Modern Portfolio Theory applied to real estate portfolio management

¶ … Property portfolio ownership and management is not based on charitable foundations but rather on the idea that investors will benefit from that ownership. Therefore, in order to ascertain the profitability of owning and managing certain specific properties is of importance to the investors interested in achieving those benefits. One method for that ascertaining is to employ the Modern Portfolio Theory (MPT).

MPT was actually developed as a tool to moderate individual and group risk in stock and bond portfolios during the 1950's but was adapted to real estate portfolios in an attempt to mitigate the risk of those types of portfolios as well. Modern Portfolio Theory states that "by combining investments with different risk characteristics into a portfolio risk is spread, and thereby reduced" (see MPT presentation). The MPT works well with stocks and bonds because those investments are very liquid and easily dispersed of or purchased, and MPT was originally designed as a theory that would assist investors in those types of financial vehicles. Implementing the MPT regarding a real estate portfolio is a different matter all together.

MPT states that "clearly it is always possible to reduce risk by switching funds into less risky assets but this comes at the expense of lower returns" (MPT presentation). According to MPT the key then would be to reduce risk yet at the same time ensure that "it does not come at the expense of lower returns." Accomplishing the objective of higher returns with less risk is especially difficult to do if the inherent investments are bulky, difficult to liquidate, have fewer buyers and sellers, and the market for the investments is not nearly as flexible as the stock and bond market; such is true of the real estate portfolio marketplace.

Factors

Since this particular portfolio is concerned primarily with the next two years, certain factors will need to be taken into consideration regarding the real estate portfolio. Some of those considerations include; the overall real estate market, the specific market in which the property is located, the specific property itself and its characteristics, and whether the property is viewed as a growth vehicle or income generating vehicle. Within those guidelines are also a number of considerations, including but certainly not limited to; what or who would purchase the property and at what price, will the market price be stronger or weaker in a two-year timeframe and will the income generated from the current portfolio be enough to augment any additional risk if the portfolio were to be held for two years?

The last two years have been rough years in general for real estate portfolios, especially effecting the value and capital growth areas. Some of the properties currently held by the portfolio suffered extensive declines in capital value and none of the properties experienced an overall rise in value over the last three years. Since the purpose of the fund is to generate high income with medium risk, it would seem to be that an analysis of the income might assuage the worry that investors might have with the drop in value if a coincident income-based return was presented. With that goal in mind an analysis of the properties is deemed important and is carried out within this report.

Total Return 42.4% 8.48% per year

Rental income rose for this property but was lower in 2009 than both 2007 and 2008; that was also true for the property evaluation and capital growth. Total return averaged 8.48% per year and net income return averaged 6.36%, second lowest in the portfolio. Risk factors include a continuing recession which would dampen retail sales affecting the retailer establishments who are currently leasing space in the mall. Another risk would be the fact that a larger portion of the fund's capital is invested in this particular piece of property. At 7,540,000 it is the largest property in the portfolio by far and away, the next closest is the Irwell House (4,875,000) also in Manchester. Income is only 6.36% per year which raises the risk of holding the property facing a continuing downtrend in the real estate market. It would have been nice to sell this piece in 2007 after it had hit its high valuation of 8,950,000 and it could reach that level again, but that time might be a long time in coming.

This property is also the most volatile of the six properties, which augments much higher potential for greater return, but could also be a forbearance of a much lower return if the property had to be sold at a time when the market was depressed.

Manchester -- Irwell House -- Office

Value as of 2004 5,190,000

Value as of 2009 4,875,000 loss 315,000

Highest Value 6,225,000

Total Net Income 2,563,664 45.26% 9.05% per year

Total Return 41.49% 8.29% per year

Rental income rose during 2005 and then fluctuated between a relatively tight range from 2006 through 2009. The income during 2005 was 504,456 and then averaged 514,802 per year for the next four years. Risk factors do not seem as depressed as displayed by the retail location in Manchester and the numbers bear that out as well. This property has generated a far more significant income portion of its valuation than the other Manchester property. Total net income for this property as a percentage of its current valuation is at 52.5% as compared to the Manchester retail property at approximately 34%. If that figure were to hold true over the next five years, this property would then have achieved a 100% return of capital, which is a positive sign for keeping this property in the portfolio, especially since it has averaged 9.05% per year in income.

Warrington -- Gateway North West - Office

Value as of 2004 2,500,000

Value as of 2009 2,450,000 loss 50,000 (2%)

Highest Value 3,057,000

Total Net Income 1,191,317 42.68% 8.53% per year

Total Return 42.66% 8.51% per year

This property generates a higher percentage of income compared to either of the Manchester properties. Its value dropped by 50,000 which was nominal at 2%. The income generated during the last five years which is approximately 48.8% of value. Describing this property as a middle-of-the-road investment that generates an income at 8.53% per year would be a good description. Since the fund is following a high income, medium -- risk investment philosophy, this property fits that description. The risk factors are relatively low as well with very little volatility in its property value and a net income return that fluctuated between 9.41% on the high end, and 7.90% on the low end. Interestingly enough, its gross income for the last two years was 243,158 and 242,798 during the last two years; the highest two years out of the last five.

