How do different properties compare?

Building types
May 2, 2016

Real estate properties are not created equal.

A reader asked whether she should purchase a motel or an apartment building. “In what option, would I ultimately be better off?” she asked. 

Her use of the term “better off” was tricky. On one hand, “better off” may imply one's desire for an increase in profits by 25 percent each year. On the other, it may imply one's wish for a passive income stream.    

Not knowing our reader's individual risk and return profile, we could not give her an answer. But, we felt a discussion on the different real estate value attributes is an interesting one.

Vacant Land: land investors seek value appreciation. And historically, that has been proven to be a viable business model. The disadvantages are: (1) a lack in financing to purchase land, (2) there is no tax depreciation advantage, and (3) carrying costs must be capitalized. 

The typical land investors are speculators and developers. Speculators are looking for short-term gains. Developers purchase land for long term operating needs. We also heard of Estates purchasing land as to hedge against inflation.

Will Rogers and Lord Keynes concluded two opposing views to the purchase of land. “Buy land. They ain’t making any more of the stuff.” Said Mr. Rogers. While according to Lord Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

Apartments: here lease rates determine value. And household and income levels drive lease rates. At times, apartment buildings also realize value based on prestige and location. 

The advantages to apartment purchase are: (1) a liquid marketplace, (2)allows for significant levels of leverage to investors with little equity, , and (3) historically, they served as a hedge against inflation. 

The disadvantages: (1) apartment buildings require active management; (2) there is competition from single-family homes as an alternative to renting, and (3) they are often overvalued because of their popularity as investment vehicle.

Office Buildings: the rule of thumb is that an office building needs local business health to succeed. Vacancies, tenants mix, and lease rate are also major value determinants. 

The advantages: (1) office buildings allows for value-add capital appreciation, increasing the vacancy or lease rate, and (2) a diverse tenant mix offers diversification benefits. 

The disadvantages: (1) office building require active management, and (2) they tend to become obsolete with time, forcing management to upgrade the property.   

Warehouses: warehouses must be designed and built to accommodate changes in the methods of handling materials. 

The advantages: (1) with longer leases, the nature of the investment tends to be passive, and (2) compared to other properties, low lease rollover cost. When one tenant moves out and another tenant moves in, there is little that an industrial property owner needs to do with that space to make it reusable. 

The disadvantage is that industrial properties tends to demonstrate minimal value appreciation in the five- to ten-year term.    

Shopping Centers: consumer sentiment and tenant mix drive value. 

The advantages: (1) there is a large capital appreciation potential, and (2) leases are long,   typically five- to 10-years. 

The disadvantages: (1) the anchor tenant usually controls the tenant mix and negotiates a below-market rent PSF, (2) not a liquid market for properties above $7 million, and (3) the financing for shopping centers is dependent on lease term and tenant mix.

Hotels and Motels: hotels can be classified to limited service hotels, mid-priced limited service hotels, and traditional full service hotels. Demand for hotel night stays – the measure of lodging demand – moves very closely with the level of economy. This is because most overnight stays are business related. 

Disadvantages include: (1) a hotel requires active management, (2) their purchase offers lacks financing options, especially at volatile capital markets, and (3) they become obsolete, as described in office properties section.