4 Steps to Evaluating CRE Investment Opportunities
For individuals interested in commercial real estate investing, there are a number of ways to gain exposure to this asset class. And for those investors looking to earn passive income, a common strategy is to partner with a private equity firm.
A private equity firm is a specialized type of investment manager that makes investments in the equity position of an operating company, including those who own real estate assets. To finance the purchase of a commercial real estate asset, private equity firms partner with individual investors to raise the capital needed to get the deal closed.
From an individual investor standpoint, the strategies, objectives, and deals offered by private equity firms vary widely, so it can be challenging to choose one. In this article, we provide a framework through which private equity commercial real estate investment opportunities can be evaluated. But first, investors must ask themselves if they qualify as an “Accredited Investor.”
What Is An Accredited Investor?
In most cases, private equity investments are only available to high-net-worth individuals who qualify as accredited investors. Accreditation requirements are defined under Rule 501 of Regulation D as any person who:
- Has individual net worth, or joint net worth with that person’s spouse or spousal equivalent, of $1,000,000 or more
- Has individual income in excess of $200,000 in each of the two most recent years, or joint income with that person’s spouse or spousal equivalent in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same level of income in the current year.
For those that meet accreditation requirements, private equity real estate opportunities can be evaluated in four steps.
Step #1: Evaluate the Sponsor
The private equity firm is also the transaction sponsor, meaning that they are responsible for finding the property, analyzing its potential cash flows, arranging the financing, getting the deal closed, and managing the property once the purchase is complete. Given the firm’s level of responsibility, its sponsorship of the deal has a significant impact on the performance of the property. For this reason, the choice of a sponsor is not one that should be taken lightly.
Sponsors should be evaluated based on the following criteria:
- Experience and Track Record: The best sponsors tend to have a significant amount of experience with a specific property type, along with a track record of delivering stable, high returns over a long period of time. They should be asked how long they have been in business and how their average returns compare to alternative investments.
- Investing Their Own Money: Sponsors who invest their own money in the deal should be taken as a sign that they have confidence in the outcome of the transaction. Ask sponsors if they invest their own money alongside their investors.
- Compensation: How is the sponsor compensated? Is it based on the performance of the property, or is the majority of the sponsor’s income derived from fees? The financial incentives of the sponsors and their investors should be aligned in all deals to encourage strong performance.
- Differentiators: There are many private equity commercial real estate investing firms. Although they all do the same general thing, their approaches can be slightly different in ways that are important. Ask sponsors what it is that sets them apart from the competition.
- Underwriting Approach: Prior to purchasing the property, the sponsor must “underwrite it,” which is to project income and expenses over a multi-year investment holding period. Doing so means that the sponsor has to make certain assumptions about things like income growth and vacancy. These assumptions can have a material impact on overall investment performance. Ask prospective sponsors about their underwriting approach, and whether their pro forma assumptions are conservative and based on verifiable data.
- Best/Worst Deal: Sponsors like to advertise their big successes, but it can also be illuminating to ask about the deals that didn’t go as planned. Ask sponsors about their best and worst deals, and the lessons that they learned from each.
- References: The best sponsors should be happy to provide references of previous equity investors with whom they have worked.
If the sponsor checks out, the next step is to evaluate the specific deal or investment offering.
Step #2: Evaluate the Offering
Every investment offering is slightly different, and there is no “right” or “wrong” choice; rather, investors should endeavor to work with a sponsor whose offering aligns with their own investment objectives. To that end, there are several factors to consider when performing due diligence on the offering.
- Fund vs. Deal: Broadly private equity real estate offerings fall into two categories: funds and deals. In a real estate fund, investors may not know much about the target properties beyond a general profile. They give their money to the sponsor and the sponsor invests it as they see fit. In a deal, investors have the benefit of knowing exactly which property is going to be purchased and where it is. For example, if an investor prefers multifamily properties, he or she would generally work only with sponsors who invest in the same.
- Property Type: There are four widely recognized commercial real estate property types: office, industrial, retail, and multifamily. Investors should seek out the option that is consistent with their own preferences.
- Market: A property’s location is an important component of its return potential. Investors should seek markets with strong population growth, significant job creation, and rising wages.
- Property Features: At the individual property level, investors should look for assets that have high visibility, excellent signage, strong traffic counts, and multiple points of entry and exit.
- Parking: Having enough parking spaces for visitors, workers, and tenants is critical to the success of a property. Investors should ensure that the property’s parking ratio is adequate for the market.
- Returns: The advertised returns should be consistent with individual investor objectives.
- Strategy: There are four types of investment strategies: core, core plus, value-add, and opportunistic. Each represents a specific risk/return profile, and investors should be comfortable with it.
If the offering is acceptable, the third step is to analyze the specifics of the deal structure.
Step #3: Evaluate the Deal Structure
The legal structure of the deal can have a significant impact on how the property’s cash flow is split between the private equity firm and the investors. CRE investors should look for the following:
- General Partners and Investment: The private equity firm acts as the General Partner or “GP” and coordinates the logistics of the investment, including property management, financing, and underwriting. Real estate investors should look for a GP that invests its own money and has an equitable split of property cash flow.
- Limited Partners and Investment: The Limited Partners or LPs are the high-net-worth individual investors who invest their money alongside the GP. But, their role is strictly passive. They have no say in the day-to-day management of the property.
- Capital Stack: Commercial properties are purchased with a mix of debt (the loan) and equity (investor funds) known as the capital stack. Investors should review the business plan to ensure that the amount of debt does not exceed 75%-80% of the property’s purchase price. Anything higher increases the risk profile of the opportunity.
- Cash Flow Split: In private equity real estate investments, property cash flow is split according to a “waterfall” distribution schedule. Investors should carefully review the waterfall’s parameters to ensure that they incentivize the GP to deliver higher returns.
If the deal structure is suitable for investor risk tolerance, time horizon, and return objectives, the last component to evaluate is the fees.
Step #4: Evaluate Fees
Private Equity asset managers invest a significant amount of time and financial resources upfront to prepare a deal for presentation to investors. Further, they may review dozens of deals for every one that is presented. To pay the salaries of the team it takes to support this effort, the firm charges fees. The key point about fees is that they should not be a profit center for the manager. Instead, they should be used to cover administrative costs while the majority of the manager’s profit should come from investment performance. Typical fees include:
- Acquisition Fee: Cost for finding and acquiring the asset, typically 1% to 2% of invested capital.
- Investment Management Fee: Cost for operating and managing the asset, usually 1% to 2% of invested equity.
- Setup and Organization Fee: Designed to recover the cost of setting up the acquiring entity and filing all of the necessary paperwork. This is usually 1% to 1.5% of invested equity.
- Admin Fee: Cost for the administration of the investment, usually .1% to .2% of invested equity.
- Sales Fees: Some sponsors charge a fee for the sale of the property at the conclusion of the investment. This can be up to 0.75% on top of the brokerage fee.
Fees can vary widely from one investment to another, so it is important for individual investors to evaluate the fee structure to ensure it incentivizes the manager for performance.
Conclusions & Summary
There are dozens if not hundreds of private equity commercial real estate investment firms, all of which offer investment opportunities. To identify the best managers, individual investors should evaluate them on their experience, the specific deal that they are offering, the deal structure, and the fees charged.
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 firstname.lastname@example.org for more information.