A Five-Part Guide for Commercial Real Estate Investors Seeking Passive Income (Part 4)
Part 4: What Every Investor Needs to Know About Offering Structure:
As a commercial real estate investor, it’s important to understand the different aspects of an offering’s structure to make the best investment decision. This article will cover four key elements of offering structure: fees and ownership structure, debt and overall capital structure, tenancy, and ESG risk. By understanding these elements, you’ll be better equipped to assess any investment’s risks and potential rewards.
In today’s market, a number of factors have to be considered when assessing the risk of a real estate investment. This paper will focus on several key areas: offering structure, debt and overall capital structure, and tenancy. We’ll also touch on the important issue of environmental, social, and governance (ESG) risk.
- Offering Structure: When considering the risk of a real estate investment, one of the first things to consider is the offering structure. This includes fees, ownership structure, and alignment of interests with the real estate sponsor.
- Debt and Overall Capital Structure: Another important consideration is the investment’s debt and overall capital structure. This includes leverage, interest rate exposure, and maturity risk.
- Tenancy: Another key factor to consider is the tenancy of the property. This includes credit risk, financial strength, diversity, and leasing risk.
- ESG Risk: Finally, it’s important to consider environmental, social, and governance (ESG) risk when assessing the risk of a real estate investment. This includes exposure to extreme weather events, insurance costs, and energy efficiency.
Private real estate can be a great investment for accredited investors and high-net-worth individuals looking for alternative investments outside of stocks and bonds. However, it’s important to understand all the fees involved and your rights and responsibilities as an LP before making an investment. In addition, be sure to align your interests with those of the sponsor so that you can achieve your financial goals.
There are a few different types of fees that you may be charged as an investor:
- Upfront fee, which is paid to the sponsor when you purchase your interest in the property. This fee covers the costs of property acquisition and due diligence.
- Management fee, which is paid to the sponsor on a monthly or quarterly basis. This fee covers the costs associated with managing and operating the property.
- There may also be a performance-based fee that is charged if the property meets certain milestones (such as reaching a certain occupancy rate).
As an investor in a private real estate offering, you may take on the role of a limited partner (LP). As an LP, you will have certain rights and responsibilities outlined in the operating agreement. Therefore, reviewing this agreement carefully before investing is important to understand your role and what is expected of you.
Other ownership structures, such as a tenancy-in-common (TIC) or Delaware Statutory Trust (DST), may also be available, depending on the property and the investment firm. TICs allow multiple investors to own a property together, while DSTs are trusts created to hold real estate. DST investors don’t own physical real estate; instead, they own shares of a trust that legally owns the properties held within the trust.
Alignment of interests
In any commercial real estate investment, it is essential that the interests of the sponsor are aligned with those of the investors. If there is misalignment, it can lead to several problems down the road. For instance, the sponsor may be more focused on maximizing their own profits rather than preserving capital or generating income for investors. This can mean that they take on more risk than is necessary or make decisions that are not in the best interests of the investment.
There are a number of ways to ensure that a sponsor’s interests are aligned with those of investors:
- Structure the investment so that the sponsor’s compensation is tied to the performance of the investment. This incentivizes the sponsor to focus on making the investment successful, as their income depends on it.
- Have the sponsor invest their own money into the deal alongside the investors. This skin in the game gives them an added incentive to make sure the investment does well.
- Finally, it is important to have clear and concise agreements in place between the sponsor and investors that outline each party’s rights and responsibilities. This helps to avoid misunderstandings and provides a clear understanding of what is expected from each side.
Debt and Overall Capital Structure
When assessing a non-traded real estate offering, it is important to understand the debt and overall capital structure. This includes evaluating the leverage being used, the interest rate exposure, maturity risk, and how all of these factors align with the business plan.
Leverage is a key element in any real estate investment. It allows you to control more property with less money downequity, which can lead to greater profitshigher returns when the property is sold. However, it may also amplify losses if the property value decreases. For this reason, it is important to choose an investment with caution and be aware of the potential leverage-related risks and rewards.
Interest rate exposure
The type of interest rate exposure (fixed versus floating) can also impact your investment. A fixed interest rate means your payments will remain constant over time, while a floating interest rate will fluctuate with market conditions. If market rates rise, your payments will increase along with them. This can make it difficult to budget for your investment and predict future returns.
