The Nuts and Bolts of Private Commercial Real Estate (CRE) Investing
A CRE Investing Primer
Real estate investing means different things to different people. It can be shorthand for buying a rental property — taking out a mortgage, finding a renter, and hoping to clear the monthly cost while the asset appreciates. It can also mean buying shares in a public real estate investing trust (REIT), the kind that has been around for decades and is accessible through most brokerage accounts.
But real estate as an asset class is much more diverse than that. Broadly speaking, commercial real estate (CRE) may refer to many different types of property, investment theses, and risk/return profiles. Fintech-enabled investing has made private-market CRE as accessible as stocks and index funds, albeit at a higher minimum investment. Indeed, private-market CRE investing and REITs also both offer the benefit of (divisible) passive investing — no “tenants and toilets” as they say.
What Is CRE Investing?
CRE is any real estate investment or transaction undertaken by a professional investor. The term “commercial” can also denote multi-tenant, including multifamily. Because of CRE properties’ size and operational complexity, CRE transactions tend to involve multiple parties and offer alpha opportunities. In principle, two factors drive CRE returns: rent and appreciation. Hence, CRE is one of the few asset classes that can deliver both solid cash flow and solid total return potential.
Following the JOBS Act of 2012, CRE syndication developed with various platforms providing a nexus between real estate investment firms, or sponsors, and networks of individual investors. These investors could passively invest in CRE with substantially lower, divisible barriers to entry. Access to private CRE investing has thus expanded dramatically over the past decade. This CRE series for Enterprising Investor is written for the individual investor who may be, for the first time, participating in private CRE as a passive LP investor through an online platform.
So, what are the potential benefits of private-market CRE investing relative to other forms of real estate investing?
- As an asset class, private-market CRE has shown lower correlation to public equity and bond markets than public REITs. Between 1990 and 2015, public REITs exhibited a correlation of between 0.48 and 0.80 with major stock market indexes. Private CRE showed a correlation between 0.06 and 0.12.
- Private-market CRE investments can demand an illiquidity premium. Their positions cannot be traded on exchanges like public REITs, and hence tend to carry greater total return potential by rewarding investors for assuming that liquidity risk. Alternative investment classes can carry an illiquidity premium ranging from 2.74% to 9.91%.
- Illiquidity also means a greater opportunity for passive investors in private-market CRE to tap into alpha. As with other alternative investment classes, sponsor selection is key. Sponsor performance introduces significant return dispersion in the top 5% through bottom 5% range, with as much as 15%-25% difference in expected returns across different CRE investment styles.
- Information asymmetry, geographic barriers to entry, and other private market inefficiencies give sponsors/CRE operators more opportunity to enter or exit a given investment at a favorable moment on favorable terms.
Common Types of CRE Investments
The four main CRE sectors, or sub-asset classes, are Multifamily, Office, Retail, and Industrial. A variety of other sub-asset classes, such as lodging, self-storage, data centers, and more exotic variants (e.g., communication towers) are CRE’s “niche” sectors. Of course, as time progresses, real estate operators innovate and expectations from tenants evolve. Macroeconomic shocks such as the COVID-19 pandemic create new demands on the built environment. As such, the lines between CRE property types may blur, and new sub-asset classes like medical office buildings (MOB) may emerge. On an institutional scale, certain properties may be mixed use, comprising any combination of residential/office, lodging, and retail.
Because the investment thesis tends to be straightforward, and the underlying function is so essential, Multifamily tends to dominate online CRE investing platforms.
CRE transactions involve debt — which is analogous to a mortgage for a single-family property — as well as equity, which is analogous to the owned portion of a home that grows in value as the asset appreciates. Due to the size and complexity of CRE transactions, there is often a middle layer of financing: subordinated (mezzanine debt), preferred equity, or both. The capital stack is the combination of financing instruments for any one CRE transaction. CRE investors may participate anywhere in the capital stack and tend to access such opportunities through online platforms, with common equity positions the most prevalent. In general, the more senior the position on the capital stack — debt, for example — the less risk and return potential. Debt-based CRE investments tend to mean less risk because of payment priority, contractually obligated rates of return, and shorter terms. The more junior the position in the capital stack — equity, for example — the more risk and return potential.
How to Evaluate CRE Investment Opportunities
The position in the capital stack and the investment style are important parameters in judging the risk/return profile of a given CRE investment. There are four main investment styles with specific risk/return profiles:
- Core are stabilized, cash-flowing properties that are more than 90% leased and generally operating optimally at top-of-market rates. Such properties do not require significant upgrades and tend to be located in primary markets with strong fundamentals. Most returns come from cash flow rather than value appreciation, so Core is among the least risky CRE investment styles. As such, Core investments tend to have longer hold periods and capitalize on the bond-like operational cash flow. Assets are generally conservatively levered, yielding the lowest total return potential, with a 5% to 8% internal rate of return (IRR) range netted out to passive LP investors.
- Core Plus are usually in primary and secondary markets and are near-stabilization in terms of leasing, at or near market rates. To increase occupancy, tenant quality, and rates, Core Plus properties may require light capital expenditure. The strategy is riskier than Core since operational cash flow is more volatile, but it is still a relatively stable and predictable strategy, yielding a total return in the 8% to 12% IRR range.
