A Five-Part Guide for Commercial Real Estate Investors Seeking Passive Income (Part 1)
Part 1: Key Elements of a Business Plan that Impact Investment Decisions
Welcome to the first of our five-part series, A Guide for Commercial Real Estate Investors Seeking Passive Income. In this article, we’ll explore several specific aspects of a project that you should consider when evaluating an investment opportunity.
When considering an investment in real estate, the proposed business plan is one of the key documents that informs and impacts investment decisions. You should scrutinize several business plan elements when assessing a property’s potential for success and corresponding risk factors.
Understanding how these elements can affect returns on your investment is critical for any investor looking to earn passive income by investing in institutional quality real estate projects and diversified real estate investment vehicles like non-traded REITs and funds.
A business plan is a formal document that provides an overview of a commercial real estate investment project. It spells out the sponsor’s goals, timeline, and budget, and details the contemplated strategy that will be used to achieve them. A well-written business plan can help attract financing and partners and keep operators on track as the project unfolds.
Key components of a business plan include:
- Property: The physical characteristics of the property, including location, age, and condition, can have a significant impact on its value and the challenges associated with certain strategies.
- CapEx budget: A well-managed property will have a solid capital expenditure budget in place to maintain and potentially improve the property over time.
- Rent growth: A property’s ability to generate consistent rent growth is often a key component of its investment potential.
- Reserves: A prudent investor will always set aside funds to cover unexpected repairs or vacancies.
- Financials: A thorough understanding of the property’s historical and projected financials is essential to making sound investment decisions.
- Holding period: The length of time a business plan contemplates holding a property can impact the overall return and execution risk.
- Taxes: A business plan should take into consideration the potential tax implications of various decisions on investors. Individual tax implications in connection with owning a property should be considered when making investment decisions.
- IRR: The projected internal rate of return is a key metric for evaluating forecast investment performance.
- Tenant quality: The quality of a property’s current and projected future tenant(s) can have a significant impact on its value and profitability and should be incorporated into any business plan.
- Underwriting quality: A business plan’s underwriting assumptions should be reasonable and well-supported with the goal of minimizing investment risk.
The first step in evaluating a business plan is evaluating the property or properties underlying the investment. There are many factors that you should take into account when doing so, as they can have a significant impact on the overall potential value and underlying risk of the investment:
- Age of the property: Older properties may require more maintenance and repairs, which can affect profits.
- Type of property: Different types of commercial real estate (e.g., multifamily, office buildings, retail, industrial) come with their own unique set of risks and rewards.
- Property class: Properties are classified into A, B, C and D with Class A properties being the highest quality (and usually the most expensive).
- Occupancy rates: Lower occupancy rates can indicate that a property is not in high demand, making it more difficult to fill vacancies and generate rental income.
- Types of tenants: Tenants with strong credit ratings and stable finances are typically less risky than those with poor credit or unstable financial profiles.
- Condition of the building(s) and improvements: A well-maintained property is more likely to attract and retain tenants than one in disrepair and would be expected to require a lower level of ongoing repair and maintenance costs.
- Potential entitlement or construction issues: If a property requires significant renovations or has zoning issues that limit its current development or operating potential, it may be less attractive to investors.
It’s important to understand the project’s capital budget clearly. This will help you assess whether the project is feasible and the degree of risk associated with generating projected cash flows. In addition, you should analyze the CapEx budget in conjunction with the overall business plan to see if the two are aligned. If the CapEx budget seems out of line with the rest of the business plan, it may be a red flag that the project is not a prudent investment.
It is also important for you to review the CapEx budget for both identified and future unidentified capital expenses. Some examples of identified capital expenses include the need for exterior paint, enhanced signage or refreshed interiors. Unidentified capital expenses might include future repairs or renovations that are not currently specifically budgeted for but would be reasonably anticipated during the projected hold period.
Rent Growth Potential
When projecting future rent growth, it’s important to understand the local market conditions. This includes understanding the current vacancy rate as well as the average rental rates for similar properties in the area. Additionally, it’s important to be aware of any planned competitive developments or changes to the appeal of the local area that could impact the longer-term potential of the investment. For example, if a new apartment building is being built nearby, this could be a sign that the demand for housing is perceived as strong in the area, but could also be competitive with an existing multifamily project.
Another important factor to consider when projecting future rent growth is the quality of the property itself and the related characteristics for that type of property. For example, for a multifamily building, you will want to know whether it is well-maintained, whether it is located in a desirable area, does it have amenities that tenants are looking for, such as ample parking or easy access to public transportation? The answers to these questions can help give you a better idea of how much rent a business plan should realistically expect to achieve in the future.
Frequently, a business plan will also include projected rent premiums based on capital improvements. Using multifamily as an example, it is common for a sponsor to plan to renovate units or add additional amenities. To properly evaluate projected rent premiums, you should ensure the sponsor has analyzed how much rents have increased for units that have undergone similar renovations at the subject property or comparable properties nearby. If the proposed rent premiums are significantly higher than what other similar properties are achieving, there may be greater risk underlying the proposed scope of the renovation project.
