January 2005 Defining and Determining Core and Non-Core Real Estate Investment Strategies With real estate assets, there are two key investment styles: Core and Non-Core. But what do these labels really mean? Both of these investment approaches have an important role to play in meeting the rates of return objectives for investors. The successful implementation of these two investment styles requires a particular set of skills and resources. In going from Core to Non-Core, the ultimate investment return is expected to be higher, but so is the inherent risk. As a result, the primary differentiation between Core and Non- Core are the rates of return the riskier the property, the higher the potential return. Table 1 provides a general guideline for the attainable non-leveraged returns under current market conditions for Core and Non-Core properties. Note that within the Non- Core category, there are two sub-types, Value-Added and Opportunistic. Value-Added is the less risky investment type with Opportunistic being the more aggressive investment type. Table 2 provides the likely impact of leverage on each strategy. Table 1 Projected Return Characteristics Non-leveraged Investment Strategy Total Return Distribution Income + Appreciation Core 8.5% to 10% gross 90% + 10% Non-Core Value-Added Opportunistic 10.5% to 12.5% gross 13% or higher gross 60% + 40% 30% + 70% Table 2 Projected Return Characteristics Leveraged Investment Strategy Total Return Distribution Income + Appreciation Core 10% to 12% + 40% leverage 80% + 20% Core Plus Non-Core Value-Added Opportunistic 12% to 14.5% + 60% leverage 14% to 18% + 65% leverage 20% to 30% + 75% leverage 70% + 30% 40% + 60% 15% + 85%
There needs to be a systematic approach in selecting individual assets that achieves the overall investment portfolio objectives. For Core and Non-Core real estate, the investment parameters are defined by the following property attributes: Property type and physical characteristics. The quality and lease term of the tenant base. Property market conditions. Relative contributions to the return from appreciation and income. Capital structure used to finance the property. Ownership competencies, including management and leasing capabilities. Liquidity. Table 3 highlights some of the key characteristics of Core and Non-Core assets: Table 3 - Characteristics of Core and Non-Core Assets Core Assets Non-Core Assets Physical Characteristics Major property types that satisfy contemporary competitive standards. Significant Capital Expenditures are required to meet contemporary standards. Tenant Base Investment Grade tenants. Higher number of strong tenants. Staggered leases. At-market rents. High occupancy levels. Weaker tenant quality. Higher number of weaker tenants. Property types with shorter or more complicated leases. Leases ending in immediate future. Occupancy levels are below the market average. Property Market Larger regional markets. Regional markets with major concentrations of property types. Regional markets with competitive advantages in particular property types. Secondary properties in larger regional markets. High quality properties in secondary markets. Good business conditions. Fundamentals set to improve in near future. Investment Returns Substantial income. Modest appreciation. Return close to gains on NCREIF Index. Modest income. Substantial appreciation. Returns significantly higher than NCREIF Index. Capital Structure Leverage generally does not exceed 40% of investment. Structure conveys essential control. Leverage may reach 75% of investment. Structure may provide less control. Unsecured positions. Ownership Predominantly wholly-owned. Strategic joint ventures due to size or complexity. Experience in achieving betterthan-market leasing. Predominantly joint ventures. Highly motivated and incentivized management and leasing programs. Demonstrated asset turn-around experience. January 2005 Page 2 of 12
Physical Characteristics Core Core investments are usually in major property types that provide a steady cash flow: office, industrial, retail and multifamily. There are key characteristics within each type. For example, office properties tend to be Class A buildings with investment grade tenants. Multifamily properties are usually larger cities with higher rental rates. For retail, it s the more traditional categories of neighborhood and community centers and regional and super regional malls. Warehouse, research and development space, as well as some mixed-use properties including office and warehouse space offer better chances for predictable cash flows within the industrial sector. What about the other property types? Because the lease terms are so short for hospitality, senior living, and public storage properties, these properties usually are not categorized as Core investments. Investments in speculative developments and in raw land are also nonconforming since they do not have adequate operating income. The timing of when the cash flows will turn positive is too problematical, making these two property types unsuitable for Core investments. Table 4 Physical Characteristics Core Class A apartment, industrial, office and retail. Must meet current market operating standards. Non-Core Class B apartment, industrial, office and retail. Hotels, land, senior living and self storage. Not meeting current operating standards. Properties with short leases. Little or no current income. Meeting the property type specification is not the only hurdle for qualifying as a Core investment property. The physical attributes of the building have to meet contemporary competitive market standards. Older properties, especially 24-hour central business district office properties and super-regional malls maintained to competitive physical standards often make excellent Core investments despite physical ages in excess of 30 years. For example, the ceiling height in a warehouse has to be high enough to accommodate modern material handling techniques. In some markets that may even mean that the truck bays are configured to allow cross-dock goods handling. January 2005 Page 3 of 12