Warrington -- Enterprise Park - Industrial

Value as of 2004 1,485,000

Value as of 2009 1,250,000 loss 235,000 (15.8%)

Highest Value 1,725,000

Total Net Income 807,056 50.18% 10.03% per year

Total Return 37.04% 7.40% per year

This industrial property provided the second highest total net income in the portfolio averaging just over 10% per year. The overall capitalization of the property is only about 5% of the entire portfolio, thereby lowering the risk of ownership by a huge margin, especially when considering the high total net income generated by the property. Another factor to consider regarding this property is that it is industrial in nature, the only property with that characteristic. It might well be worth purchasing an additional similar property to this one if such a location can be found in Warrington; this is especially true since the current market price is at its lowest point in over five years.

Historically speaking this property has held its value very well except during the last year, even through the recent recession. This property is also relatively inexpensive and its type (industrial) is also a small portion of the total real estate portfolio held by the fund.

Liverpool -- Tropicana - Retail

Value as of 2004 4,000,000

Value as of 2009 3,250,000 loss 750,000 (18.7%)

Highest Value 4,950,000

Total Net Income 972,564 22.57% 4.51% per year

Total Return 6.01% 1.20% per year

This property is the most underperforming property in the portfolio; both in income and total return. Its income for the last five years has averaged under 5% and the total return barely reaches six percent for the entire five years, that's only 1.20% per year. The property has also lost almost 18.7% in value over the last five years, and the property encompasses almost 15% of the entire portfolio. If there were any property in the portfolio that would evidence a sale, this property would be it. Considering the fact that the cash garnered from the sale (even at 3,250,000) could be used to purchase two industrial properties in Warrington (if they can be found) it would make a lot of sense to pull the trigger on a sale. A loss on this property could also have some positive tax implications and rid the portfolio of a poor performing investment.

Liverpool -- City Central - Office

Value as of 2004 1,310,000

Value as of 2009 1,250,000 loss 60,000 (5%)

Highest Value 1,475,000

Total Net Income 1,055,531 76.32% 15.26% per year

Total Return 70.81% 14.16% per year

This property comes with the reminder that the fund is seeking properties that provide high income with medium risk, and therefore (unlike the other Liverpool property) this property is one that should be considered a core investment for the portfolio. This property has averaged over 15% net income per year, although the 2009 was much closer to 14% than its high of 17% in 2006. Another strong consideration for this particular property is that the total income generated is 1,055,531 versus the value of the property (2009) at 1,250,000; at approximately 84.5% of value the income generated is the highest percentage of all the properties in the portfolio. An additional strength for this property is the fact that it currently comprises less than 7% of the entire portfolio. Keeping this property would also maintain a fund presence in Liverpool if the first Liverpool property is disposed of. This geographical diversity is important in that geographical considerations also have an effect on the entire portfolio.

The Future

The future seems to be brightening in the real estate investment arena. One recent report concludes that "the proportion of commercial property which is rented is growing" (Property Data, 2010, p. 6). The same report declared that many corporate owners of commercial property have long shied from the heavy financial investment and management involved in owner-occupation. If that is true, then it would seem that the rental marketplace will continue to be strong during the foreseeable future.

Considering the six properties in the portfolio, the fund has averaged an impressive 9.6% total return during the last five years, that is a per year percentage of over 10% income during what many experts would say was the worst recession in 70 years. The fund's focus is on income and that has been evident during those years.

During the next several years the fund will continue to focus on investment opportunities that offers a high rate of net income return. The properties now owned by the fund offer the investor(s) a diverse portfolio with medium risk while creating and maintaining an above average income net return. There are two properties that comprise over 50% of the portfolio value and disposing of one of those (Liverpool -- Retail) might be a good call, especially if tax benefits and reinvestment opportunities present themselves. The five remaining properties are all considered medium risk investments with the potential of some capital gains and upward market evaluations along with a steady and higher than average income.

Since the future also will continue to see a lot of consolidation between business' and government entities under current circumstances, the fund should also be prepared to investigate newer, refurbished and more flexible types of buildings that offer more to the renter. With a huge amount of belt tightening being attempted by governmental entities, these types of spaces will be in relatively high command and will engender a much high rate of income from these entities. More efficient and 'green' buildings will also be the rage for the next several years, so consideration towards those types of buildings could be beneficial to the fund.

Conclusion

The portfolio overall seems to be relatively stable and producing above average income with the exception of two not so stable investments; the Liverpool Tropicana and the Manchester Style Mall. Both of these properties are retail and therefore considered much more volatile In nature. One recommendation would be to rid the portfolio of the Liverpool Tropicana.

Reinvesting those funds in properties that are industrial in nature would smooth the risk curve, and allow for a more diverse portfolio overall. The property in Manchester, although not producing as much in capital growth, still offers a high net income return and therefore should be held. The Manchester Style Mall could see a bounce in value due to its volatility and therefore it is also recommended that if such a bounce occurs, this property too should be sold.

Using the proceeds from the sale (or sales) of properties for additional purchases it recommended, especially if the properties can be purchased in any of the three cities currently held by the fund. However, a recommendation to reinvest the proceeds into additional retail is not suggested, rather additional industrial space might make more financial sense. It is also recommended that such industrial space be purchased in the Warrington area due to its relative real estate stability, even during the 'bad' times.