Many business owners that I speak with are oftentimes surprised when a buyer of their business is not interested in the accompanied real estate the business sits on. For many business owners who own the both property and business, the relationship between the operating business and the real estate has been profitable and mutually beneficial. Effectively, the business pays for the real estate, and the business owner is left with two valuable assets – the business and the real estate.
Because of this beneficial relationship, the question for many sellers is ‘why would a buyer not be interested in the real estate?”
Remember a while back I wrote about ROIC, or Return on Invested Capital. It was a bit wonky, so I would understand if you skipped that one. The simple premise of that article is that ROIC is important – it tells us what the return is for every dollar invested into the business (not just equity).
When private equity and Wall Street types invest into a business, they are also considering ROIC. The metric they most often look at is IRR, or internal rate of return. Leaving the math aside for a moment, IRR simply takes a return metric like ROIC and annualizes it. In other words, it tells us what our expected return is each year for a given investment.
Most private equity groups are target a levered IRR of 40% or greater. Put another way, a successful private equity investment is one that doubles in value every 2 years. Not every private equity investment is successful, but even after taking into account the losers, many private equity funds aim to triple the value of their portfolio over 5 years, achieving a 25% annualized return. Some do even better than that.
What does ROIC have to do with Real Estate?
When considering return on invested capital, real estate has much lower returns relative to an operating business. This is logical, as real estate has a much lower risk profile and is much more liquid compared to an operating business. While private equity groups target a 40% or greater levered IRR, real estate investment group may target a levered ROIC of only 12% annually. In fact, in today’s market, it is not uncommon to hear of certain groups targeting unlevered returns of only a few percentage points.
The difference in target returns underlies the fact that real estate and operating businesses are two very different asset classes with two very different risk and return profiles. Operating businesses are risky and in return, owners of operating businesses seek to generate returns that compensate them for such risk.
Similarly, private equity funds are in the business of owning private businesses. They are experts at owning, holding, and divesting privately held companies. Real estate investment trusts (REITs) are experts in owning, holding and divesting real estate. The challenges faced in operating a privately held business are very different from the challenges of holding and operating a real estate investment portfolio.
The same holds true for operating businesses. The challenges and risks facing an operating business are very unique to that of managing a real estate portfolio. But perhaps even more important than the additional risk is that investing in real estate requires additional capital. Even the largest companies with the largest private equity sponsors in the industry still have limited capital which they can invest.
The Irony of Diversification
Diversification is often bandied about as a way to eliminate risk in a portfolio. While that is theoretically correct, true diversification is extremely difficult to achieve. For example, an individual may believe that by acquiring real estate they are diversifying their risk. However, if the individual only acquires real estate within the same town that they currently reside, they do little to diversify away risk associated with their specific geographic location. Diversification may actually further compound risk when practiced incorrectly.
Does that make real estate a bad investment?
Real estate can be a very attractive asset class, in the same way that bonds, equities, and operating businesses are similarly attractive. But real estate has a very different risk profile compared to an operating business. I have a client that recently completed an acquisition, acquiring both the business and the real estate. Taking into account both the debt and equity invested, the projected unlevered return on invested capital (ROIC) this year will be about 12% for the real estate and about 40% on the operating business. While he is very happy with the expected returns given the relative risk of both he also recognizes that the real estate investment required twice the capital for a fraction of the return. As he continues to grow his business, he is considering alternatives ways to finance growth.
What do you think? How have you approached real estate as a business investment? Do you feel real estate is an important part of your business portfolio, or that it unnecessarily ties up capital that you could otherwise invest in higher growth opportunities. If you have struggled with these decisions, I can help you with this. Subscribers hit REPLY, or use my contact page to get a hold of me. All communication is kept confidential.
Until next week!