Office buildings should have cabling that is appropriate to meet current and prospective needs for telecommunication services and computer linkages. Elevators and HVAC systems that work fast and that are programmed for efficient utilization need to be in place in a Core investment property. Non-Core Non-Core properties may have some but not all of the Core property attributes. The most obvious difference relates to property type. Most lodging properties, for example, are just not going to qualify as a Core investment. The extra risk in the lease structure of these properties means that they are usually placed into the Non-Core Opportunistic subcategory. In addition to the very short leases is the dependency of lodging properties on business and leisure travel, making this sector inherently riskier than the four main property types. The most common attribute of the Non-Core property involves the need to make substantial capital expenditures to bring the building s physical attributes up to competitive market standards. This is usually why the building has a high vacancy rate or weaker revenue stream. Tenant Base Core Vacancy rates and tenant quality have to be judged in the context of the current real estate and business cycle. That s why vacancies alone don t qualify a property as a Core asset. For example, a 12% vacancy rate might indicate a sub-par property during a period of strong property market conditions but just the opposite if the average regional vacancy rate is 16%. Yet, over the last few years certain properties were able to maintain solid occupancy rates even in difficult markets. These high occupancy rates are due to the tenants strong credit quality, smooth distribution of lease maturities and the property s ability to attract and retain its tenants in the first place. While there are no hard and fast rules about vacancy rates when characterizing Core and Non-Core properties, usually Non-Core properties have vacancy rates of 25% or higher when they are acquired. In some cases the vacancy rate may be lower but the leases for a substantial portion of the tenants are due to terminate in the immediate future, raising the prospect of a jump in the vacancy rate. The goal here is to make the necessary capital improvements that will boost the property s occupancy rate along with competitive lease rates. January 2005 Page 4 of 12
Regional Characteristics Core Core properties enjoy being in primary locations within major regional markets. This ensures that these properties can be more easily bought and sold, providing Core s allimportant attribute of having market liquidity. So, what constitutes a major regional market? They are usually defined in terms of the population size in a given metropolitan area. Many Core investments in office properties are often located in the central business district of what is called 24-hour Cities. San Francisco, for example, is one such city despite having less than a million residents. It is San Francisco s unique physical attractions and its role as the financial and business service center for the high-tech industry in Northern California that has resulted in a measure of investment interest that exceeds its size. In the industrial sector, Riverside-San Bernardino, Calif. has become one of the major distribution centers in the U.S. deriving its importance both from domestic manufacturing and international trade with the Far East. The importance of this regional market in portfolios of industrial properties exceeds the population size of this market. South Florida has emerged over the last five years as a very important region for investments in multifamily properties. Limitations on development activity have emerged as new construction began to infringe on protected land. Demand from retirement and recreation activities has expanded rapidly as the Baby Boom generation in the U.S. begins to approach retirement. Demand for units from Latin Americans has also improved with the revival of those economies. Strong household formation growth and limitations of new development have transformed the South Florida into one of the major Core multifamily investment markets even though it is not one of the largest markets in terms of population. Table 4 shows how primary and secondary markets can each provide both Core and Non- Core opportunities. Within these markets, some are experiencing very different conditions. Those markets with robust fundamentals and growth are labeled as Accelerating. The Idling markets are those that are still waiting to see solid improvement in employment trends and property space absorption. January 2005 Page 5 of 12
Table 4 Current Property Market Classifications Primary Markets Secondary Markets Accelerating Idling Accelerating Idling Los Angeles Boston Riverside/San Bernardino Hartford Phoenix Chicago San Diego New Orleans Washington, D.C. Dallas/Forth Worth South Florida San Jose Core Assets & Possible Core Assets Possible Core Assets & Possible Non-Core Assets Non-Core Assets & Non-Core Assets Non-Core Assets Core type assets are more likely to be located in the primary markets. It is more difficult to find properties in Idling primary markets that also have a strong tenant structure with a prospect of revenue increases over the next few years. The Accelerating primary markets provide the opportunity to acquire Non-Core assets by investing in secondary properties. These are the properties which have a good chance to enjoy a burgeoning demand for space over the near term. Charts 1 and 2 both show the trends of office employment in a set of primary markets since the trough in the last recession. Accelerating markets are depicted in Chart 1, where employment levels have begun to improve. The Idling markets in Chart 2 still have not turned the corner with clear gains in employment. Core assets can also be found in the Accelerating secondary markets. This is especially true for those secondary markets that have a major presence in a particular property type. These markets are fertile ground for Non-Core assets, too. If the current economic and business conditions are favorable, then the competition to acquire properties may be less intense than it is in the primary markets. The idling secondary markets are the riskiest, since economic and property market conditions have not yet started to improve. January 2005 Page 6 of 12
