Over the next three years, the commercial real estate (CRE) market is projected to reset expectations to market-based interest rates and pricing. This shift will affect the actions and strategies around cashflow and cost of capital, impacting asset valuations, deal flow, and transactions.
The ability to be nimble and quickly adjust your cashflow management strategies with the market will be key in 2023 and beyond. But first, you must understand the performance levers you have available to drive cash, valuation, and the promote for your portfolio.
In our webinar, 2023 Outlook Across the 4 Levers of Performance, we discussed strategies to manage and optimize the four performance levers: operations management, debt management, equity management, and entity management. Understanding these levers enables predictability and will ultimately give you more control over the outcomes of your portfolio.
Watch the webinar to hear the full conversation. Or, read ahead for an overview of the discussion.
Performance Lever #1: Operations Management
The focus of the operations management performance lever is the income and expense ratios, as well as all of the leading indicators that impact your net operating income (NOI).
Over the past three years, expenses have grown faster than revenue. As we move into an inflationary environment, it is no longer safe to assume a constant percentage concerning expense growth. Neither is it safe to assume that revenues will be greater than expenses. As expenses continue to outgrow revenue, effective operations and expense management is critical. The 2010-2012 Operation Chart, shown below, illustrates the median change of revenue, expenses, and NOI over the course of a decade.
2010-2021 Multifamily Operational Performance Chart
Source: Freddie Mac, Thirty Capital Performance Group
The chart below represents the percentage of expense growth by operating statement line items. According to the chart, some expense categories have doubled and even tripled over the years. Therefore, a blanket rate is not always accurate when reviewing expenses.
To navigate today’s inflationary environment and maximize operation’s management, our panelists recommend:
- Considering your asset’s geographic region
- Examining your assets and their expenses
- Reviewing each line item
- Identifying where cost adjustments can be made
- Determining expense growth
Performance Lever #2: Debt Management
Historically, debt management has not been a focus area. But as interest rates rise and leverage decreases, it’s becoming a critical lever to understand, manage, and optimize. The focuses of the debt management performance lever are the leverage, obligations, and covenants against your real estate assets.
Today, we are in a volatile rate environment that has led to uncertainty across the commercial real estate industry. The model above illustrates how cap rates and valuations should change as the market shifts. Using this model, we see that interest rates and cap rates remained in the 1-3% range over the past decade. Now, these rates are both in the 3.5-4% range.
As shown in the table below, the 10yr US Treasury Yield is over 250 basis points higher than the prior year average. Based on correlation models, cap rates should reprice approximately 100 basis points higher.
In summary, as interest rates and cap rates increase, the value of assets decrease. When asset valuations decrease, loan amounts decrease and eventually impact loans as they come to maturity. As panelist Kevin Swill commented, “You need to understand your income, expenses and debt. If you can understand all three of these, you’ll have a good foundation and will be prepared when asset values come down.”
Performance Lever #3: Equity Management
The focus of the equity management performance lever is on how equity contributions, distributions, and equity stakeholders’ expectations are managed.
Equity management and debt management go hand-in-hand. The usual capital stack will always involve debt and some form of equity. Although equity is just as important as debt, equity sometimes takes a leading role in the Sponsor’s decision-making.
Equity investors always want to know the return on investment, the projected timeline to achieve that ROI, and when they will be able to exit the transaction. When analyzing your asset and portfolio, you should take a look at your equity and determine what needs to be the optimal ROI so that you can execute at the right time. The graph below shows the optimal time to refinance or exit and the optimal return on the equity for a loan that will mature in August 2024.
Performance Lever #4: Entity Management
The focus of the entity management performance lever is risk and compliance management across the real estate portfolio to ensure that entities are in good standing within the jurisdiction.
The Corporate Transparency Act (CTA) is anticipated to impact over 25 million existing business entities in the United States. This mandate requires domestic and foreign legal entities to file a report with the Division of the Department of Treasury called the Financial Crimes Enforcement Network (FinCEN). The report must provide personal information about the entities’ individual beneficial owners and applicants with the intent of preventing corrupt actors, terrorists, and criminals from laundering money in the United States.
Today, a number of organizations are ineffectively managing their legal entity data and documents. As we prepare for the CTA’s January 1, 2024 effective date, organizations that do not have a handle on entity management may face compliance challenges. As you begin to think through some of the operational components of your business, consider how to implement a framework for tracking and filing your documents. A strategy such as this will help you comply with annual reporting requirements. Plus, you’ll be better prepared for future changes in regulations.
As we navigate the “recalibration” of commercial real estate, understanding these four performance levers will be key in managing and optimizing cashflow in 2023 and beyond. Watch the 2023 Outlook Across the 4 Levers of Performance webinar on-demand now.
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