For individual investors who want exposure to commercial real estate (CRE) assets, the easiest way to obtain it is by working with an investment manager. That manager could take the form of an individual deal syndicator, a private equity firm, or a dedicated real estate fund. No matter who the manager is, they are all required to provide investors with a series of documents that outline the details of the investment opportunity.
Because these documents can be lengthy, dense, and filled with complex terms, many real estate investors tend to ignore them. This is a mistake. These documents contain valuable information about the investment offering and should be read in great detail. In doing so, investors should keep their eyes open for five specific areas of the “fine print” that will help them to determine the risk reward tradeoff of the proposed transaction.
#1 – The Proforma
A proforma is a projection of a property’s income, expenses, and cash flows. One is made for every commercial property investment opportunity. But, the investment holding period can often stretch to 10 years so it can be challenging to make an accurate proforma. As such, transaction sponsors must make a series of assumptions about the property’s performance. They are typically detailed on a “Notes” page in the offering documents and they should be read carefully. Investors should pay special attention to the following:
- Purchase / Sale Price: The cap rate used to calculate the sales price should be conservative relative to the one used to purchase the property. If it isn’t, it could be a sign that the assumptions are too aggressive.
- Rent / Expense Growth: Due to inflation, property income (from monthly rent) and operating expenses (like property taxes) are expected to rise over time. These assumptions should be built into the proforma and they should be in the range of 2% – 3% annually. Anything appreciably different should be fully justified by market data.
- Financing Assumptions: At the time the proforma is created, loans terms may not be known. They should be reasonable and consistent with current market conditions and with terms provided by other lenders. If they aren’t, they should be questioned.
- Leasing / Lease Renewal Assumptions: If there is a significant amount of empty space at the time the property is acquired, an assumption must be made about how quickly it is filled and at what price. If tenant leases expire during the investment holding period, assumptions must be made about lease renewal rates. Assumptions for each should be conservative and consistent with market trends. If they aren’t, they should be questioned.
The point about the proforma is this. While there is a significant amount of effort and research that goes into creating one, it is still just an estimate. All numbers should be fully justified with market data and individual investors should perform their own due diligence to ensure it is reasonable.
#2 – Fees
Putting together a real estate investment requires a lot of time, effort, and resources. To cover their costs and to compensate themselves for their effort, transaction sponsors charge fees. Specifically, there are two fees that potential investors should look for in the offering documents:
- Asset Management Fees: For their ongoing work in managing the day to day operations of the asset, a transaction sponsor may charge an asset management fee. The exact amount may vary by sponsor, property type, and location, but the fee should be reasonable and consistent with those charged by other real estate industry participants.
- Cash Flow Split: In a so-called “waterfall” return distribution, transaction sponsors are entitled to a portion of the cash flow produced by the underlying property. The larger the return, the higher percentage they are entitled to.
Fees can have a material impact on ultimate returns and investors should be able to identify them and be comfortable that they are reasonable.
#3 – Liquidity
Income and profits from real estate investments are earned over time, not in the short-term. As such, many transaction sponsors require investors to commit capital for a long period of time, often 5-10 years. The offering documents will detail the conditions, if any, under which the investment may be sold or redeemed prior to the end of the holding period. In many cases, this is not allowed. If it is, it often comes with a steep penalty that could cause losses for the investor.
#4 – Risk Factors
Commercial real estate investments are not risk free. In order to make a return, investors are required to take some level of risk. Risks are typically outlined in the “risk factors” section of the offering documents and they should be read carefully. Typically they include:
- Idiosyncratic Risk: Depending on the property type, there are risks specific to that asset class. For example, multifamily properties carry one set of risks while owning office space or office buildings carries another set of unique risks.
- Market Risk: Market conditions are unpredictable and they can have a material impact on the investment’s return. Typical real estate market risks include unforeseen changes in: interest rates, vacancy rates, rental rates, and demand for a specific property type.
- Regulatory Risk: Many commercial properties are bound by rules developed by local municipal authorities. These rules can change at a moment’s notice and can have a negative impact on returns. For example, a change in the zoning rules could alter the allowable use of the property or require expensive renovations.
- Natural Disasters / Acts of God: There is no telling when a storm will hit or if an earthquake will damage an asset. These are unforeseen events that can result in expensive repairs and/or a long period of lost income.
Individuals should read through all of the risk factors to ensure they are comfortable with the risk/return profile of the investment opportunity.
#5 – Exit Strategy
Commercial real estate returns come from a mix of income and appreciation. In most cases, the plan is to hold the asset for a certain period of time while collecting rental income and then to sell it when market conditions are favorable. But, what happens if the investment nears the end of its planned holding period and the market conditions are not favorable for a sale? For example, say a global pandemic has depressed market prices and a forced sale will result in a loss. Or, conversely, what if market conditions are red hot halfway through the planned investment period and a profitable sale could be made much sooner than expected?
The fine print should detail exactly what the exit strategy is, when a sale will be considered, and when it won’t. Often, this may mean a significant extension of the planned holding period or a forced sale at a loss.
The broader point surrounding the fine print is this, the details matter. The real estate transaction sponsor is required to provide potential investors with as much information about the risks, returns, and structure of the proposed investment as possible. It is up to investors to read them, ask questions, and consult with a real estate attorney if necessary to make sure they are fully comfortable with the investment offering.
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 email@example.com for more information.