when principal, such as loan repayment, is returned. (Interest is taxable, but principal is not.)

Over the years, income has been divided into these categories as the IRC was influenced by a variety of factors. At this point in time, revenue laws have been modified so that their sole objective is not simply raising revenue. Encouraging economic development and social and political goals, as well as the feasibility of enforcement, are now among the basic components of federal tax laws. Consequently, the tax system-not necessarily logic-determines what and when income is taxable.

Lenders and other suppliers of capital have changed their attitudes toward inflation. Generally, prior to 1980, most lenders ignored inflation or believed that whenever it went up, it would soon return to “reasonable” levels. However, after years of basically negative real interest rates, the financial community has drastically revised its expectations concerning inflation. If the future inflation rate could be forecasted reliably, lenders would write in advance loan contracts that contained interest rates that would offset future price increases. The difficulty, of course, is that the actual inflation rate may be different from the expected one.

The basic distinction HUD-FHA makes regarding the borrowers eligible for particular programs is whether the borrower is a private, profit-motivated entity or a public or non profit organization.

The program is a special case in that it involves a rent subsidy paid to owners on behalf of tenants in approved low-income housing. It typically applies to newly constructed or substantially rehabilitated buildings, but it is also available to tenants occupying existing nonrehabilitated apartment dwellings.

By 1989, labor costs in Sweden, the Netherlands, and West Germany exceeded our own, and costs in France, Italy, and Japan were not far behind. Yet American imports of Toyotas from Japan, Volkswagens from Germany, and Volvos from Sweden grew as wages in those countries rose relative to American wages.

By comparison, European and Japanese wages were far below those in the United States in the 1950s, and yet American industry had no trouble marketing our products abroad. In fact, the main problem then was to bring our imports up to the level at which they roughly balanced our bountiful exports. Ironically, our position in the international marketplace deteriorated as wage levels in Europe and Japan began to rise closer to our own.

Clearly, then, cheap foreign labor need not serve as a crucial obstacle to U.S. sales abroad-as a “common sense” view of the matter suggests. In this chapter we will see what is wrong with that view.

Using cash flows as a basis for decision making. Two basic decision-making tools: traditional valuation methods and rules of thumb and ratios. Since traditional valuation methods and most ratios do not explicitly use after-tax figures in their analysis, here we cover only one commonly used rule of thumb along with new techniques called discounted cash flow models.

Rule of Thumb: The After-Tax Rate (ATR)

Operationally,
ATR = ATCF equity investment

For instance, the expected ATCF for our apartment building example was $1,860 for the first year, and the equity investment is the $140,000 price plus the acquisition costs ($1,500) and the financing costs ($2,240) less the $112,000 mortgage, or $31,740; the ATR then would be 5.86 percent. As a basis for decision making, the ATR is subject to the same limitations as the EDR.

The expected rate of return is the rate investors expect the investment to provide in the future, given a set of assumptions. These assumptions are based on estimates about what will occur in the future with items like rents, expenses, and tax consequences. The required rate of return is the rate investors demand for a certain type of investment given the riskiness perceived inherent in it. In the apartment building example, we compared the required rate with the investment’s expected rate to determine whether we should buy the building. Since the expected rate exceeded our required rate, we made the decision to buy.

Both the expected and the required rates are based on future expectations and are used to make the investment decision. The actual rate of return, however, can be computed only after the investment has been made. It is thus a historical, after-the-fact rate that is not directly useful in making the investment decision. And it may differ from the required and expected rates since they are based on estimations of the future.

This distinction between various rates is fundamentally important in real estate investing. The investor unwilling to assume large risks will have a lower required rate and will search out those investments whose variability of income is low. In addition, this investor will be wary of investments that promise high rates of return and low risk, based on historical (actual) rates of return. The past is not necessarily representative of the future, and if the elements of risk are still present, then the investment’s risk level is not really “low.” But all else being equal, given two investments with equivalent returns, the investor will always choose the one with the lower risk. Conversely, for investments offering the same risk level, the investor will choose the one with the higher return.