How to Determine When to Sell a Commercial Real Estate Investment
Determining when to sell a commercial real estate investment involves a process as rigorous and analytical as acquiring an asset. The process is challenging because no one can predict exactly what the future returns will be by holding an asset. Consideration must also be given to reinvestment opportunities and potential tax consequences of holding instead of selling.
Before we purchase a commercial real estate investment, we develop a rigorous business plan for how we are going to make money on the investment and when we expect to sell it. When the time to sell approaches, we go through the same lengthy process, regardless of when our original business plan predicted.
For example, we predict an asset priced at $25 million will generate a 15% return on equity over the next five years. However, using the same set of assumptions, that asset priced at $30 million may only produce a 7% return. There is always a price at which the future return of owning the asset no longer meets our minimum investment return threshold and if someone comes along offering us that price, or more, it’s time to consider selling.
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In March 2016, we were approached by an off-market buyer who wanted to acquire Lux24, a property within Origin Fund II. Lux24 was a 73 unit multi-family property located in Chicago’s West Loop. We had already completed our business plan for Lux24 and significantly reduced the risk of the asset. In less than three years, we completed the unfinished units, leased the retail portion of the property, repurchased the sold condo units to achieve 100% ownership of the property, and stabilized occupancy above 92%.
However, we identified upcoming market concerns, such as an increasing supply of new Class A apartments entering the West Loop submarket and tenants’ unwillingness to pay an increased rent. While selling off market is not something we typically do, we recognized the price the buyer was willing to pay was well beyond what we thought it was worth and not something easily replicable — even through a full marketing process.
Estimating the Potential for Future Returns
An asset’s return potential is dictated by the value a buyer is willing to pay for that asset in today’s market. One of the first steps to determining if it’s the right time to sell is to estimate the potential for future returns. Ignore the asset’s original purchase price and compare its continued hold to the amount that could be freed up by a sale at that time. Comparing future cash flows to this fair market value presents a more accurate indication of the opportunity cost of holding versus selling.
Think of it this way: Do the potential future returns represent a sufficient reward for the risks and opportunities analyzed in criteria above? The decision to not sell is effectively the same as choosing to purchase the asset at the determined fair market value.
At Origin, we estimate the potential future returns from holding an asset by looking at opportunities to create additional value and grow cash flow, the availability of debt at current interest rates, and the asset’s value relative to new supply. To gauge a potential sale, we analyze what similar assets have traded at while researching the active buyers in the marketplace.
We also compare the new market value returns relative to the cost of acquiring a new asset. In some instances, a lower return today may be a better risk-adjusted return for investors in the long-run, given the transaction costs, execution risk and individual tax treatment associated with acquiring a new asset. This was the case with Lux24, where our estimated future returns did not meet our costs to acquire a new asset. After we completed our internal valuation process for Lux24, we determined a fair market value of $420,000 per unit, which was confirmed by three independent brokerage firms.
Assessing the Pool of Potential Buyers
Determining the right time to sell and what price the market will bear also depends heavily on who we expect the potential buyer to be.
For example, if we plan to sell to a large institutional buyer who has access to a low cost of capital, they may be willing to offer a substantially higher price than a regional buyer. Then there are buyers seeking a tax-deferred exchange who often pay the highest price in securing a deal to safely defer large tax penalties. These buyers are typically attracted to assets with stable cash flows. If we want to align our asset with a potential buyer like this, it may require more investment into the property to ensure stable cash flows and secure the highest price.
Alternatively, assets that still have opportunities to add value may attract the deepest pool of buyers, allowing for the most competitive pricing process. Some assets, primarily due to their location or size, may never attract interest from real estate investment trusts or other low cost of capital participants; however, competing bids may develop from other buyers seeking value-add opportunities. In some instances, it is better to leave some “meat on the bone” for this next buyer. It is important to know what type of buyer will pay the most at exit and ensure your business plan is in line with that profile of buyer.
The buyer of Lux24 was a 1031 exchange buyer who was motivated to put capital to work quickly for tax advantage reasons and looking for steady cash flow in a great location in an emerging neighborhood. They offered just under $480,000 per unit, which was $60,000 more than our internal valuation and allowed us to make a quick decision to sell the asset and reduce a residual risk from our investors.
Subsequently, Lux24 was sold again in November 2017, 20 months after our sale, for 10% less than what we sold it for. This deal is a perfect example of how important it is to understand your buyer. When we sold in March of 2016, we found a motivated buyer who wanted to act quickly to receive tax savings. The transaction price the deal received later in November 2017 was in line with what we had previously estimated through our internal valuation process.
At Origin, we frequently examine the above criteria, not only to determine whether or not we should sell an investment, but also as a tool to evaluate the effectiveness of our current leasing, marketing and capital improvement plans. Looking at these metrics also helps identify opportunities to capture demand, increase rents and optimize the value upon eventual exit.