What is a Holding Period in Commercial Real Estate?
Commonly, commercial real estate is defined as real estate assets that are purchased with the intent to earn a return through income, price appreciation, or both. Like any investment, the individuals and lenders who finance commercial purchases have an expectation that they will receive their money back at some defined point in the future. In a typical commercial investment, they will earn a portion of their money back through rental income, but the bulk will be received when the property is sold or refinanced.
To manage the timing of return expectations for commercial lenders and real estate investors, managers will often guide them by defining an estimated “holding period” prior to purchase.
Holding Period – Defined
A commercial property holding period is simply the amount of time for which an investor plans to “hold” an asset. It begins on the day that the property is purchased and it ends on the day that the property is sold. In commercial real estate investing, an optimal holding period is between 5 and 10 years.
Why Does The Holding Period Matter?
There are a number of reasons why the holding period matters, but there are three that are most prominent: expectations, returns, and business plans.
First, when sourcing investment capital, one of the first questions that a potential investor may ask is, “how long will it take for me to get my money back?” For this reason alone, managers tend to put a time limit on the investment to provide investors with a general idea of when they can expect to receive their capital back. During the defined holding period, an investor’s capital is illiquid and they are unable to access it in most circumstances.
Second, a defined holding period is necessary to measure the return on a real estate investment. The most commonly cited return metrics like Internal Rate of Return (IRR), Equity Multiple, Capital Gains, and Cash on Cash Return, are time bound. For example, time – specifically annual cash flows – is a critical input into the IRR calculation. To be able to calculate it accurately, the proforma must estimate cash flows for each year in the planned holding period.
Finally, and perhaps most importantly, it simply takes time to implement the business plan for a commercial investment property. This is particularly prevalent with a value-add investment strategy.
What is a Value-Add Strategy?
Commercial properties are valued based on the amount of Net Operating Income (NOI) they produce, which is calculated as the property’s Gross Income less its operating expenses. The core aim of a value add strategy is to increase NOI through increased rental income, decreased expenses, or both.
Although there are several ways a value-add strategy can be implemented, our preferred method is to acquire a property for a good price and to invest time and capital into physical renovations and tenant upgrades. The hope is that, once the renovations are complete, the upgraded asset will command higher rents and more prominent tenants. When this increased income is combined with expense reduction strategies, the result is increasing Net Operating Income. But, it takes time.
Why Does It Take 5-10 Years To Implement a Value-Add Strategy?
Value-add activities do not happen overnight. The actual renovations and property improvements are relatively short-term activities, usually 12-24 months. But, the benefit of the management efficiencies and increasing lease rates are realized over a longer period of time.
For example, suppose that the property’s physical improvements are sufficient to attract a new anchor tenant who signs a 25 year lease with a 3% rental growth rate annually. In order for the benefits of these rental escalations to have a significant impact on Net Operating Income, it just takes time. At the end of a 8 or 10 year hold period, they add up and make a material difference in Net Operating Income (and value).
Does The Holding Period Ever Change?
In short, yes. In an institutional real estate investment, the investment objectives are laid out ahead of time. For example, the manager may target an internal rate of return of 15%, which is dependent upon selling the property for a certain price or at a certain cap rate – over a certain period of time.
On occasion, market conditions can be such that the investment objective may be achieved earlier than expected and it may make sense to sell a property before the end of the planned holding period. In many cases, this is a relatively easy investment decision and it results in a profit for all involved. This is the “happy path.”
But, there are also times where an investment opportunity reaches the end of its planned holding period and there is a significant amount of real estate market volatility. Interest rates are high, the stock market is down, and the pricing that could be achieved in a sale does not allow the investment to meet the target real estate returns. This is the less happy path. In such a case, the manager faces a choice. They must balance the desires of the investor to get their capital back versus a potential suboptimal return (or loss). Common real estate portfolio management practices dictate that it may make sense to extend the original holding period and to sell the property when it can command a higher price.
Conclusions & Summary
A commercial real estate holding period is the amount of time for which an investor plans to hold an asset. It starts on the date the property is purchased and it ends on the day when the property is sold.
The planned holding period matters for three reasons: to guide investor expectations about how long their money will be tied up, to calculate potential returns, and to implement the property’s business plan.
Although there is always a “planned” holding period, the plan can change based on market conditions. In a positive sense, markets can get hot and a property can sell for a significant sum prior to the end of the planned holding period. Or, conversely, the market can experience a downturn and the property may not fetch the purchase price necessary to achieve the target returns. In such a case, the manager must decide to either sell the property at a reduced price or continue to hold until a more favorable time.
The holding period varies by investment, but the average commercial property holding period is 5-10 years.
Interested In Learning More?
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