5 Gotchas in Evaluating Commercial Real Estate Investments

Investing in commercial real estate can be overwhelming in the best of circumstances, as there are many known and unknown variables that may lead to an investment’s ultimate success. To properly evaluate an investment in commercial real estate, we input the data points of the deal into an excel data model that calculates an estimated return taking into consideration the terms of the debt and equity, the hold period, and the timing and success of the execution of certain events laid out in a business plan for the project. The following details five “gotchas” that every investor may want to look out for to help determine whether an investment has been rigorously underwritten, or whether to take additional care and consideration before proceeding with an investment that may be too good to be true.

1. The Estimated Hold Period is Too Short to Execute on the Expected Business Plan

Investors typically look at the estimated internal rate of return (IRR) to determine the overall time valued return of a particular investment.¹ If a project is anticipated to be held for 5 years, and all other projections remain the same, the investment will increase its actual IRR by selling in less than 5 years, and reduce its actual IRR by selling after more than 5 years.² The project’s return is impacted by the time-value of the investment’s capital outstanding; the less time capital is outstanding, the higher the internal rate of returns are, and the more time capital is outstanding, the lower the internal rate of returns are. If a sponsor wants to make their investment opportunity more attractive to investors, and if they believe that investors will invest more readily in a transaction with a higher IRR, a sponsor could reduce the projected hold period in their model in order to increase the estimated return and entice more investors to invest in the deal.³

Some investors like shorter estimated hold periods and associate shorter hold periods with less risk of changes in the market. A 2-3 year estimated hold period is not necessarily an indication that the sponsor is attempting to inflate the IRR to make their deal more attractive. But the investor may want to determine whether the size and scope of the business plan that the sponsor is planning is reasonable for the estimated time frame presented. If the sponsor is purchasing an asset at a low price (i.e., out of distress), doing only minor upgrades, or only upgrading a portion of the property, it is possible that the sponsor could complete all expected work in 12-18 months and then put the asset on the market. To determine whether the timing of a business plan is reasonable, the investor can question the sponsor about the size of the budget, absorption rates in the market for the subject’s asset type, and the estimated time comparable assets have taken to be marketed and sold.⁴

2. The Exit Cap Rate Used to Underwrite the Exit Price is Unrealistically Low

Another way the estimated IRR may be increased is to increase the property’s sales price at the end of the hold period. Arguably the hardest part of underwriting a commercial real estate investment is to project what the sale price of the asset could be 3, 5, 7 or even 10 years after purchase, and the sale price is estimated by using a capitalization rate applied to the estimated net operating income at the end of the modeled hold period.⁵ The IRR calculation requires the sale price as an input, as the profit or loss made at the sale is a significant part of the investor’s overall return or loss on the project. There are two ways to analyze if the exit cap rate the sponsor uses in their model is reasonable for the subject property:

Use a higher cap rate at exit than the reality of the market going in: Investors can start by looking at the stabilized going-in cap rate of the market at the time of the purchase of the transaction and see if the sponsor uses an estimated higher cap rate on exit in the model. Because value-add transactions are common for crowdfunding platforms, the going in cap rate of the particular asset may be below market if the property isn’t stabilized, or above market if the property is being bought for a “deal” (i.e., a good price relative to the comparative set), so it’s best to not use the investment’s actual acquisition cap rate.⁶ Rather, a better benchmark to look at is the stabilized market cap rate for the subject property’s asset type in the specific market at the time of purchase, and to stress the transaction by using an exit cap rate that is 25-100 basis points higher for the sale price at the time of exit. Using a higher cap rate reduces the price of the property. Investors typically want to be as conservative as possible with projections by making the assumption that the market will be worse at the time of sale which leads to a lower sale price and have a more conservative impact on estimated returns. It is important to note that this test works when the investment is made in a strong market; if an investment is made during a downturn or depressed period, it may be reasonable to assume that the market will recover and a lower cap rate than the going-in cap rate may be used in the future.

