Private equity commercial real estate investment returns come from two sources: cash flow and profit. Income is derived from monthly rental payments, and profit comes from the difference between the property’s purchase price and sales price. Cash flow tends to provide a steady, moderate return, but the big gains are generally from a profitable sale.
As professional real estate investors and asset managers, knowing when to sell an investment property always presents a challenging scenario. On one hand, we want to lock in a solid return in a favorable market, but we also don’t want to leave any future profits on the table. Knowing when to sell a property is more art than science, but there are a number of factors that we take into consideration when making the decision. Broadly, they can be divided into two buckets: financial and non-financial.
Financial Sale Considerations
From a financial standpoint, there are three major considerations in the hold vs. sell analysis: (1) Yield for a continued hold; (2) Tax consequences; and (3) Potential for reinvestment. Each one of these is discussed in detail below.
If a CRE property gets to a point where a sale is a possibility, one of the first questions we ask ourselves is “what is the yield that we can expect to achieve from continuing to hold this property?” In any given market, there are three things that can improve a property’s future yield: increasing rental rates, decreasing capitalization rates (cap rate), and/or decreasing interest rates.
For example, we may perform a market study for comparable properties to determine if leasing rates are increasing, decreasing, or stagnant. Since rising rental rates are strongly correlated with future value increases, this would be an argument to continue holding the property. Or, if interest rates are forecast to fall, we could refinance the debt in the future and realize the improved yield. It can be difficult to predict these trends 5-10 years into the future, but we make our best effort to create a future pro forma and use all available data so we can be as accurate as possible. If it looks like the yield will continue to improve in the future, we will likely continue to hold the property; if it looks like the yield will decline or remain stagnant, this may be an argument to sell.
The second major consideration is the tax consequences of a sale. The tax code is complex, but the key consideration with regard to taxes is whether it is more advantageous to sell the property and pay the taxes now, sell the property and defer taxes using a 1031 Exchange, or sell the property in the future if we think the tax code could change. Again, this type of analysis can be tricky because tax rates can be unpredictable. But, the bottom line is that a sale will be considered if it is more advantageous from a tax standpoint to sell now. Otherwise, it may be better to hold.
Finally, the third major financial consideration is: what to do with the sale proceeds. Rising prices may be great for our property, but it also means that the prices for other properties are rising as well. If there are no suitable options for reinvestment, it may be an argument to continue holding the property. But, if there are other options for which we can profitably reinvest the proceeds, a sale may be justified.
Non-Financial Sale Considerations
Likewise, there are three non-financial sale considerations: the holding period, market conditions, and future goals.
The holding period consideration is fairly simple: when raising equity for investment opportunities, we advertise a specific holding period, often 5-10 years. If a property is nearing the end of its advertised holding period, it is likely that investors will be expecting their money back. So, if we are able to sell and hit our Internal Rate of Return (IRR) target, then the decision may be relatively simple. But, there are also times where the market is not favorable for sale and the valuation may be impaired. In such cases, it likely makes sense to continue holding the property past its initially advertised holding period until there is a more opportunistic time to sell.
Market conditions are one of the primary drivers of a sale price. They can have a material impact on a property’s Net Operating Income (NOI), Operating Expenses, cash flow, and potential liquidity. Further the impact of these conditions can have different levels of impact on different property types. For example, demand could be high for multifamily properties, whereas it could be falling for office buildings. In the hold vs. sell analysis, non-financial market metrics are studied to determine how they may impact the property’s underwriting and future yield. For example, if net migration or company formation numbers are high for a given market, this is favorable for future increases. Conversely, if a market’s population is declining and there is little-to-no new business formation, it may not be a good sign.
Finally, the future goals for the property are the last non-financial consideration. We are value-add investors, which means our business plan is to buy a property and inject a significant amount of capital upfront to improve it through renovations and cosmetic updates. Typically, this work occurs in the first few years of the holding period. Once complete, there may not be many more opportunities to add further value. To that end, we spend a lot of time thinking about our current and future goals for the property and whether or not they have changed along the way. If our goals remain the same and our value-add projects are complete, it may be time to sell. But, if we think there is more value that can be added, it may make more sense to keep working to maximize the sales price in the future.
Conclusions and Summary
There is no magic formula that tells us when to sell a real estate asset. Instead the decision comes from years of asset management experience and careful consideration of both financial and non-financial factors. On the financial side, we look at opportunities for future yield, tax consequences, and opportunities for reinvestment. On the non-financial side, we look at the planned holding period, market conditions and future goals for the property.
Through careful due diligence we reach a sell or hold decision.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