You should look closely at the projected level of reserves for a commercial property when reviewing a business plan. Reserves provide a margin of safety and are set aside upfront or over time to cover unexpected repairs, renovations, or other costs associated with the property. To determine if enough risk is being accounted for in the sponsor’s business plan, you should consider the following factors:
- Look at the age of the property and its location. Older properties and those located in areas with high crime rates or poor infrastructure are more likely to need ongoing and unexpected repairs.
- Consider the property’s current condition and whether any major repairs are already budgeted.
- Research the historical performance of similar properties in the area to get an idea of how much money is typically required to maintain them.
It’s important that you carefully review the acquisition price to ensure that it is in line with similar properties in the area. You’ll also want to take a close look at relevant metrics such as the price per square foot or price per unit, as this can give you an idea of the cost of the property relative to comparable sales.
If applicable, the costs associated with renovating and adding value to the property should also be considered. If the property is located in an area with high demand, it may be very reasonable for a sponsor to expect to attract new tenants and increase the property’s income with renovations and value-adds. On the other hand, if the property is located in an area with low demand or heavy competition, it may not be easy to find tenants willing to pay more.
Cap rate is another important financial metric for a real estate investor to consider when evaluating a sponsor’s business plan. Cap rate is calculated by dividing net operating income (NOI) by the purchase price. When evaluating a real estate investment, it’s important to consider the cap rate at both the time of purchase (entry) and the anticipated time of sale (exit). The difference between these two rates is referred to as the “spread.”
A hold period is the length of time a sponsor’s business plan projects keeping a property before selling it. Hold periods can vary depending on the type of investment, the market conditions, and the your goals. The hold period is an important factor to consider when making a real estate investment, as it can impact the IRR (internal rate of return) and also the length of time you may have to wait for a significant portion of overall returns. Hold period can also impact the risk of a project, as a shorter term business plan may leave less time for a sponsor to execute its strategy or ride out a market downturn.
IRR is the annualized rate of return on an investment over a hold period, expressed as a percentage. The internal rate of return (IRR) measures an investment’s performance that considers the time value of money. IRR calculations take into account the present value of cash flows for an investment and assume that all future cash flows are reinvested at the same rate.
Although one might think that the higher the IRR, the more attractive the investment – in reality, returns are risk-adjusted and therefore, a riskier project such as a development deal with greater execution risk should have a higher IRR than a less risky, stabilized apartment building. It is important to remember that a high IRR over a shorter holding period does not necessarily mean high returns in terms of actual quantum of dollar returns (i.e., the equity multiple) of an investment.
To illustrate, consider this simplified example. If you paid $1,000 for an asset and sold it one year later for $1,200, the IRR would be 20%. However, if the same asset were held for two years and sold for $1,400, the IRR would be 18%. In this case, even though the IRR is lower over the longer holding period, the investment has actually generated higher returns in terms of multiple of an investment (1.4x versus 1.2x).
There are a few downsides to having a shorter holding period in a business plan:
• It creates a tighter timeline, making it more difficult to execute a business plan.
• The investor will typically have a lower return of principal invested.
• There is less time for unforeseen events to occur that could impact the investment negatively, but also less time to respond to unforeseen events.
On the other hand, the most obvious upside is the faster return of principal invested. This can be appealing to investors who are looking for a quick return on their investment.
The use of depreciation is one of the key benefits of investing in commercial real estate. Depreciation can be used to your other passive income earned by you, which can help to reduce your overall taxable net income. In many cases, you may benefit from accelerated depreciation and cost segregation to increase the positive impact of depreciation. As with all tax matters, we recommend you consult your tax advisor to understand the implications for your personal tax circumstances.
Tenant quality is a term used in commercial real estate to describe a tenant’s creditworthiness and financial stability. Generally speaking, a higher-quality tenant is less likely to default on rent payments or damage the property, while a lower-quality tenant may be more likely to do so.
Tenant quality is a major factor in multifamily properties that can impact the potential return on investment. For example, poorer quality tenants may lead to rent collection problems, eviction costs, and higher tenant turnover. On the other hand, a property with higher quality tenants may deliver more stable and predictable rental income and cash flows.
Underwriting is the process of evaluating a potential investment and assessing the risks involved. Commercial real estate underwriting is typically more complex than other types of underwriting due to the unique nature of the asset class. As a result, underwriting quality can be a critical factor in determining whether or not an investment is successful.
You should always analyze an investment opportunity thoroughly before committing any capital. There are a few key best practices that you can follow to help ensure the underwriting assumptions are accurate and reasonable:
- Review the historical performance of the asset or comparable assets.
- Review the assumptions made by the sponsor.
- Review the sponsor’s track record of achieving prior projections or executing on other business plans.
Having a cushion or margin for error in underwriting assumptions can help you protect yourself from potential financial losses if something goes wrong during a commercial real estate project. By seeking out investments with business plans that incorporate a level of prudence in their underwriting, you can increase your chance of successful investment and potentially avoid unnecessary risks.
On the surface, evaluating a business plan might seem complicated. But, as with any investment, careful consideration and knowing the key elements to look for can make it much easier. Whether it’s considering what type of asset to buy, what locations to buy in, or even what sort of sponsors to invest with, focusing on the right aspects of a business plan can be a great first step.
To learn more about, be sure to read the next article in our series: The Three Pillars of a Successful Commercial Real Estate Investment: Sponsor, Demographics, and Comparables.
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This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. This content is intended for accredited investors only. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment.