Commercial real estate (“CRE”) investing is a vast matrix of potential offering investors a diverse menu of opportunities across multiple market types, asset classes, locations, conditions, and strategies. CRE has long been a favorite arrow in the investing quiver of sophisticated and ultra-wealthy investors who gravitate towards it for wealth-building cash flow, appreciation, and tax benefits – all backed by a physical asset.
CRE can be rewarding, but it can also be overwhelming to the novice investor wondering how best to access its investing benefits while avoiding the pitfalls. This discussion will help you make sense of the CRE investing matrix.
There are so many ways to access the CRE investing class that it can be dizzying to the novice investor trying to understand it all. With CRE investing, you have to consider what to invest in and how to invest in it. First, we will discuss the what; then, we will discuss the how.
The WHAT of CRE Investing –
Commercial real estate can be divided into asset classes, building condition and location, risk-reward profile, and geographic location.
The six primary CRE asset segments include:
CRE can be further categorized by building condition and location designated with the letters:
Finally, CRE can be classified by risk-return profile with the designations:
- Value Add.
THE SIX ASSET SEGMENTS
According to this classification system, properties are graded according to a combination of geographical and physical characteristics. These letter grades are assigned to properties after considering a combination of factors such as the property’s age, location, tenant income levels, growth prospects, appreciation, amenities, and rental income.
Class A properties are new construction or built within the last 5 to 10 years with top-of-the-line amenities and professional management. They’re located in the most desirable areas with a high potential for appreciation, high-quality tenant profiles, and little to no deferred maintenance issues.
These properties’ prime locations and conditions command high rents and experience low vacancies. Because of their premium condition and locations, Class A properties also come with premium prices.
These properties are generally 15-20 years old, with lower-profile tenants, and may or may not be professionally managed. Rental income is lower than Class A, and there may be some deferred maintenance issues. These buildings are typically well-maintained.
Class C properties are typically more than 20 years old and located in less-than-desirable locations. These properties generally need significant renovations for repositioning in the market to achieve steady cash flows.
Class D properties are old, run-down, and typically, without exception, needing significant repairs. They are located in distressed communities with high crime and poor schools. Tenants have low income and bad credit, with many even having criminal backgrounds. These properties are relatively cheap to acquire but experience high vacancies and low appreciation.
Assets under this classification system are differentiated by their levels of risk vs. reward, with Core real estate investments on the low end and Opportunistic real estate investments on the high end of the risk-reward spectrum.
Not all geographic locations are created equal – with some offering more upside than others. When deciding where to invest, investors are not limited to domestic opportunities. The globalization of investing – thanks to technology – has made offshore investing more accessible to more qualified investors than ever before. For those looking to stay stateside, investors have regions and states to consider and particular metropolitan markets categorized as primary, secondary, and tertiary markets. What’s the difference?
In simplest terms, A primary market has 5 million or more people. A secondary market has 2 million to 5 million people, and a tertiary market is under 2 million. That may be an oversimplification. Many consider primary markets (aka gateway markets) those that attract the most attention from investors – both foreign and domestic, as well as institutional and individual.
The size and wealth of a populace, like those found in a place like San Francisco, New York, Los Angeles, Boston, Seattle, and Miami, may offer reliable and steady income, but because of the competition from investors, the cap rates may also be constricted. Investors willing to forego the reliability and familiarity of primary markets may end up finding a higher potential upside in secondary and tertiary markets.
The HOW of Real Estate Investing –
Once you narrow in on the types of CRE assets, you would be interested in and where now comes the question of how.
Active vs. Passive
One of the first questions investors face when considering the CRE asset class is whether to invest actively or passively. When it comes to active investing, investors have the option to go it alone on the one hand – investing directly in CRE and managing all the minute details along every step of the investing roadmap from research to acquisition to operations and disposition – or relying on someone else to manage the details on the other hand.
For most investors, the prospects of learning the ins and outs of a new asset class can be daunting – not to mention the high capital costs of acquiring commercial properties on one’s own.
The steep learning curve and the high capital barriers to entry inevitably lead many investors to the passive option – investing in companies that invest in CRE.
Public vs. Private
Investors who invest passively have both public and private options to consider.
On the public side, the most popular type of public real estate investing is through REITs (Real Estate Investment Trusts), where investors buy the stocks of public real estate investing companies qualifying as REITs under Section 856(c)(3) of the Tax Code. To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment. It must distribute at least 90 percent of its taxable income to shareholders annually as dividends. This all sounds great on paper, but there’s one problem. Because shares of REITs are publicly traded, these stocks are susceptible to the same volatility plaguing the stock market.
For investors looking to avoid Wall Street altogether – making public REITs a non-starter – there’s the private real estate option.
What is private real estate? Private real estate is investing in real estate indirectly by investing in private companies engaged in CRE investing.
Private real estate allows investors to participate passively in the commercial real estate class without the volatility of Wall Street.
In addition, investing in a private company or fund sponsored, promoted, and operated by seasoned experts in particular asset segments and geographic locations eliminates the high knowledge and capital hurdles while shielding your portfolio from market volatility.
Debt vs. Equity
Once you’ve decided to invest passively in a private company, there’s the whole matter of the structure of your investment – debt vs. equity. You can think of equity as taking ownership of a company and debt as borrowing money from the company. In one case, you’re a part owner of the company and will share in its upside, while in the other, you’re a creditor entitled to a fixed return but with no upside.
For those willing to forego guaranteed returns but potentially participate in a huge upside, equity is the way to go. For those seeking security, debt is the option for them.
Private companies may offer hybrid security to attract a broad pool of investors, giving investors the best of both worlds. One example is the offering of preferred equity, where investors are offered a fixed percentage of first-dollar profits (i.e., preferred returns) while retaining the upside potential by virtue of equity ownership.
Single vs. Multi-Asset
A passive real estate investment can be focused solely on a single asset or offer exposure to multiple assets. The single vs. multi-asset approach may impact an investment’s risk-return profile. Whereas a multi-asset investment can offer diversification benefits, the higher returns from the more successful properties may be diluted by less-performing ones. A single asset may entail higher risk but may also generate higher undiluted returns if successful.
Single-asset investments are often structured as syndication deals, where investors pool their capital to purchase a single asset and then share in the profits. Real estate funds involved in multi-asset investments are more common than single-asset syndications.
Multi-Family Investment – For simplicity’s sake, let’s assume you’ve narrowed your CRE investment options down to value-add, Class B and C multi-family assets in a secondary market in the Midwest. Now, what are your options for investing?
Active vs. Passive: If you’re the hands-on type, active investing may be the way to go. You may outsource the property management, but you’ll still manage the investment’s key aspects. For the passive types, you’ll move on to the next step.
Public vs. Private: Believe it or not, every strategy has a public REIT. If you looked hard enough, you could find a REIT that focused on value-add multi-family properties in secondary markets in the Midwest. For those wishing to avoid Wall Street, you have the private markets to find the right private company with investment objectives that align with yours.
Single vs. Multi-Asset: You need to weigh the pros and cons of investing in a syndication focused on a single property or a fund diversified across multiple properties.
Debt vs. Equity: How do you want to be paid? Do you want the upside from ownership? Then equity’s for you. Or do you want the assurance of a fixed return? Then, debt is the structure for you.
CRE has proven to be a valuable and essential asset for any portfolio for building and sustaining wealth. Finding the right asset and approach can be daunting, but keeping the few categories and techniques discussed here should make your decision more manageable.