Use Market Data to Determine A Market Average Exit Cap Rate: A prudent methodology for determining a reasonable exit cap rate is to use a credible data source to pull 10-year cap rate averages for the submarket and use the average cap rate upon exit. In ten years the submarket has likely gone through a real estate cycle, so it will have some years with lower cap rates reflecting the height of the market and some years with higher cap rates reflecting the bottom of the market; by using a 10 year average, the goal is to find a cap rate that is within a reasonable range when projecting the exit price of the asset in that market in the future. This is not an exact science, however, it is one method that may provide a reasonable, and defensible, assumption of value at exit.

Most importantly, if your projected exit cap rate seems “low” relative to the exit cap rates expected in that particular market, you may want to ask the sponsor about their methodology for selecting the exit cap rate to make sure they are not using this input to reverse engineer a more attractive investment for today.

3. The Rent Growth Assumptions Used are Unrealistically High

From the time the commercial real estate market was at the bottom of the last downturn, and through the past 10 years, many markets in the US at various times have enjoyed significant annual rent growth that outpaced historic averages. This is because during the downturn, rents were significantly depressed and had a long way to return back to where they were pre-recession.⁷

It is not reasonable to assume, however, that because a market has enjoyed 6% rent growth in the last 3 years that an investment will enjoy that same annual rent growth for the next 5 years of an estimated hold period. For some value-add transactions, the asset that is being purchased may have below-market rents, which means they may enjoy a 12-18 month catch-up to market after the renovation is completed. Once the rents have reached at or close to rest of the market though, the property will not likely enjoy significant rent growth for the rest of the hold period. Prudent underwriting will look at commercial real estate data to determine the expected rent growth in the market, and many will underwrite to a 3% rent growth assumption or less, if not supported by the market data. If the investment shows substantial rent growth throughout the hold period, it is reasonable to ask the sponsor what data sources they are relying upon to model their project, as merely relying upon data over the past few years may be unreliable.

4. The Sponsor Has No Cash Equity in The Transaction

When reviewing a project there should be a clear breakdown of the ‘sources and uses’ of capital with a description of what capital is being brought into the project by the sponsor. Some large deals will permit 5% of the equity co-invested by the sponsor, as that might be a significant check (over $1M) per deal. Smaller deals might require 10% or more of the equity co-invested, depending on how much that is on a nominal basis. It is possible that if a sponsor presents a limited co-investment, and if they are securing acquisition or other fees at closing, the sponsor may be “rolling” their fees into their co-invest requirement, resulting in the sponsor having little to no cash equity coming in out of pocket. Why is this important? In real estate it is called having “skin in the game” and it means that the sponsor should have some personal financial impact if a transaction is under-performing, and the impact should not merely be that they are not receiving all of their management fees from a deal.⁸ The assumption is that a sponsor who puts their own capital into a transaction will be more likely to fight hard to get a project back on track than they would be if their own capital was not at risk.

5. The Sponsor’s Track Record is Not Strong

When looking at a sponsor’s track record to determine if they are a “good” operator, one place to look is where the sponsor owns other assets. Many sponsors start their careers as local operators in a particular market and get to know real estate from the ground up. Other sponsors work at larger institutional shops to get experience with a more comprehensive set of transaction types before they start to acquire. The sponsor’s track record will first show if they own assets that are close to the subject property, which is a good indication that they know the particulars of their market.⁹ If the sponsor has a much larger portfolio or is investing in a more niche asset class like student housing or self-storage, they may have less regional focus and more asset type focus. For many investors, a good rule of thumb is not to be an investor’s first investment in a new market with a new asset class. If the sponsor has a regional focus of multifamily in the northeast, you may want to reconsider investing in sponsor’s first office acquisition in Florida, but perhaps will consider a multifamily investment in Florida if the sponsor has partnered with a strong local property management company that has a local presence.

There are no fixed rules for what makes up a “strong track record”, but some good indicators are:

a large number of assets in their current and/or sold portfolio
a history of positive returns (although past performance is not an indication of future results)
a history of working at companies that have a significant volume of real estate transaction flow
owning and operating a vertically integrated property management company and/or employing a team of dedicated real estate professionals
offering deals with a high level of professional due diligence and underwriting
operating in the same business for many years and been through several real estate cycles

These five “gotchas”, along with other analysis, help the RealtyMogul team evaluate specific sponsors and specific deals before presenting them to investors on our platform. While investing with an experienced sponsor cannot prevent losses in real estate investing, it may help maximize investment opportunities and mitigate problems.