Government real estate: Unlocking the value of a strategic asset
INSIGHT ARTICLE |
An organization’s real estate or real property is one of its most important physical assets, and typically represents one of the largest asset classes on its balance sheet.1 And for government entities, this is especially true as these organizations are the largest owners of real property, with the U.S. federal government being the largest individual property owner in the nation. However, while federal government-owned real estate is a major source of national and public wealth, in some instances, this potentially robust asset may not be delivering optimal value to its stakeholders, especially at a time when the public sector is being required to do more with less.2 Vacant lots, underutilized structures, redundant properties and bloated inventories all burden the balance sheets of governments across jurisdictions.3
To address these concerns and unlock the value of this important asset, an effective real estate portfolio management strategy, similar to what a nongovernment fund manager might use, is required to provide structure, focus, performance metrics and more.
Benefits of this include:
- Consistent rules, policies and procedures that address the entire real estate portfolio. Ideally, the focus should include an objective to transact similar to the private sector.
- Established common culture and vision within the governmental institution, along with coordination among agencies to achieve desired strategies.
- Established incentives among agencies and staff that align with the real estate strategies and that create accountability.
- Engagement with private market participants via public-private partnerships and advisory services.4
There are other considerations in play as well related to government real estate asset management. A closer look is in order.
Essential to delivering an effective real estate portfolio management strategy is the development of an appropriate structure. A private real estate fund is an ideal structure to serve the federal government’s immense portfolio of real estate. This structure should incorporate asset identification, portfolio analysis, investment strategies, return objectives and performance measurement. A private real estate fund often possesses many of the characteristics of traditional operating businesses. Managers and employees must consider numerous operational issues related to an investment fund. For example, a private real estate fund must be able to provide for the development, improvement, property management and maintenance of its investment assets. The federal government has historically maintained these capabilities or oversight of these functions to some degree internally.
Private real estate funds are structurally complex, although there is relative ease of implementation. The investors often possess a high level of investment sophistication and will expect to participate on terms that not only align with their interests and those of the general partner or sponsor, but also those that reflect current market trends.5 Successful real estate fund operators plan for operational challenges in advance to allow the fund to achieve its objectives and return capital to investors.
A real estate fund structure is typically a limited partnership or limited liability company that enables managers to pool capital while avoiding the cumbersome securities registration process involved in launching a publicly offered investment fund or real estate investment trust. Since investments in real estate are illiquid, private real estate funds have many unique structural issues that must be addressed.6 An initial consideration is whether to use an open-end or closed-end fund structure.
An open-end structure, which in the simplest form, allows investors to enter and exit the fund at regular intervals determined by the fund’s sponsor. Due to the illiquid nature of a private real estate fund’s investment assets, a dual problem of establishing a fair value for each contributing and withdrawing investor exists.7 Closed-end funds, on the other hand, require all investors to join the fund at the same time. This avoids the issues concerning the initial value of their investments, and restrictions can be crafted to match investor withdrawal rights with the fund’s liquidity profile.8
An alternative or hybrid to the aforementioned structures would be to allow for investors to participate on an investment-by-investment basis. This offers flexibility to investors over the control of their investments. In lieu of committing capital, the federal government would contribute select real estate assets or properties to the fund while investors commit capital to specified assets.
Under each of the aforementioned fund structures, an advisor or third-party manager is needed. The role of the advisor is to ensure that the fund strategies are appropriately and effectively executed, and optimal returns are generated. The advisor is also responsible for accounting and investor reporting, oversight of property valuations, performance measurement, disposition strategies and capital raising (debt and equity). The advisor or manager is designated as the general partner while the contributor of the real estate assets or capital is the limited partner, in this case the federal government. The advisor is compensated by a management fee and often some level of equity participation upon specified return hurdles being achieved.
Value-added and opportunistic strategies
Real estate portfolio management for a non-real estate business, like a governmental entity, must utilize metrics to determine the contribution of its real estate holdings. It would be a fair assumption to say that government, in particular, focuses primarily on cost reduction or capital minimization to assess property financial gains. However, revenue growth and productivity supported by cash returns are also essential areas to analyze and enhance for further growth. Strategies that address these areas include increasing the value of assets, promoting properties via marketing and sales, and creating a property atmosphere of innovation, employee satisfaction, productivity and flexibility.9 This value-added portfolio management approach can add to overall property appeal, worth and inevitably, spark long-term growth. Opportunistic strategies may pose greater risks, but also offer greater return opportunities.
Per the Federal Real Property Profile report, the federal government owned 7,859 underutilized and 3,120 unutilized properties within its portfolio. These assets were comprised of offices, laboratories, hospitals, warehouses, family housing, dormitories and barracks. Underutilized and unutilized properties are ideal candidates for value-added and opportunistic real estate strategies. These strategies include redevelopment, ground-up development, repositioning, renovations, upgrades and adaptive re-use.
