- Commercial real estate is a broad class of real estate assets that are acquired with the intent to earn a profit through rental income, price appreciation, or both.
- For individuals interested in investing in commercial real estate, there are a wide variety of investment options and trying to choose one can be confusing and overwhelming. There are several ways to narrow down the choices.
- There are four commercial property types: Office, Industrial, Retail, and Multifamily. Each type has its own risk profile and operational quirks.
- To evaluate potential returns, a variety of metrics should be considered including: Cap Rate, Internal Rate of Return, Equity Multiple, and Gross Rent Multiplier.
The term “Commercial Real Estate” describes a broad class of real estate assets that are acquired with the intent to earn a profit through rental income, price appreciation or both. As an asset class, commercial real estate (CRE) has a strong track record of delivering respectable returns over time, which makes it an attractive investment option. Even so, there are a wide variety of investment options within the asset class, and trying to choose one can feel confusing or overwhelming for even the most seasoned real estate investor. In this article, we will break down the various choices when investing in commercial real estate and describe the risks and benefits of each.
Active vs. Passive Investing in Commercial Real Estate
Commercial real estate investing is not a passive endeavor. These are large, complex properties that require a significant amount of attention to run efficiently. So, one of the first major considerations for commercial property investing is how much time and/or expertise they have to contribute to managing the investment.
In an active investment, investors take a direct role in the property selection, acquisition, due diligence, financing, leasing, and management processes. In many cases, the decisions they make across these milestones have a direct impact on the success, profitability, and cash flow of the property investment. An active investment requires a significant amount of time and a high degree of operational expertise to profitably execute. Not all individuals seeking to invest in commercial real estate possess all of these attributes, so a passive investment may be a better option.
In a passive commercial real estate investment, investors commit capital to a third party manager (like us) and outsource the property selection, acquisition, due diligence, leasing, and property management tasks to that entity. With this strategy, the investor gets all of the benefits of commercial real estate ownership (e.g. passive income) without the time commitment and expertise needed to operate it directly. For many individuals with W-2 jobs and a desire to save or invest for retirement, a passive investment in commercial real estate may be their best option. And for those who choose this route, the next most logical decision is which manager to entrust with their funds.
Choosing a Passive Commercial Real Estate Investment Manager
There are hundreds of private equity commercial real estate firms like ours that work with individuals to pool investment capital and deploy it into commercial real estate assets. Given that we all perform the same basic function, it is important for each investor to choose one whose strategy is consistent with their own risk tolerance, time horizon, and return objectives match their own. To that end, passive investors in commercial real estate should evaluate potential managers on the following attributes:
- Experience: The best managers tend to have a significant amount of commercial real estate investment experience. Look for managers that have been in business for 10 years or more, and have an established track record of delivering strong returns to their investors.
- Diversification: Because the needs and objectives for each individual investor vary, management firms should have a diverse slate of investment offerings designed to meet the needs of different groups of investors. For example, they should offer “core” investment opportunities for those who are risk averse, and speculative opportunities for those who are willing to take greater risk.
- Deal Flow: Consistent deal flow is the lifeblood of every commercial real estate investment firm. Potential managers should have strong broker, lender, and property owner relationships to drive new investment opportunities.
- Fund vs. Deal: Some managers offer investments in a blind “fund,” which requires an investor to commit capital without actually knowing exactly how their funds will be deployed. Other managers offer opportunities to invest in specific deals, which allow individuals to know exactly how their money will be used. We happen to offer the latter and believe it to be the superior option.
- Public vs. Private: Some passive managers offer securities that are publicly traded on well-known stock exchanges (like REITS). These provide a high degree of liquidity and a relatively short-term time commitment. Other managers offer securities that are non-publicly traded. Typically, these are only available to investors who meet certain income and net worth requirements. While such securities are less liquid than their publicly-traded counterparts, their prices aren’t subject to the whims of public markets and tend to appreciate slowly over time.