Chart 1 Level of Office Using Employment: Accelerating Primary Markets 104.0 103.0 Index of Office Employment 102.0 101.0 100.0 99.0 98.0 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 Sources: U.S. Bureau of Labor Statistics, Realpoint Los Angeles Phoenix Washington, DC Chart 2 Level of Office Using Employment: Idling Primary Markets 102.0 100.0 Index of Office Employment 98.0 96.0 94.0 92.0 90.0 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 Sources: U.S. Bureau of Labor Statistics, Realpoint Boston Chicago Dallas/Fort Worth January 2005 Page 7 of 12
Non-Core Non-core properties tend to be located in secondary markets, but what is a secondary market? A secondary market is usually defined as a moderately-sized regional market with few prospects of growing fast enough to escape its relative size parameters. Hartford and Indianapolis are two such examples. To make a Non-Core investment provide appropriate returns in these types of markets, it is usually not enough to just make some cosmetic improvements. The economic and business cycle needs to be recovering, generating new demand for property space. The property needs to be in a primary location within the regional market, making it a preferred location for the expanding tenant base. Table 5 shows some examples of locations for Non-Core Assets. Table 5 Favored Locations for Non-Core Assets Repositioned Properties in Accelerating Primary Markets Strong or Repositioned Properties in Secondary Markets Higher Leveraged Strong Properties in Primary Markets Charts 3 and 4 indicate the recent differences in employment trends between Accelerating and Idling secondary markets. January 2005 Page 8 of 12
Chart 3 Level of Office Using Employment: Accelerating Secondary Markets 115.0 113.0 111.0 Index of Office Employment 109.0 107.0 105.0 103.0 101.0 99.0 97.0 95.0 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 Sources: U.S. Bureau of Labor Statistics, Realpoint Riverside-San Bernardino San Diego South Florida Chart 4 Level of Office Using Employment: Idling Secondary Markets 105.00 100.00 Index of Office Employment 95.00 90.00 85.00 80.00 75.00 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 Sources: U.S. Bureau Of Labor Statistics, Realpoint Hartford New Orleans San Jose January 2005 Page 9 of 12
A secondary market is characterized not just by its physical size but also by its economic and business conditions. A premier property in a good location will gain tenants and raise rents in a projected economic recovery, resulting in higher returns on invested capital than are possible from a Non-Core investment property. There s another approach to Non-Core investing where the properties are in a primary market but are situated in a secondary location. Capital may be needed to make the physical attributes of the property more competitive in the market. If the basic economic and business conditions in the metro remain positive, then the property will attract tenants. Future growth has to be strong enough to generate a net incremental supply of tenants. Investment Returns Core Core properties have market or above market occupancy rates at market rent levels. Tenants have strong credit ratings and the leases are structured so that maturities are fairly smooth, meaning they are distributed over time, reducing the probability of interruptions in cash flow. Because the property has a high occupancy rate with few leases terminating in any one year, there is little chance that prospective rents and therefore, cash flows will either increase or decrease significantly in the future. With limited future increases in cash flow, the potential appreciation rate on the market value of the property is modest. A large jump in market value, generally measured at 5% or greater in any year, typically occurs with a decline in the discount rate used to value cash flows. It can also occur when there are rapidly tightening market conditions resulting in accelerated market rents. This is what happened in the 24-hour CBD office sector during the late 1990s into 2001. The large decline in market interest rates and the concomitant decline in real estate cap rates over the past two years have pushed market values of Core properties higher. This escalation in market values is not a customary source of return for Core investors, since most of the investment return comes from current income. Because current yield represents so much of the prospective return on Core properties, it is critical to not overpay for an investment. The acquisition price of Core properties usually does not exceed 5% to 10% over the current replacement cost for the building. By definition, new structures can be supplied to the market at the replacement cost, and these new buildings compete with the Core investment property for tenants. If the acquisition price for the Core property exceeds 10%, for example, then the opportunity to realize any price appreciation on the Core property in the immediate future is substantially reduced. Non-Core The portion of return on Non-Core investments from current income is much more limited. Non-Core investments are expecting that occupancy rates and rent levels will increase substantially in the future. So even if cap rates remain constant the investor will see significant appreciation in the market value of the property. A major portion of the return on Non-Core properties is from property appreciation. January 2005 Page 10 of 12
