A Five-Part Guide for Commercial Real Estate Investors Seeking Passive Income (Part 2)

Three Puzzle Pieces for Successful Investment

Part 2: The Three Pillars of a Successful Commercial Real Estate Investment: Sponsor, Local Market Conditions, and Comparables

When evaluating a business plan for a potential commercial real estate investment, there are three key factors to consider: the sponsor, the local market conditions, and comparable properties.

The sponsor is the individual or team responsible for the investment, and their relevant experience and track record should be carefully evaluated. The market conditions of where the property is located are also important, as they will help to determine the tail or headwinds to achieving the business plan. Finally, comparable properties can provide insight into what rents the market can support and what capitalization rates or prices may be reasonable or “market.”

By considering these three key factors, investors can make more informed decisions about whether or not to invest in a particular real estate opportunity.

Executive Summary

  1. If you’re considering passive income investing in commercial real estate, partnering with an experienced sponsor is a great way to get started. With a sponsor’s help, you can increase your chances of success and maximize your potential returns.
  2. Market conditions are crucial to consider before investing in an equity partnership, as they can assist you in getting a better grasp of the potential market for the project. You will want to look into things such as population growth, income levels, and economic conditions.
  3. An investor can glean valuable insights into future market direction by analyzing trends in rents and sales transactions for comparable properties over time. By understanding these trends, investors can make more informed decisions about whether a sponsor’s assumptions are reasonable in comparison to other similar properties.
A Man Signing Sponsor Paperwork

Sponsor Background and Track Record

A sponsor is a key player in any syndication or real estate investment opportunity. Frequently referred to as the general partner or GP, the sponsor is the organization or group of individuals responsible for acquiring real estate projects, maximizing value and returning any investor profits. When compensation is aligned with the project’s performance, the sponsor can be properly incentivized to maximize potential returns for its investors.

Sponsor experience is especially important in real estate investing, where acquisition and management skills can mean the difference between a successful project and a flop. A strong business plan is also critical to success; without a clear strategy for profitability, even the best-managed property can struggle. Finally, market familiarity is key to understanding whether a particular project is likely to be successful, so the sponsor’s team should have highly and relevant experience in the product type and subject market.

When analyzing an equity partnership to invest in, it is also important to carefully consider the two types of operational risk: asset management risk and property management risk. Asset management risk is the potential for financial losses due to a decline in the value of the underlying asset. This could happen if the sponsor is inexperienced and makes poor investment decisions, or if there are problems with the property itself that lead to lower-than-expected returns. Property management risk is the potential for financial losses due to poor management of the property by the team hired by the sponsor. This could happen if the property manager has little presence or experience in the specific market, or lacks sufficient experience in managing this type of property.

Both of these risks can be mitigated by doing due diligence on the sponsor and business plan for the project before investing. Reviewing the sponsor’s experience and success with similar projects will give you an idea of their abilities, and looking at the project’s business plan will help you understand the risks involved and how the sponsor is proposing to address and manage them. Asking questions and getting as much information as possible will help you make an informed decision about whether or not to invest in any specific real estate partnership.

Local Market Conditions

The local market trends and demographics are important to consider before investing in an equity partnership because they can help you better understand the potential market for the project. Since each location and market is unique, it is important to understand the specific dynamics impacting the subject property (and the property type generally) in the specific market and submarket. Seek to understand key trends, including demographics, local economic conditions (job growth, household incomes, etc.) and the local regulatory environment.

Historic Rent Growth

By understanding how rents have increased (or decreased) over time, investors can better predict which areas are likely to experience continued growth and where potential problems may arise. Additionally, data on past rent growth can help identify neighborhoods that may be gentrifying or undergoing other changes that could impact passive income investment returns.

Five Different Hands Symbolize Partnership

Strength and Diversity of Existing Employers

A diversified employment base is an important factor for several reasons:

  1. Indicates that the market is stable and has good potential for future growth.
  2. Provides tenants with more options and makes it more likely that they will be able to find a job in the area.
  3. Reduces the risk that the local economy will be impacted negatively by the loss of one or two major employers.
  4. Tends to create a higher quality of life for residents, which can lead to increased demand for housing and higher prices.

Projected Population and Job Growth

Job growth in a city or submarket can be one of the strongest predictors of the potential growth in demand for all types of commercial real estate . As more people are employed, they will have more income to spend, leading to businesses doing better and needing more space. Additionally, population growth often drives demand for new housing, creating a need for more retail and office space to serve those new residents.

State Population Growth Map

Migration Patterns

Migration patterns are constantly evolving in response to various factors, including the cost of living and job growth. When the cost of living in an area becomes too high, people will often migrate to other areas where the cost of living is more affordable and there may be greater employment opportunities. This increases the household income in these areas and may drive increased demand for space and put upward pressure on rents.

Other Demographic Factors to Consider

Evaluate other demographic factors that may affect potential returns from a commercial real estate investment. For example, for a multifamily property:

  1. The population’s age and income distribution can significantly impact the demand for multifamily property. For example, an increase in the number of young adults in the workforce will tend to increase housing demand.
  2. The level of education and training can also affect demand. A highly educated workforce is generally more productive and is willing to pay more for an apartment with desirable amenities. Conversely, a less experienced workforce may require more affordable rents offered by Class B and C properties.

Regulatory Environment and Supply Risks

There are two additional types of risks that an investor should consider when investing in a commercial real estate project: supply risks and regulatory risks.

Overbuilding is a common supply risk in real estate investing. New construction can sometimes be a sign of market growth. However, if there is not enough demand to fill the new space, it can end up being a costly mistake for investors.

Regulatory risks refers to the risk that changes in government regulations could adversely affect the profitability of a commercial real estate project, such as rent control. These risks should be considered by investors when making decisions about whether or not to invest in a particular project and market.

Apple and Orange Symbolize Partnership

Comparables

It is important for an investor to analyze trends over time when analyzing rent comparables and sale comparables, because they can provide valuable insights into current demand dynamics and investors’ views on the future direction of the market. Comparables are useful for better understanding the relative attractiveness of a given project or business plan when compared to other similar properties and transactions in the market. By analyzing trends, investors can make more informed decisions about whether to invest in a particular property or market.

When looking at rent comparables, investors should pay attention to both the overall trend and the specific sub-market trends. The overall trend can give clues about the health of the rental market as a whole, while sub-market trends can provide insights into which areas are accelerating and which ones may be slowing or contracting.

Some of the best practices to follow when analyzing comparables include:

  1. Reviewing a wide range of data points to help ensure that you are making an informed decision based on all the available information.
  2. Considering multiple perspectives by looking at the data from different angles and considering different interpretations.
  3. Studying both historical data and current trends to identify the drivers of the recent comparables and whether these trends are likely to continue.

Closing Thoughts

If you are looking to diversify your portfolio with real estate through passive income investments, take a closer look at RealtyMogul’s platform. It’s one of the most popular real estate investing platforms which provides access to investment opportunities from different sponsors in multifamily properties, industrial properties, office buildings, shopping centers, and REITs.

A key advantage of investing on the RealtyMogul Platform is that it gives investors the ability to seize opportunities arising during periods of economic uncertainty through access to a broad range of commercial real estate offerings. This empowers investors to construct real estate portfolios that align with their personal risk profile. In addition, with investment minimums that allow for diversification, members have the opportunity to invest passively in high-quality, large-scale commercial real estate projects.

This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. 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.

1https://www.pewtrusts.org/en/research-and-analysis/articles/2021/07/27/population-growth-sputters-in-midwestern-eastern-states

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