Maturity risk is another consideration when determining the appropriate debt structure for an investment. Maturity risk refers to the risk that a loan will come due at a time when it cannot be refinanced or paid off from other sources of capital. For example, this can happen if market conditions have changed such that loans are no longer available or the property has not been appreciated as anticipated. Therefore, it is important to consider both the timing of a loan’s maturity and its relation to the expected holding period for investment when determining its appropriateness.
Debt Service Tests
If the sponsor is relying upon debt to finance renovation programs, it is important to understand what test are required to draw on the additional debt proceeds (expand)
When considering a real estate investment offering, it is important to evaluate the quality of the tenancy. The rent roll should be reviewed for creditworthiness, diversity, and financial condition. In addition, the rollover risk and leasing risk should be assessed.
The creditworthiness of the tenants is an important factor to consider when evaluating the rent roll. Tenants with strong credit profiles are more likely to remain current on their rents and renew their leases. Conversely, tenants with weak credit profiles may default on their rent payments or be more likely to move out when their leases expire.
The diversity of the tenant base is also an important consideration. A property with a diverse tenant mix is less likely to be adversely affected by changes in market conditions than a property that relies heavily on one type of tenant. For example, a property leased primarily to office tenants may be more susceptible to vacancy if there is a downturn in the economy. Conversely, a multifamily property may be more “recession-resilient” because people always need a place to live.
The financial condition of the tenants should also be evaluated. Financially stable tenants are less likely to default on their rent payments or terminate their leases early. Conversely, tenants that are struggling financially may be more likely to miss rent payments or habitually pay their rent late.
Leasing risk is another important factor to consider before investing. This is the risk that a new project or repositioned property will have difficulty leasing up, or if a tenant moves out and the vacant space must be rented at a lower rate. This can happen for various reasons, such as poor location or outdated finishes. When considering leasing risk, it is important to look at market trends and compare the property to similar properties in the area.
When investing in non-traded real estate offerings, it’s important to consider all potential risks - including those related to the environment. In recent years, capital allocators have been increasingly focused on environmental, social, and governance (ESG) issues. As a result, evaluating a property’s exposure to extreme weather events, insurance costs, energy efficiency, and potential upgrade costs before making an investment decision is crucial.
Exposure to extreme weather events
With climate change, we see more natural disasters, from hurricanes to wildfires. These events can wreak havoc on properties, causing physical and financial losses. That’s why it’s important to consider a property’s location when investing. For example, properties in coastal areas are at a higher risk for damage from hurricanes, while properties in drought-prone areas are at a higher risk for wildfires. It’s also important to consider a property’s vulnerability to flooding or other types of water damage.
Another environmental concern for investors is insurance costs. As hurricanes, floods, and wildfires become more frequent and intense, property damage and business interruption costs are expected to rise. This is already starting to impact insurance rates and is especially true for properties in high-risk areas. Not only will this increase costs, but it could also make it more difficult to find insurance for a property. That’s why it’s so important to factor in insurance costs when evaluating a potential investment. You may find that the increased costs are simply too high to justify the investment.
Finally, energy efficiency is another important environmental concern for investors. With utility costs on the rise, it’s becoming more and more important for properties to be energy efficient. Tenants are also interested in occupying energy-efficient property. As tenants become more environmentally conscious, they are increasingly demanding buildings that use less energy. This can necessitate significant upfront costs to upgrade HVAC systems and install energy-saving features such as LED lighting. However, these investments can pay off over time through lower operating costs and increased tenant satisfaction.
Capital allocators must carefully weigh any real estate investment’s potential risks and rewards. Those who take environmental considerations into account are likely to be well-positioned for the future.
To learn more about equity partnerships, be sure to read the final article in our series that explores why sponsor background and track record are essential to a successful private real estate investment.
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A benefit of investing through RealtyMogul is that it can help investors take advantage of opportunities created during uncertain economic times through access to a wide range of commercial real estate offerings.
Investors can choose to invest in many different types of real estate projects that meet their personal risk profile. For example, commercial projects that are high quality and large-scale may be good choices for those looking for passive investments. The investment minimums for these types of projects allow for diversification, allowing investors to take advantage of opportunities created during uncertain economic times.
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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 not 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.