One of the major benefits of commercial real estate investing is that it is a tried and true method of portfolio diversification, generating cash flow, creating wealth and putting those who own it on the path to financial freedom. This means that there are no secrets to the business plan. First time and seasoned real estate investors (like us) alike can purchase a commercial property in the United States, fix it up, extend the leases, reconfigure the tenant base, increase rents, decrease expenses, and, when combined with the right market, sell the investment property for a profit when the planned holding period matures.
This process is highly repeatable and highly scalable, which means that an investor can develop a specific process and well defined strategy over time. We have done just this and compiled out best practices into what we call the “Seven Commandments of Investing in Commercial Real Estate.”
Commandment #1: Commercial Real Estate is a Local Business
One of the major contributors to the success (or failure) of a commercial real estate deal is its location and real estate market. But, it can be challenging to pick a particular location because the fundamentals of a given market can vary widely from one location to another (e.g. the market in New York is very different than the one in Omaha). The challenge is compounded when attempting to scale a portfolio over multiple locations (we invest nationwide) because it can be difficult to master the nuances of each one. For this reason, our first commandment is that, despite the national scale, commercial real estate investment is a local business and we are not area agnostic.
To be truly successful and to understand the specifics of each market that we invest in, we take a two pronged approach. First, we don’t hesitate to partner with local experts to gain a greater understanding of the local market dynamics. These experts may be our own employees or they could be brokers, property managers, fellow investors, or real estate attorneys, any of whom can give us the “report on the ground” in a given market. Second, we rely heavily on data for confirming evidence that a market is investable. While there is a significant amount of publicly available economic data, we also utilize proprietary data sources and methods to perform our own analysis.
Commandment #2: Commercial Real Estate is a Full-Time Business
That commercial real estate can generate “passive” income is a common misconception. It is not a part time business and there is a significant amount of work that goes into managing the day to day operations of a commercial income property. These tasks include things like: collection rent, paying vendors, negotiating leases, basic repairs, large scale renovation projects, and monitoring market conditions for potential weaknesses.
There is no doubt that a significant amount of work is required so, perhaps the better question is who does it. In a direct investment scenario – where an investor purchases a property on their own – the work may be performed by the investor themselves or by a property management company that is hired to do it. In an indirect investment scenario – where an investor places their capital with a professional manager – the work could also be performed by a third-party property manager. Or, as is the case for us, we prefer to insource this activity and perform it on our investors behalf to maximize the value of the asset.
Commandment #3: Creating Value is Essential
Commercial real estate assets are value based in the amount of Net Operating Income that they produce. Because Net Operating Income is calculated as a property’s income minus expenses, it means that the opener of the property has direct control over it.
When we purchase an asset, we do so with a specific business plan in mind and it often involves target projects designed to increase Net Operating Income over time. These could include things like property renovations, rental increases, lease extensions, expense reductions, and filling existing vacancies. Combined, these activities have the potential to add significant value to a project and, when combined with a strong market, can be a major contributor to overall returns.
To provide an idea of how powerful a value creation strategy can be, consider the following. At a 7% Cap Rate, every $1 added in Net Operating Income results in an additional $14.28 in property value.
Commandment #4: Money is Made on the Buy
In our office space, we often refer to this as the single most important phrase in commercial real estate investment, “you make money on the buy.” Simply, this means that it is critically important to acquire the right assets, at a favorable price.
To ensure we are paying a good price, we devote a significant amount of time and resources to performing due diligence on a property which includes activities like: conducting detailed financial analysis, ordering third party appraisals, studying environmental reports, reviewing sales and rental comparables, analyzing leasing activity, and hiring inspectors to review the property from top to bottom to ensure there are no major repairs required. We plug the output of these activities, along with our required return criteria, into our financial models to determine the price we want to pay.
Commandment #5: Middle Market Assets Generate Superior Returns
We believe that the “middle market” price point, properties in the $10MM – $75MM range, is ideal to deliver superior returns and the logic is simple. Properties priced below $10MM are generally considered to be priced for the “retail” market, which means they are typically most appropriate for well capitalized individual investors with the appropriate risk tolerance. Properties above $75MM generally fall into the “institutional” market, which means that they are only affordable for large investors like college endowments, pension funds, and private equity firms.
So, properties in this middle market sweet spot are too expensive for individual investors and too small for institutional investors, which we believe positions us well to be able to acquire strong assets at favorable prices with minimal competition.
Commandment #6: Access to Capital is Critical
Undercapitalized commercial real estate rental properties often find themselves at the precipice of a downward spiral. They don’t have enough money to perform the necessary repairs and maintenance to keep a property running smoothly and looking good. So, when a tenant’s lease comes up for renewal, they may be more likely to move to a better maintained property at similar prices. If a tenant leaves, the rental income is lost, which provides even less money for repairs and maintenance, which could cause even more tenants to leave in a true downward spiral.
So, access to capital (investor or lender) is a critical component of a property’s investment plan and success. We actually view under capitalized properties as an opportunity because they can allow us to purchase them at a favorable price and use our resources and operational expertise to perform the repairs and maintenance necessary to bring the property back to market standards.
Commandment #7: Self-Management is an Important Ingredient for Success
Finally, there is no question that active management is a critical component in ensuring that a property’s operations run smoothly on a day to day basis. However, many investors are content to outsource this responsibility to a third-party management company, which can be expensive. In addition, it can allow an investor/owner to lose sight of the day to day activity at the property.
We prefer to manage the property ourselves and we believe that doing so provides two key benefits: (1) it provides cost savings that can be passed on to our investors; and (2) it gives us more direct control over the property on a day to day basis. Combined, we believe that these factors are a major contributor to our successful track record of delivering strong investment 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.
As we evaluate assets for investment, we follow a rigid and detailed investment process, including these seven commandments, to ensure the best possible outcome for our investment partners.
Whether you’re just getting started or searching for ways to diversify your portfolio and secure your financial future, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information