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Industry Analysis: Property Management
Companies under our review in the Property Management Industry own, develop and manage an array of real estate, ranging from apartment complexes to office towers to correctional facilities. Geographic diversity is another attribute of this group. The companies we follow are based in North America and some of them have extensive operations in Western Europe and the Pacific Rim. A few conduct business in developing regions. Meanwhile, property management is a capital-intensive business, and the group’s fortunes tend to follow the real estate cycle.
Property management companies differ from real estate investment trusts (REITs). In particular, a REIT is a tax favored structure wherein corporate income taxes are eliminated, provided the trust maintains 75% of its assets in real estate and distributes 90% of its taxable income to shareholders. Accordingly, the operating structures of property management companies are more flexible.
Top- and Bottom-Line Influences
Property managers primarily generate revenue growth in two ways. One is to wring out more rental income from existing properties through rent increases and improved operating efficiency. Another is to build new developments. Though the first strategy is comparatively easy and inexpensive to implement, there are limits as to how much managers can charge and cut back on services. New projects offer significant revenue gains, but entail greater funding, construction, and occupancy risks. Finally, although not a large influence in this industry taken as a whole, large business property managers may supplement growth via acquisition.
Operating margins tend to vary. The office segment can produce the best margins, especially when properties are in prime locations with reasonable vacancy rates. Office buildings, requiring large spaces and high-grade materials, are expensive to construct, and premium multiyear rents are crucial to cover development expense, normal wear-and-tear, and earn a fair profit.
Residential real estate can be costly to develop, as well. Tenant turnover is usually greater than that in the office segment, constraining rental rate power. Leases are typically shorter, and margins tend to be slimmer.
Correctional facilities have the tightest margins. It’s true that construction costs in this segment are more modest, since structures are simple and made of basic materials, and demand for detention centers holds relatively steady in good times and bad. But companies operating in this field rely almost exclusively on government contracts, which fall under public review and budget constraints.
Of the many factors that come into play in determining a property manager’s success, the single most important is the cost of development. This cost may take the form of interest paid on debt, the rate-of-return required by equity investors, or alternative uses of cash. Effective property managers are able to accurately value a project by determining its total cost and ability to generate cash flow.
The biggest risk in the real estate market is the time it takes to develop a property. A typical project can take three to five years to transition from a concept on the drawing board to a producer of revenue. More challenging projects, such as high-rise towers in dense urban areas, may take ten or more years to develop. The lead times necessary to secure financing, aggregate land and build a project are considerable. An idea that initially seemed very promising could become unappealing by the time it is developed.
Adverse economic conditions can disrupt projects and cause lengthy, costly delays. Companies funding projects in phases can, at times, run into a liquidity crunch. When financing is scarce, the cost of capital will rise appreciably, threatening the viability (or profitability) of an undertaking.
Also, a prolonged downturn will hurt results. In a difficult environment, corporations will look for ways to cut costs. Often they will consolidate operations, which may involve reductions in leased office space. A weak economy will also have a negative impact on the residential side. When unemployment is high it’s not easy for apartment managers to raise rents. Additionally, in an economic slump demand and prices for real estate will come under pressure, curtailing growth opportunity.
Weak macroeconomic conditions can also affect managers of correctional facilities. Governments may find it hard to raise tax revenue for projects when there are other pressing public needs.
There are several things to consider when contemplating an investment in the Property Management Industry. Investors should look for a company that consistently achieves occupancy rates at or above the average for the segment in which it participates. Cash flow is another key measure. Dependable cash production enables management to maintain and upgrade properties, while servicing debt. It’s important for investors to watch out for excessive dependence on debt. Debt ratios and fixed-charge coverage should not be out of line with a company’s historical averages or those of its peers.
Dividend policies have tended to vary considerably between different segments of the Industry, with some companies maintaining very generous payouts, while others made no distribution at all. However, that changed in recent years. Most notably, correctional facility operators, which have historically paid no dividend, have begun to return capital to shareholders. Some developers and managers of properties have a meaningful dividend, but when times are tough, they are not averse to a reduction. Property Management equities are best classified as growth vehicles. In an upturn, price appreciation outweighs the benefits of a dividend.