Creativity on the part of organizational leadership is needed to complement the real estate strategies, as well as an acceptance of additional financial risk. Delivering value-added and opportunistic strategies include the flexibility for government entities to enter into structures that allow for maximizing stakeholder interest. For example, in a redevelopment project, perhaps the government entity contributes land in the form of partial equity into a deal that is accompanied by cash proceeds from a partial sale of the land or subject property. This would allow for the organization to receive cash up front and participate in the income generated from the completed development, thus capitalizing on the value created by the new use of the property. Returns for government organizations can be enhanced through operational enhancements, capital improvements and total repositioning combined with access to low cost financing and grants, such as community development block grants, and tax credits.
Weighing risk and return
Successful real estate investment strategies strike the optimal balance of cost-versus-reward, measured by return on investment. This requires strategic planning to include the development of performance metrics that align with the market environment. What may be overlooked and is vital to the success of a value-added or opportunistic portfolio management strategy, however, is the appetite to take on financial risk, often avoided by government. The risk referred to entails accepting a longer investment horizon for greater returns and sharing in on development or redevelopment risk in lieu of immediate cash associated with a disposition of a property. Therefore, the risk return metric is essential to this value-added and opportunistic real estate portfolio management proposition.
On average value-added and opportunistic strategies have internal rates of return targets of 12 to 18 percent and greater than 18 percent, respectively. The opportunity to realize returns of this nature are forfeited when outright sales of properties take place without the evaluation of alternative solutions. Primary consideration is for cost savings when undergoing a sales transaction. When a value-added or an opportunistic strategy is employed, the property owner is able to enjoy the benefit of the enhanced value created by utilizing either strategy while also evaluating the annual operating costs and costs savings. The fund manager is capable of determining the optimal course of action based on the probability of success to execute a sale or to hold and invest in the subject property.
Challenges and opportunities
The current market environment is primed for the federal government to take advantage of value-added real estate investments as investors seek returns in the commercial real estate space. Real estate investments represent an important asset allocation for institutional investors.
According to the 2017 Allocations Monitor, a report prepared by Cornell University’s Baker Program in Real Estate and Hodes Weill & Associates, a global real estate advisory firm, institutional investors continue to increase their targets for real estate investments. The report indicated that surveyed institutions’ target allocations to real estate averaged 10.1 percent in 2017, up from 9.9 percent in 2016 and 8.9 percent in 2013. The expectation is that in 2018, target allocations will likely rise to 10.3 percent based on a survey of respondents, including public and private pension funds, insurance companies, sovereign wealth funds, endowments and foundations.
However, despite this target allocation increase, there are challenges affecting real estate, including overvaluation, rising interest rates and ever-present geopolitical instability. These factors contribute to investor sentiment and overall market uneasiness. In part, average real estate returns fell to 8.6 percent in 2017 from approximately 11 percent the year prior.
While investment sentiment appears to be down along with recent real estate returns, opportunity is buoyed by unmet demand for this asset class. The aforementioned report indicated that actual allocations have trailed target allocations by about 100 basis points, with 60 percent of surveyed institutions reporting they were underinvested compared to targets. In 2016, the figure was 50 percent.
So what does all this mean? Despite this volatility, there is substantial capital seeking real estate opportunities, which bodes well for an untapped market that the federal government may offer.
The federal government is positioned to serve and view itself as a formidable player in the marketplace. With the assistance of private market participants and a comprehensive portfolio management strategy, government entities can realize substantial value from its utilized, underutilized and surplus real property. As government organizations continue to engage the private market, internal competencies can be gained as well as future efficiencies. Then by moving to a structure and mindset that accommodates a typical fund manager operation, both internal and external stakeholders can take part in and benefit from this value-added proposition. Therefore, the promise to deliver cost savings and provide for a more efficient government will be delivered, along with the bonus of maximizing taxpayer dollars.
1 Peter J.M.M. Krumm and Peter Linneman “Corporate Real Estate Management”, (Mar 2001) Working Paper #370.
2 Cristina Garmendia and Alexander Kapur, John F Kennedy School of Government Harvard University “Enhancing Government Property Management with Data and Technology” (July 2013) M-RCBG Associate Working Paper Series No. 21.
5 Investment Law Group of Davis Gillet Mottern & Sims LLC, “Structuring Private Real Estate Funds”
9 Anna-Liisa Lindholm and Kari I. Levainen, “A Framework for Identifying and Measuring Value Added by Corporate Real Estate,” (October 8-13, 2006) Shaping the Change XXIII FIG Congress.