An Unexpected Way to Generate Alpha
Oct 22, 2019

GeneratingAlphainRealestate

Generating alpha is a crucial metric to assess the effectiveness of any portfolio of investments. In the world of commercial real estate, it is especially meaningful and difficult to influence.

What Is Alpha & What Does It Mean For Real Estate Asset Managers

Alpha can be described as the excess return on a portfolio of assets when compared to its benchmark. Relative to commercial real estate, a given asset manager’s ability to generate positive alpha means they performed better than their peers or a relevant benchmark. 

In real estate, two aspects make alpha generation difficult to influence: 

  1. Yet-undiscovered/unidentified areas for value creation/optimization are generally thought to no longer exist or be too difficult/complex to unlock for commercial real estate.
  2. The underlying value of a commercial real estate asset is typically driven by a multiple of the net operating income (NOI) of that property. NOI is, basically, the net of the income that the property generates less its direct expenses. The trouble comes when you realize that income is driven by rent, and rent is largely driven by market conditions (general economic conditions, unemployment rates, interest rates, job creation statistics demand for/supply of commercial real estate, etc.) that the asset manager has little influence over. 

How Alpha is Generated 

Generating alpha is challenging. That’s why active managers constantly have to seek out new advantages to create it, such as risk-free or low-risk cost-cutting methods that are worth the effort. And, you’ve probably already used all of the methods you know of to increase revenue: you’ve already maxed out rents, reduced tenant turnovers as much as possible, and reduced vacancy rates.  

Generating alpha means finding ways to get additional NOI that others are unaware of. In commercial real estate, there are nine key places to look to increase alpha: 

  1. Capital improvements 
  2. Capital redevelopment 
  3. Management and leasing 
  4. Lease structures 
  5. Income and expense management 
  6. Market arbitrage 
  7. Ownership and advisor change 
  8. Financial engineering 
  9. Cap rate arbitrage 

You can read more about these strategies here. 

On a daily, ongoing basis the only lever available to pull is expense/cost management, and even here you have to be very careful. The commercial real estate business has always been very cost-focused and for this reason, there is typically little “fat” to cut. While spending more lavishly on a building’s exterior or interior will rarely result in the ability to materially increase rents (though it will make the property/space more marketable), cutting too far can have devastating impacts on occupancies and average rents. 

As a result, leading asset managers have always pursued ways to cut the operating costs of a building, without negatively impacting its operation. Over the last two decades, this has led to a near transformation in the operations of properties. Technology has been embraced, lean principles drive daily operations, and the ability to mitigate risks have blossomed.  

The situation can best be summarized by a conversation we recently had with a mid-market Asset Manager, who shared, “The problem we’re facing today is that there’s just no more low-hanging fruit to cut. We’ve cut about all we can.” 


The Maintenance, Repair & Operations (MRO) Procurement Opportunity 

With all of the changes that have taken place in property operations, there is still one area that has remained untouched, or at least hasn’t been optimized to fully capitalize (pun intended) on the opportunity. MRO procurement is still managed much like it was a decade or two ago. Consider: 

  • The typical operator controls less than 50% of the MRO spend, as more than half of MRO costs come from third-party contractors who are not properly managed. 
  • Tail spend continues to be difficult to manage. 
  • While more of operations have been centralized and automated, MRO is still managed primarily on a location basis and, worse, it’s done with predominantly manual systems. 

Cutting MRO (Maintenance, Repair, and Operations) costs, using modern procurement strategies, is often one of the most effective ways to maximize property portfolio valuations, especially during a late-cycle economy. In fact,  key way to maximize the value of real estate is to control costs because any improvement goes straight to the bottom line--which helps to generate alpha. 

Reducing procurement costs is a “last frontier” for alpha. It’s been neglected over the years because it’s traditionally very labor-intensive in terms of negotiating discounts and enforcing employee purchasing compliance. Put simply, compliance can be a huge issue for procurement programs—but digital platforms have finally made it easy to save money. The most effective way to tackle these costs is via a user-friendly, one-click procurement platform that lets you save money.  


Watching this Strategy Work 

As an example of how this strategy can work: a large institutional investor with $30 billion in managed assets recently compared their historic prices for MRO parts and materials to the pricing for comparable parts and materials available via Qmerit’s MRO Marketplace. Qmerit’s MRO Marketplace pricing was, on average, 20% less than the large institutional asset manager’s historic prices. Not only does every dollar of MRO saving drop to the bottom line (increase NOI), but in low cap rate environment (4-6% cap rates)each dollar saved on MRO translates into a $16-25 increase in property valuation. When extrapolating these MRO savings portfolio-wide in a low cap rate environment, a typical large institutional investor could easily realize more than a $100 million increase in total property portfolio valuation. This is just one example of how purchasing cooperatives can help commercial property owners/investors shed  unnecessary expenses and increase their bottom line. 

That’s what Qmerit can do for you, too. Qmerit works because it’s a risk-free way to cut costs in ways that other companies overlook. To learn about ways you can increase your alpha with Qmerit, please get in touch. 
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