- Value Add are located in primary, secondary, and tertiary markets, and expanding to such niche asset classes as hotels, health care properties, etc. These properties often lease at large discounts to market rates, providing a mark-to-market opportunity to reset rents during re-leasing. Major upgrades to both interior and common areas — capital expenditures — may be needed to compete for renters/tenants, drive rents to market rates, and achieve market occupancy. Value Add relies less on generating steady operational cash flows and more on property appreciation as a key total return driver. Total returns tend to fall in the 10% to 18% IRR range.
- Opportunistic occupies the opposite end of the spectrum from Core. Property appreciation rather than operational cash flow drives performance. Often associated with ground-up development, substantial redevelopment, or a complete repositioning of a property, these opportunities are often highly levered or carry significant development or leasing risk. The overall volatility and equity-like nature of this style is reflected in its total return profile, which is heavily back-ended or skewed towards the exit of the investment, and generally exceeds a 16% IRR.
The associated return targets of these investment styles may overlap or differ for individual investments. In addition, IRR is subject to timing and cash flow factors, among other influences. For Core and Core-Plus offerings, the focus may be on the cash-on-cash (CoC) return. For value-add and opportunistic investments, IRR and equity multiples may be more relevant.
How to Find the Right Real Estate Investment
Since the JOBS Act, CRE investment platforms have proliferated and now that the US economy has weathered two major periods of volatility, the wheat has been separated from the chaff. Only the platforms with stronger track records remain. Different types of private-market CRE investments are available, generally at very low minimums. To select the right investment for their portfolios, investors need to take the following into consideration:
- Risk Tolerance: What is the appropriate position in the capital stack and the right business plan relative to their risk/return profile?
- Time Horizon: Are they nearing retirement, already retired, or earlier in their investing journey? That should help determine what CRE investments they choose.
- Liquidity Needs: Is the investor pursuing a certain yield/distribution over time? Or are they taking on a different risk-profile and going after a back-ended return or upside at the time of exit? This should influence their strategy selection. What is their hold period? Can they redeem the investment at a time and in an amount of their choosing?
- The Track Record and Focus of the CRE investing platform and investment sponsor: Investors should ask questions to make sure they understand the risks and are comfortable with the associated platform and sponsor. If the client can’t get a human to answer their queries, it’s a red flag.
As it is in portfolio construction, diversification is the key for CRE investing. The streamlined, tech-powered nature of CRE investing platforms and the low prevailing minimums mean that investors can diversify across platforms, operators, property types, markets, and risk/return profiles.
Appendix: Glossary of Terms
Real estate investments have a few standard return metrics that should be familiar to those with corporate finance expertise. The metric or metrics used for any given real estate investment should be based on the investor’s objectives and the investment’s characteristics. Here are a few key metrics to consider when looking at a CRE investment:
Internal rate of return (IRR) is the most common return metric with which to evaluate CRE equity investments. The IRR represents the discount rate that makes the net present value (NPV) of all cash flows, across all time periods, equal to zero: It is a rate of return that takes the time value of money into account. Differences in hold periods, investment scale, cash flows, and risk-adjusted basis notwithstanding, the higher the IRR, the better the investment.
Equity multiple is total profit plus equity invested divided by equity invested. So to double the money, the equity multiple for the investment would be 2x. This metric is a clean expression of total return but does not take time — the hold period — into consideration.
Cash-on-cash return (CoC) is the annual pre-tax cash flow divided by equity invested. Often averaged across a CRE investment’s lifespan, CoC is sometimes referred to as average annual return and is a key metric for cash-flow-focused investors. Positions lower in the capital stack — debt or preferred equity, for example — tend to feature more certain CoC returns. Common equity investments may only feature anticipated cash flow.
The capitalization rate (cap rate) is the net operating income (NOI) divided by the purchase price or current market value of a property. So, net revenue from rents — less management cost, insurance, etc. — is divided by the asset’s value. The cap rate is essentially an inverted valuation multiple and a direct estimate of expected returns given its yield nature within CRE. As a stand-alone measure, and since it factors in NOI before any debt service, the cap rate reflects an unlevered return to an investor. Assuming no capital gains or losses or changes in NOI, the cap rate would therefore equal the unlevered IRR. That means a higher cap rate suggests the market believes the asset will generate a higher NOI relative to its valuation, has a higher yield, or entails more risk. All else being equal, that may be true for an older building, for a less mature market, or if macroeconomic conditions make for more pessimistic real estate investors. On the other hand, newer buildings in New York City and other robust markets would command a lower cap rate given a lower NOI relative to valuation, or a lower yield.
For the appreciation, or total return, of the real estate investment, investors look for cap rate compression — a lower cap rate at their anticipated time of exit compared to when they acquired the asset — perhaps because the market has grown in stature, the manager of the investment improved the property, or both. In predicting exit cap rates, real estate operators often leverage predictive analytics. Be sure there is a clear and sound thesis for cap rate dynamics in any real estate investment under consideration.
Loan-to-value (LTV) is the ratio of debt to total value of the real estate asset. Just as lenders on single-family homes charge higher mortgage rates for buyers who put less down, CRE investors command higher LTV in the form of higher potential return. This holds true across the capital stack. Investors should be wary of any real estate investment with an LTV above 80% and confirm that the return potential is commensurate with LTV. For capital-intensive or value-add real estate investments, the loan-to-cost (LTC) — the ratio of leverage to the total cost of the project, including acquisition and capital improvements — may be relevant as well.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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