Investing in commercial real estate (CRE) can be a very rewarding financial decision that allows individuals to create diversification in their investment portfolio. There are multiple types of commercial real estate asset classes such as retail buildings, office buildings, multifamily buildings, industrial buildings, and self-storage facilities, each of which presents a unique risk profile and their own operational quirks.
In this article, we address five factors to bear in mind while evaluating a potential commercial real estate investment as well as four risk categories to remember. We will describe what they are, why they matter, and the risks and benefits associated with each of the strategies described. By the end, readers will have all the information needed to make an investment decision that is consistent with their risk tolerance and time horizon.
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Evaluating Potential Commercial Real Estate Investments
Before committing capital to an investment, there are a number of factors that investors should consider.
“Location, location, location” is a common phrase used in commercial real estate. While this is good advice, many investors don’t understand exactly what it means.
Location is important because it is permanent. For example, suppose an investor purchases an apartment complex that is a bit run down but in a great location. The owner can complete renovations or remodel the property,, but it is impossible to change where the apartment complex is situated. Location always plays an important role in the expected rate of return as well as the property’s value.
When considering a property’s location, factors to consider are: location premiums, zoning and title surveys, property access, environmental concerns, and flooding or seismic activity.
As major urban real estate markets remain in demand and continue to grow, investors have to make the decision about whether to pay a premium for a prime location or move to an emerging market in order to generate a higher rate of return. Prime locations in the United States are often classified by tiers, where “tier one” markets are cities like New York, Los Angeles, Boston, and others. These are thriving markets with proven real estate growth, massive populations, and low cap rates. Commercial properties in these markets tend to trade at a premium, and investors must decide if the premium is worth it or if they would be better off investing in a lower cost market.
Zoning & Title Surveys
Property zoning is also of critical importance because it determines the range of allowable uses for a building. Investors should review ALTA surveys in conjunction with title documents to ensure compliance with regulatory oversight.
Many commercial real estate investors think that just because a road leads to a parcel it has insurable access, however, that is not always the case. “Insurable” means that the title company will insure that the property has legal and deeded road access which is an important distinction.
Investors should ensure that an environmental assessment is conducted to evaluate the property for contaminants or any history that would impact future plans. Surrounding properties should also be evaluated to determine if there are any potential contamination issues.
Flooding & Seismic Activity
Flooding and seismic reports should be obtained in order to ascertain whether the property is at risk for damage. These reports can also help an investor to understand risks posed by new legislation or updates to the local building code.
Commercial real estate debt is money used in conjunction with equity funds to purchase, refinance, or develop a real estate venture. This money is provided by banks, life insurance companies, or other real estate lenders in exchange for a promise to repay with interest.
In general, the addition of debt to a financing package can help to boost returns. But, it also raises the risk profile of a transaction. In general, debt should not exceed 75% of the property’s value to ensure a property does not become “upside down” in the event of a market downturn.
Investors working with a transaction sponsor should ensure they plan to place a safe amount of debt on a property.
The condition of a property is important because buildings rely on various engineering systems to operate properly, and their condition is not always evident when buildings are leased or bought. Investors should be diligent in ensuring a building’s condition meets the standard of their investment criteria by having a Property Condition Assessment (PCA) performed as part of the due diligence process.
The occupancy rate is the percentage of all units in a rental property that are occupied during a specified period of time. These rates are correlated with macroeconomic trends and shifting demographics and can play a key role in the viability of a commercial real estate investment. Higher occupancy corresponds with higher rates of return on an investor’s capital, so investors go to great lengths to project occupancy rates over the anticipated holding period.
Further, asset managers work closely with property managers to ensure occupancy stays at a suitable level while the real estate investment is held. It’s important for investors to understand that different asset classes usually have different targets for their occupancy levels. For example, luxury student housing complexes on major college campuses may run at a 99% occupancy level, compared with a multifamily complex in a big city which could run at a 92% occupancy level. Occupancy assumptions are built into investors’ pro forma financials, and investors should take the time to understand how occupancy rates can impact the bottom line.
As discussed above, return potential is driven by many factors such as location, debt load, a property’s condition, and occupancy levels. Generally, more desirable locations require a location premium while less desirable locations may offer better returns, but at a greater level of risk. Debt is often used in order to achieve higher returns but also increases an investor’s risk. In addition, a property’s condition is evaluated by examining the engineering viability of the factors that allow it to operate. Expected occupancy is dependent on the type of asset class and also has an impact on a commercial property’s risk level and potential profitability.
With these factors in mind, commercial real estate investment opportunities generally fall into one of four categories
4 Commercial Real Estate Risk Categories
Investors can classify the risk and return profile of a commercial property investment into four buckets: foundational, foundation plus, value, and speculative. Details on each bucket are described below:
Foundational investments, also known as core real estate investments, are the safest and most stable options. They sit at the bottom of the risk-return ladder and are usually best-in-class properties with stable occupancy and high credit tenants.
Foundational assets are often owned by large institutions or REITs and usually trade at lower cap levels, which limits the upside an investor can achieve. However, they provide a more predictable and stable cash flow which limits investment risk.
Foundational Plus Investments
Foundation Plus investments, also known as core-plus investments, have many of the same qualities as foundational investments but with one or more added risk factors. For example, the property may be slightly aged, the tenants may have higher credit risk, or the location may be suboptimal. An example of a foundational plus investment could be a nice office building in Chicago that is several blocks from the Magnificent Mile, which is considered to be the “prime” commercial location.
Leverage on Foundational Plus assets usually ranges from 50-65% and while the benefits of debt are certainly seen in the increased returns, debt is usually limited to ensure these assets remain relatively safe. Annualized rates of return usually range from 10-14% on these assets when levered.
Value investments are real estate assets that may have a problem that needs fixing such as a retail shopping center that lost a major anchor tenant or a property that needs significant renovations.
Investors typically approach value investments with a very specific business plan as a means to improve the utilization of the asset. In our example, the investor may have the opportunity to buy the building at a discount given the absence of the anchor tenant with a business plan to reposition the space into a foundational plus investment.
Leverage on these assets usually falls in the 65-85% range with returns in the 15-19% range.
Speculative investments fall at the top of the risk/return ladder and generally require a very robust business plan to improve utility. There are often major obstacles to overcome like extremely low occupancy levels or a major structural deficiency. These investments are opportunistic in nature and sometimes involve business strategies like acquiring foreclosed assets from banks at a major discount to reposition the asset to its highest and best use to generate the highest rate of return.
While speculative investments may offer the highest returns, they also have the highest level of risk. Leverage levels usually range from 0-70%, but it is not uncommon for a speculative investment to be purchased with cash and the debt injected later for renovations. Speculative investments are highly case by case dependent but usually offer rates of return in excess of 20%.
When evaluating a potential investment, there are a number of factors for investors to consider including: location, debt, condition, and occupancy, all of which contribute to the potential return a property may produce.
With these factors in mind, there are four classifications of commercial real estate investments that are indicative of the risk and potential return.
Foundational investments are the safest and most stable options and, consequently, provide the safest and most stable returns.
Foundational Plus investments have slightly more risk due to some type of deficiency such as expiring tenant leases or major repairs needed.
Value investments are characterized by properties with some sort of deficiency that can be purchased at a good price and repositioned to current market standards.
Finally, speculative investments are the riskiest and are characterized by properties that may require a complete tear down or ground up development. Consequently, they offer the highest, but most variable returns.
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.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.