Capital Structure Core The operating characteristic of Core properties is a stable cash flow. It is important that the financial structure of the acquisition not jeopardize this stability. For this reason, the common practice is not to exceed 40% debt financing of a Core property. Yet, with the opportunity to employ very favorable debt today, many investors are using more than 40% leverage. This strategy is generally termed Core-Plus investing. Other than increased leverage, Core-Plus attributes are the same as Core. While the cash flow from a Core investment is designed to be stable, there is some inevitable uncertainty built in, via an orderly base rollover of 10% to 15% per annum. During the holding period, portions of the building will have to be re-tenanted, even assuming a 60% to 75% tenant retention rate. Weakened property market conditions may delay filling the space or market rents may be lower. A high level of fixed-rate financing would reduce the level of cash flow to the investor. That s why prudent Core investing employs a moderate amount of fixed rate financing. By doing so, the essential return characteristics of a Core real estate investment are maintained. Because Core assets may be harvested sooner than anticipated, many knowledgeable investors obtain LIBOR-based floating-rate financing, thereby eliminating prepayment yield maintenance penalties. Interest rate maximums and hedging strategies may also be employed to better manage any interest rate fluctuation and its impact on investment cash flow. Non-Core Leverage on Non-Core properties is much higher. It frequently rises into the range of 70% to 75%. Current operating cash flows from these properties are often minimal at the beginning of the investment period, and the financing charge is just part of the cost associated with repositioning the property. Since the projected unleveraged return on the property is substantially higher than the level of interest rates, financial leverage enhances the total return on the investment. The high level of leverage also increases the amount of risk. Fool s Gold Risk In today s office property market, there are a number of over-leased assets with in-place contract rents that are well in excess of current market rents and, more importantly, also noticeably in excess of replacement cost-justified rents. Buyers of such properties, using a high degree of leverage, often end up paying a price per sf that exceeds replacement costs by 15% to 20% - and in rare situations, even more. While current cash distribution may in fact qualify for solid income returns in an accounting sense, in fact the distribution may in economic reality be a return of capital. That s because as the excess rent is burnt off, the property s value typically reverts back to an industry mean value - approximating replacement costs plus or minus anywhere from 0% to 10%. In past property cycles values have even gone as low as -20% or more of replacement costs. Investors need to proceed with caution and understand that over-leveraged, over-leased and over-priced investments may result in underperformance. January 2005 Page 11 of 12
GMAC Institutional Advisors LLC Research & Surveillance James Titus Managing Director Director of Research 215-328-1220 Kim Betancourt Senior Vice President 215-328-1453 Peter P. Kozel, Ph.D. Senior Vice President 215-328-1458 Copyright 2005 GMAC Institutional Advisors LLC The material contained herein (the Material ) is being distributed in the United States by GMAC Institutional Advisors LLC ( Institutional Advisors ). Institutional Advisors makes no representation as to its accuracy, timeliness or completeness and does not undertake to update any information or opinions contained in the Material. The Material is published solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or derivative. The Material is not to be construed as providing investment services in any state, country or jurisdiction. Institutional Advisors, its affiliates and subsidiaries and/or their officers and employees may have positions in securities or companies referenced in the Material and may, as principal or agent, buy from or sell to clients. From time to time, Institutional Advisors, its affiliates and subsidiaries and/or their officers and employees may have a corporate finance relationship or perform other services for companies mentioned in the Material. Opinions expressed herein may differ from the opinions expressed by other divisions of Institutional Advisors, its affiliates and subsidiaries. The Material has no regard to the specific investment objectives, financial situation and particular needs of any specific recipient of the Material and investments discussed may not be suitable for all investors. Investors should seek financial advice regarding the suitability of investing in any securities or following any investment strategies discussed in the Material. Past performance is not indicative of future returns. Certain assumptions may have been made in preparing the Material that has resulted in certain returns detailed herein and any changes thereto may have a material impact on any returns detailed. No representation is made that any returns detailed herein will be achieved. If an investment is denominated in a currency other than the investor's currency, changes in the rates of exchange may have an adverse effect on value, price or income. GMAC Institutional Advisors LLC, 200 Witmer Road, Horsham, PA 19044 (215) 328-GMAC January 2005 Page 12 of 12