Continued from page 61
85
Owner-Occupied Real Estate, Continued from page 61
A commercial building is only worth the value of what it provides its owners in cash flow — no matter how pretty it is or how much it cost to build — and the bank will base the loan amount on that value. For example, if the appraised value of a commercial property is $5 mil- lion, the bank’s lending standards might support a loan amount up to $4 million, as long as the income stream of the prop- erty can service the mortgage payment. Banks typically require debt ser-
vice coverage of at least 1.20×, which allows a cushion in case the property’s net operating income (NOI) were to decline slightly. The DCR is the ratio of the property’s NOI to the monthly mort- gage payment. In an owner-occupied scenario, a decline in the DCR is usu- ally directly related to deterioration in the business’s performance; when the operating performance of the business begins to falter, the owner decreases the amount of rental expense to the level of the mortgage payment. That is one reason why banks generally require the entrepreneur to sign a personal guar- anty for the amount of the loan granted.
Another advantage:
Asset diversification The addition of real estate to a typi-
cal “stock-and-bond” portfolio often provides a reduction in portfolio risk without the sacrifice of return. This is because of the negative correlation of returns between real estate invest- ment and financial securities. The U.S. National Council of Real Estate Invest- ment Fiduciaries (NCREIF), which cal- culates quarterly rates of return for all commercial properties based on NOI and changes in market value, studied the correlation of real estate, stocks and bond returns from 1978 to 2006. The fol- lowing table details the results of that study and shows that real estate returns
Trends magazine, November/December 2010
over the period are negatively correlated with the S&P 500 and 10-year bonds.
Return Correlation* NCREIF Index S&P 500
10-Year Bonds
−0.0302 −0.1600
*Years 1978 to 2006.8 The combination of negatively cor-
related assets in a portfolio provides enhanced diversification of systematic risk and makes a portfolio more efficient — it achieves a greater amount of return for the same level of risk. The graph below details the improvement in return of a stock-and-bond portfolio when real estate assets are added.
C B
Same risk, but higher return
A Lowest risk
100% fixed income Low risk and low return
Expected Risk Highest risk The red line represents a typical stock-
and-bond portfolio’s efficient frontier, as espoused by Harry Markowitz, the father of efficient portfolio theory. When real estate assets are combined, the portfolio’s efficient frontier moves to the green curve, representing lowered risk at each level of return. The improvement in the portfolio’s risk-adjusted return is due to the negative correlation between real estate and equity and debt securities.
The creation of
value and net worth There are many innovative and legal
ways of creating and capturing value in property. M & G will find that as its busi- ness and its building mature, they will
100% equities High risk and high return
The combination of negatively correlated assets in a portfolio provides enhanced diversification of systematic risk and makes a portfolio more efficient — it achieves a greater amount of return for the same level of risk.
Expected Return
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