Individuals looking to invest in commercial real estate (“CRE”), especially for the first time, can be overwhelmed by the number of available options and the managers who offer them. We have found that it can be easy to narrow down the choices by first grouping them into two buckets, active or passive.
Active vs. Passive Investment
The first two questions that a potential commercial property investor should ask themselves is: (1) How much time do I have to manage this investment; and (2) Do I have the expertise needed to select, underwrite, finance, and manage the asset on my own? The answers to these questions will drive whether an individual should pursue an active or passive commercial real estate investment.
In an active investment, an individual or group of individuals forms a Limited Liability Company (LLC) and uses it to find and purchase a commercial real estate asset, like a multifamily property or office building, directly. Many of the common sources for finding commercial properties include broker relationships and web-based search tools like LoopNet or CREXi.
Because they own the property directly, active real estate investors are entitled to 100% of the property’s cash flow and appreciation, which can be significant over time. But, they are also responsible for finding the property, performing the necessary due diligence, arranging the financing, and managing the asset once the purchase has been completed. These activities require both a significant time commitment and a high degree of real estate specific expertise that not all individual investors possess. So, an active investment may not be the best option for those who don’t have the time and/or expertise to manage it effectively. For these individuals, a passive commercial real estate investment may be a better option.
In a passive commercial real estate investment, an individual commits their investment capital to a third party and outsources the task of property identification, selection, acquisition, and management to them. This allows individuals to obtain all of the benefits of commercial property ownership without the time commitment or expertise needed to manage it. Most individuals seeking exposure to the commercial real estate asset class are a good fit for a passive investment strategy, but this is where the number of options can become overwhelming. So, for those that choose the passive investment path, it can be helpful to next group the investment options into two more buckets, Real Estate Investment Trusts (REITs) or Private Equity firms.
A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. Because REITs are formed as corporate entities, investors are able to purchase shares in them, providing access to the rental income and profits produced by the underlying assets. In addition, there are tax benefits to the REIT structure as long as it meets certain requirements. REITs can be publicly traded, which allows investors to buy and sell shares like stocks or mutual funds, providing a high degree of liquidity. Or, they can be private, which provides less liquidity, higher management fees, and a longer term commitment.
Generally, passive commercial real estate investors who prefer the REIT structure can choose from one of four types:
- Equity REITs: Equity REITs are publicly traded companies (their shares can be bought and sold in the stock market) that own or operate income-producing real estate for the purpose of distributing dividend income to their shareholders. The majority of REITs fall into this category and are considered attractive because of their liquidity and high dividend yields. REITs can specialize in specific property types like apartment complexes, office space or single-family homes.
- Mortgage REITs (mREITs): Mortgage REITs (mREITs) provide financing for income-producing real estate by originating mortgages or purchasing mortgage-backed securities. They earn income from interest on the loans and/or dividends from security investments.
- Public Non-Listed REITs: Public, non-listed REITs (PNLRs) are registered with the SEC but do not trade on national stock exchanges. However, they follow the same philosophy of investing in income-producing properties for the purpose of distributing dividends to their shareholders.
- Private REITs: Private REITs are exempt from SEC registration requirements and their shares do not trade on national stock exchanges. To invest in a private REIT, an investor must meet income and/or net worth hurdles or demonstrate that they are sophisticated enough to understand the risks of investing in non-publicly traded securities.
Given the number of REIT categories, there are enough options to meet the needs for nearly all investors. However, one of the major drawbacks to investing in a REIT is that an individual has little to no say how or where their capital is deployed. They just contribute funds to a “pool” and it is up to the asset manager to choose the properties and/or loans for investment. For those individuals who want to know exactly what property they are investing in, a private equity commercial real estate investment may be a better fit for their objectives.
Private Equity Firms
Private Equity Real Estate firms and REITs have a similar mandate, to pool investor money and deploy it into real estate assets to produce passive income. However, the securities offered by Private Equity Real Estate firms are not publicly traded and they are only available to accredited investors.
Because they aren’t bound by the same regulations as publicly-traded REITs, private equity real estate companies have wide latitude to invest in a variety of real estate asset classes, which may or may not include income-producing rental properties. In addition, the legal structure may differ significantly from a REIT and they are not required to pay out a high percentage of their income in dividends. Instead, the majority of private equity returns are derived from profitable investment exits in the form of capital gains and carried interest.
A private equity investment comes with a series of impressive benefits:
- Acquisition and Operational Expertise: The identification, selection, acquisition, and operation of a commercial real estate asset requires deep expertise and significant experience, which a private equity real estate firm specializes in. This type of expertise allows the manager to keep a close eye on key operational metrics like: leasing activity, Net Operating Income (NOI), vacancy rates, operating expenses, and real estate taxes.
- Diversification: There is a strong case to be made that commercial real estate investing can provide an added element of diversification in the traditional stock/bond portfolio.
- Tax Efficiency: Private Equity Real Estate investments are structured in a tax-efficient manner, allowing investors to reduce taxable income through depreciation.
- Flexibility: Because they aren’t as heavily regulated, private equity firms can be flexible in their investment strategy, giving them the freedom to pursue profitable deals in whatever real estate market makes sense. For example, they could pursue a commercial residential property in one deal or an apartment building in the next.
- Incentive Alignment: Because private equity firms themselves are also invested in their deals, their incentives align with those of the investor in that they both want a profitable outcome.
- Exit Plan: Private Equity Real Estate firms enter an investment with the exit and desired cap rate in mind, which provides investors and lenders with a roadmap to a successful outcome.
- Clear Fees and Compensation: The fee and profit participation structure is clear from the outset and closely correlated to performance, which means that all parties are working together towards a profitable outcome.
Like REITs, there are different types of private equity real estate passive investments that an investor can choose from. There are two main categories to be aware of:
- Fund vs. Deal: Some private equity firms offer “blind fund” investment opportunities that are similar to a REIT in the sense that an investor contributes capital to the private equity firm and the firm decides where, when, and how the capital will be deployed. Or, and this is the case with our firm, an individual can invest in a specific real estate deal. In such cases, they would be able to know exactly which property is going to be purchased, where it is, who the tenants are, what the income statement looks like, and what the business plan is post-purchase. We believe this is the superior option for most individual investors.
- Specialization: Commercial real estate is a broad category so asset managers tend to specialize in certain segments of it. For example, some firms specialize in industrial space, some in office space, some in multifamily, or, as is the case with us, retail assets. There are enough options that an individual can choose one that aligns with their investment objectives, risk tolerance, and time horizon.
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.