- Communication: When a manager accepts investment capital from an individual, they are implicitly agreeing to provide periodic updates on the investment’s performance. The best sponsors communicate clearly and consistently. Before the transaction, the manager should be clear about the potential risks as well as the timeline, business plan, and any associated fees. After the transaction, the manager should provide regular, transparent communication about the investment’s status and any inherent risks.
- Suitability Review: The burden of determining suitability flows both ways. While an investor should choose a manager that best represents his or her own objectives, a firm should also take a proactive stance when choosing which investors they want to work with. This process is called a “suitability review” and should happen prior to the manager accepting funds from an investor.
- Commercial Real Estate Market Expertise: The success of a commercial real estate investment is highly dependent upon the dynamics of the market in which it is located. The strongest managers have a high degree of expertise in the markets in which they operate, and they use this to identify the most promising opportunities.
By evaluating potential managers on these variables, investors should be able to narrow the options down to a few that are a good fit for their own objectives.
What Type of Commercial Real Estate Should You Invest In?
After a manager is chosen, a decision should be made about what type of commercial real estate you should invest in. Broadly speaking, there are four commercial real estate asset classes, each of which comes with its own risk profile and operational quirks:
- Office: Office space is designed for the unique needs of running a business. The office building could be general, meant to cater to the business needs of companies like accounting and law firms. Or, it could be designed to meet the unique needs of a specialized tenant, such as a doctor’s office or medical imaging center. Office investors benefit from favorable lease terms and generally low tenant turnover because it can be difficult or expensive to move a business. But, those same leases may come with infrequent rental increases and expensive tenant improvements to entice a company to move in the first place.
- Industrial: Industrial real estate is characterized by properties with an “industrial” purpose and may include standalone warehouses, logistics facilities, or “flex” spaces. Examples of industrial tenants include shipping companies such as UPS or Amazon, as well as other light manufacturers. Industrial investors benefit from predictable cash flow, lower operational risks, low CapEx requirements, and generally favorable supply/demand characteristics. On the other hand, industrial spaces can be especially vulnerable to economic disruptions and may have high upfront costs due to their large physical footprints.
- Retail: Retail properties are designed for tenants who operate direct to consumer businesses like clothing or electronics stores. Classic examples of retail spaces include strip malls, shopping centers and standalone bank branches. Retail investors benefit from high visibility and long term leasing activity. But the financial strength of tenants can be impacted by changing market tastes, and the interior of a retail property is often built for a specific purpose, which can make these spaces difficult or expensive to re-lease without major renovations.
- Multifamily: A commercial multifamily property is an apartment building with five or more units. Multifamily apartment complex investors benefit from relative stability in times of economic distress (such as the current pandemic), but they may face challenges with high tenant turnover, short-term leases, and increased collection expenses.
Once a property type is chosen, it is important to understand how returns are measured.
Measuring Potential Returns on a Commercial Real Estate Investment
Unlike residential properties, which are valued on comparable sales, commercial investment properties are valued on the amount of Net Operating Income (NOI) they produce. In turn, that Net Operating Income and other figures are used to calculate a series of return metrics that provide an indication of the return an investor can expect:
- Cap Rate: A commercial property’s Cap Rate is the return that can be expected on an all cash purchase of a property. It is calculated as a property’s Net Operating Income divided by its purchase price. It is influenced by a variety of factors, but we generally aim for a Cap Rate in the 4% – 8% range.
- Internal Rate of Return (IRR): The Internal Rate of Return is the annualized effective compound rate of return on a series of cash flows. The method for calculating it can be complex, as it represents the discount rate that sets the Net Present Value of all future cash flows equal to zero. Generally, we aim for an IRR in the range of 10% – 20%.
- Equity Multiple: The Equity Multiple is the ratio of the total cash distributions to total cash invested. It is expressed as a decimal and we generally aim for an Equity Multiple of greater than 2.0x.
- Gross Rent Multiplier: The Gross Rent Multiplier is the ratio of a property’s purchase price to its annual rental income. It represents the number of years it would take a property to pay for itself from gross rent collections. The lower the number, the better.
If the return metrics advertised by the investment manager match those required by the investor, it can signal a potentially good fit.
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
To learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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