Investing like an Expert: What I learned Investing $2 Billion in Commercial Real Estate
Commercial Real Estate
Like with any investment, an investor’s first venture in commercial real estate can be intimidating. There are many different acronyms, metrics, and variables to consider before making the decision to invest. Our team has many years of experience originating, underwriting, and vetting a large variety of commercial real estate deals. With this experience, we have developed specific strategies that we believe allow us to evaluate potential deals quickly and accurately, and strive to only provide our investors with what we consider quality opportunities. While working at RealtyMogul, I have had the opportunity to work side-by-side with veterans in the industry, and have gained extensive knowledge about the real estate investment vetting process. Remember, you can avoid some common investor mistakes through simply educating yourself. Here are six important tips to consider before investing in commercial real estate.
It is important to have in depth knowledge of the markets you are investing in. What are the major job drivers? Major centers of employment? Is proximity to public transit a factor? Are there large additions to supply projected? RealtyMogul strives to maximize market knowledge through a twofold approach: data/research and working with operating partners that have developed in depth knowledge through years of experience in those markets. RealtyMogul spends nearly $1 million per year on data and technology which allows us to study market metrics in both their current settings, as well as historically, to determine market health and how they have fared in previous real estate cycles. In addition to market metrics, the data also allows us to see how prices have risen or fallen for particular asset classes. Combined with the site visits that are done for every RealtyMogul investment, this data can provide valuable insights into markets we are investing in. Working with experienced partners is one of the major cruxes of RealtyMogul’s investment strategy. Although data can give you valuable insights into a market on a more macro level, there is no substitute to years of transacting in a market, learning neighborhoods, building relationships, and streamlining operations. Experienced operators are oftentimes able to find deals ‘off market’, brokers are more inclined to steer deals to operators they are familiar with, and if an operator has been active in a market for an extended period of time, they are likely familiar with qualified property managers, construction groups and other vendors in the area.
Related to the concept of working with partners who understand their markets, it is also important to work with partners that specialize in the type of product you are investing in or have experience executing similar business plans. For example, RealtyMogul is not likely to proceed in a value-add multifamily transaction with a partner who has historically invested only in stabilized office buildings. Although the partner may have a good handle on office market dynamics, they may not have the same level of knowledge in regard to multifamily metrics or how to efficiently complete a renovation while minimizing unit down time and cost overruns. For this type of transaction, RealtyMogul would be much more comfortable working with a partner who has had years of experience in accurately budgeting the expected costs, completing similar renovations at other properties, and has developed operational efficiencies such as the ability to purchase construction materials in bulk due to the size of their portfolio.
Proper capitalization can make or break a transaction, and those that are property capitalized will have a much higher likelihood of success. Oftentimes, real estate operators are incentivized to keep the capitalization of a transaction as low as possible to maximize returns and may plan on funding future capital needs from operating cash flow. While it is true that returns will increase with a lower capital outlay at the outset, it opens the investment to additional risks. For example, an operator may capitalize funds to renovate half of the units at a particular apartment building and intend on funding future unit renovations from future cash flow, but what happens if the initial renovations end up costing substantially more than expected and construction delays have increased the vacancy at the property, therefore reducing the cash flows that were intended to fund the future renovations? Typically, the operator will need to go back to the investors and ask for additional funds to be contributed, and if they are unable to do so, the operator may ‘lend’ the project the funds which will need to be paid back (with interest) and may also result in dilution of the other owners’ equity. For this same reason, it is also important to ensure that the project is capitalized with appropriate contingencies in case the original budget is not sufficient to cover unexpected delays or additional costs.
Although many hours of time go into the underwriting of a deal and the creation of the proforma, for better or for worse, things will always play out differently than projected. This is in part due to the uncertainty and variability of real estate operations. While some cash flows can be reasonably projected (e.g. a long-term lease to a credit tenant with fixed rental increases), there will still be other variations in things like actual vs expected occupancy, operating expenses, changes in floating rate debt, and market conditions at the time of sale to name a few. The takeaway from this point is not that the proforma provides no value, as it should provide a well-researched and thought-out attempt at projecting the future cash flows for a property, but that there will always be some variability in the actual performance of a property. When creating a proforma, it is important that the assumptions used are reasonable given the information at hand and not overly aggressive, leaving little room for things to play out less favorably. Real estate transactions are long-term investments which means that there are plenty of opportunities for things to play out differently than projected.
Related to the concept of creating a conservative well thought-out proforma, is the importance of not relying on potential windfalls, or upside scenarios, for the success of the transaction. For example, in a retail transaction, the business plan may call for the sale of a pad (a portion of the overall property) at some point during the hold period. While the sale of said pad would likely result in a large cash windfall and a potential return of capital, the transaction needs to be analyzed if the sale is not successful. Does the transaction still provide the potential for an attractive risk-adjusted return? If not, then it is a deal that RealtyMogul is unlikely to participate in. Upside scenarios are factors that should be taken into consideration when analyzing a deal, as they can provide attractive bumps in yield, however the overall success of the transaction should not hinge on these non-guaranteed events occurring. Other examples of potential upside scenarios include refinances, loan earn-outs, or partial sales of a portfolio.
As Limited Partner (“LP”) investors in transactions, the bulk of the decision-making authority lies with the Sponsor, or General Partner (“GP”), of the transaction. However, as RealtyMogul is often the largest LP investor in a transaction, we typically require certain rights in order to maintain some control over the direction of the investment. For example, we may require that we can sell the property after a certain number of years of ownership. Other controls include the right to approve any budget increase over proforma, the ability to remove/replace the property manager, or approval rights over the annual budget. While LP rights are not as extensive as those of the sponsor, they can be a valuable tool for influencing the direction of the investment if things play out differently than expected, as well as giving our investors the potential ability to exit a transaction that the sponsor may wish to hold for the long term.
We hope giving you an inside look at our process has given you a better understanding into the world of commercial real estate investing. We know navigating your investment options can be complex. Here at RealtyMogul, we want to make investing in commercial real estate accessible to everyone. Our members gain access to exclusive investments on our platform that have been vetted by our team of experts. Explore open investment options and start your investment journey with us today: https://www.realtymogul.com/investment-options
Please note that the RealtyMogul vetting process does not negate an investor’s responsibility to perform his or her own due diligence. Important information about risks, fees and expenses are outlined in the official offering documents. Private Placements are speculative and involve substantial risks such as illiquidity, lack of diversification, complete loss of capital, default risk, industry and capital call risk. Investing in REIT common shares is speculative and risks include, illiquidity, complete loss of capital, limited operating history, conflicts of interest and blind pool risk. 1031 Exchange eligible investments have additional unique risks including technical requirements to qualify for tax deferral under Section 1031.