The ins and outs of commercial investing

  • 2002-09-05
  • Lau Melchiorsen
The Baltic commercial real estate investment markets are currently developing and changing rapidly as more investors are researching or even investing in the markets.

Investors in the real estate markets here have traditionally been looking on the investment from a short-term perspective. The measurement for an investment's worth was traditionally the expected payback time.

Only with the entrance of international investors thinking in the longer term has the calculation of net yields and returns been introduced.

Professional investors generally compare the gross investment to the net operating income and thereby calculate the net direct yield, which is basically the interest on a never-ending mortgage annuity. In other words, expecting the current net cash-flow indefinitely.

The yield thereby becomes the measurement for commercial real estate investments which can be compared to other alternative investments like bonds, shares or investments in real estate markets elsewhere.

When investing in commercial real estate an investor puts many considerations into the yield figure. The general understanding is that the yield consists of two main elements – the safe part which could be achieved by investing in 10-year government bonds and the risk element, which includes future expectations of income and costs.

In general, yields tend to fall as the markets mature and value is added to the property. As the Baltic states approach the EU and the local market develops, we expect the yields to drop.

One should, of course, realize that there are also potential threats to this — the general economic situation, employment rates, the general supply and demand situation and many other factors affecting the expectations for the future income and thereby also the yields.

The rental levels in the Baltic countries are quite high compared to other European cities and it is currently not expected that they will increase significantly above the general inflation rate.

The decrease in yields should therefore come from the maturing of the market and the decreases in risks affecting the yield.

Valuators are often asked to valuate property and the figures they come up with are generally used to document the market value to banks, accountants, shareholders and other parties with a direct interest in a company. .

A valuator should generally always valuate the Open Market Value based on the following definition:

An opinion on the best price at which the sale of an interest in property would have been completed unconditionally for cash consideration on the date of valuation if:

There is a willing seller.

That, prior to the date of valuation, there had been a reasonable period (keeping in mind the nature of the property and the state of the market) for the proper marketing of the interest, for the agreement of the price and terms and for the completion of the sale.

The state of the market, level of values and other circumstances were, on any earlier assumed date of exchange of contracts, the same as on the date of valuation;

No account is taken of any additional bid by a prospective purchaser with a special interest.

Both parties to the transaction had acted knowledgeably, prudently and without compulsion.

This generally means that a valuator can only take into account the present situation based on completed and comparable transactions plus the added experience. Professional investors who are entering a new market often rely on local market experts to provide evidence of the open market value of an investment opportunity.

When local real estate owners try to sell property sometimes expecting higher prices than are offered by investors (arguing that yields should be lower due to future EU membership, economic growth or other reasons) they should realize that the investor most often is assuming that the market knows better. He is therefore rarely ready to pay much more than the local market as he also has to calculate future potential gains or losses in his investment calculation.

The decrease in direct yields and thereby increased prices is therefore a process which we expect to happen –- but also a process which will take time and only come as it is justified by the maturing markets and the realized economic growth.