Investing into commercial real estate directly is becoming a new wave for investors looking for an alternative to traditional investing into stocks and bonds. Direct access to commercial real estate, and technology at the sponsor level, has created online accessibility to detailed information about real estate assets, sponsors and potential investments.
Why are many investors looking to invest directly into commercial real estate?
With the equity and bond markets displaying recent volatility, the traditional investment markets may not present the most interesting risk/reward investment opportunities for some investors. Many investors are turning to alternative investment options, and specifically to investments into commercial real estate. Real estate investing is generally for the longer term and is typically not liquid in the short term. The longer-term hold period for a CRE investment may reduce the volatility of the investment as prices of buildings and CRE investments do not get marked-to-market every second as traditional investments do in traded markets. Investing into CRE is attractive to some investors because it is a diversification away from the potentially volatile traditional markets, and may be more predictable for cash flow purposes.
DIY Investing: Direct access to CRE investment information
So once an investor has decided to join the revolution of investing into commercial real estate directly, how should one consider building a portfolio of multiple investments into various different types of CRE?
First investors must gather information on CRE markets and understand where the opportunities are for different types of CRE investments. Part of this process is evaluating the risk/return profiles that are interesting to the specific investor.
The first question to be asked by an investor: Are you investing for cash flow for immediate yield, or are you investing for capital gain at the end of the investment? When a CRE asset is producing sustainable cash flow from rent collected, the asset can then distribute that cash flow to investors, once expenses and debt service is covered. CRE assets with strong cash flow and attractive distribution rates, tend to have less upside to investors at the end of the investment, unless the market for that asset improves over time. The other option for investors is investing in CRE assets for growth and potential capital gain at the end of the term for the specific investment.
Below, you will see a pyramid of various investment returns and profiles. Don’t yield shop! BEWARE of the temptation to Yield Shop. A sponsor may display a high yield or target IRR for an investment, but that means nothing. It is often just a projection by the sponsor. Investors must understand that to reach for higher return targets, there is significantly more risk involved. Also, cash flow and distributions to investors can be very different depending on which type of CRE investment is made.
At the bottom of the pyramid, in the blue section, investors can evaluate return profiles of 5% -9%. These types of properties are more established buildings with existing tenants and cash flow. These types of assets can be Class A/B buildings in Office, Multi-Family, Industrial or Retail. The end investor is typically looking at these types of investments for steady cash flow and lower risk to the value of the asset. Questions must be asked by the investor about tenant and rent sustainability; location risk, and leverage and financing risk to sustain the cash flow. There may be upside potential in the assets if the specific market for that the asset appreciates in value, and another buyer will pay a higher price than the entry price for the current investor.
The middle part of the pyramid, in the yellow section, investors typically focus on value-add real estate where the sponsor and investors are going to potentially enhance value by making significant upgrades to the asset. These upgrades cost money and thus there is often very little, or any cash flow distributed to investors in the first few years of ownership. The goal is to enhance the value of the property and then lease up that property to a sustainable level so that it can be sold to another type of buyer in the future. Thus, the gain to the investor comes when the building starts producing cash flow and is eventually sold at a higher price above its acquisition price. The risk to investors is that if the cost of the value-add takes longer than expected and if the expected tenant lease rate increases are not achieved it could impair the the value of the building on resale.
The top of the pyramid, in the red section, investors are striving for a much higher return profile and thus are taking significantly more risk to try and achieve this return. Typically, the +15% return profile is for ground up development projects, which includes new construction or a complete teardown of an old asset and then new construction on the lot. There could be no cash flow for years as the project is built. These types of projects can include: office, multi-family, industrial, retail, hotel/leisure/lodging and residential. Investors may achieve gains in their target ranges if the assets are sold to new buyers or refinanced at levels significantly higher than the development costs and financing costs of the project.
Building a DIY CRE portfolio:
The pyramid is used to suggest that when building a CRE investment portfolio, that a larger amount of capital is allocated to the return profile with a more predictable cash flow from sustained assets: the bottom of the pyramid in Blue. This way an investor can have a base to the CRE portfolio of both cash flow and some potential upside growth in the value of the CRE. The value-add section of the portfolio will have a smaller allocation compared to the ‘cash flow’ base of the portfolio because it is taking on more risk than the bottom BLUE section, and the cash flow will not be as immediate in the first 1-3 years of the investment. Finally, the RED SECTION of the allocation will be even smaller, as the risk is even higher than the previous 2 portions of the pyramid. The RED SECTION of the allocation could have very little or no cash flow until the project comes on line. Market conditions may change for the worse by the time a project comes on line, and thus investors must be prepared for this risk.
A blend of all these tranches of the CRE pyramid is a potential way to begin building a CRE investment portfolio for the DIY investor. In the end it comes down to the risk profile of the investor and what the goals are for building an alternative investment portfolio with CRE as an allocation for yield and/or growth. Evaluate the type of CRE asset, the sponsor, the location, the risk to cash flow and value, and the exit plan. Work with sponsors where there is total transparency and the ability for the investor to gather as much information as possible on the investment options.
Welcome to the DIY CRE INVESTMENT Revolution.