They tend to be owned by pension funds, life insurance companies, endowments and the like – groups that have tens (if not hundreds) of millions of dollars to invest in Class A commercial real estate.
The 2012 JOBS Act opened the door for accredited investors to invest in these commercial buildings for the first time. Reaching the accredited investor threshold is much easier than becoming an institutional investor.
Yet a common misconception is that institutional quality real estate is untouchable by anyone other than giant institutions. That’s simply not the case.
There are indeed ways for average investors to invest in institutional-caliber real estate without the need for having institutional scale capital. The key is in finding value-add opportunities in up-and-coming locations. In other words, don’t look to invest in so-called “trophy” real estate in New York or San Francisco. Instead, find well-located Class B and Class C properties that can be renovated to Class A or near Class A, institutional standards.
Repositioning properties with thoughtful value-add strategies in secondary locations that may soon become primary locations is one of the best ways to enter the commercial real estate market. If there is rapid population and job growth, it is possible that by the time the repositioning and lease-up is complete, these properties often draw interest from institutional buyers.
It’s important to understand how institutional investors operate. Most have a very low risk tolerance. Let’s take the case of a life insurance company. The company’s primary business is selling people life insurance. The younger and healthier someone is, the less they’ll pay in a life insurance premium. The insurance company takes in annual premiums from its policyholders and then has to pay out benefits to the beneficiaries of the policy upon the person’s death.
As a way to safeguard their ability to pay out the ultimate claim, life insurance companies want to invest the premiums they collect into something that’s going to yield better than a U.S. Treasury bond (which yields less than 2%, on average). An investment that earns the insurance company more than a U.S. Treasury bond will be attractive provided that has a significant degree of safety. So the life insurance company eyes fully leased, newly constructed or heavily renovated Class A commercial real estate in the best locations. These assets are expensive, but institutional investors have the capital available to invest (unlike mom-and-pop investors).
Whereas an average investor might be looking to earn 6-10% or more on their investment, the insurance company is happy earning a modest spread above the U.S. Treasury. In other words, a property with a 4-5% cap rate might be sufficient for the insurance company’s needs. The company just wants to be sure they’re invested in a relatively “safe” asset, which Class A properties tend to be. The life insurance company just needs to have confidence that the investment will result in a positive spread so they can eventually pay out life insurance benefits and make some profit along the way.
Like most institutional investors, this insurance company will steer clear of riskier investments like Class B or Class C office buildings with substantial vacancy or deferred maintenance.
This creates an opportunity for other investors, like Feldman Equities. We purchase value-add properties in up-and-coming markets that will ultimately become attractive to institutional investors. For example, we purchased our Wells Fargo Center building in downtown Tampa in 2012. At that time the building was only about 70% leased and it was in need of significant renovation. Today the building is over 90% leased and we have recapitalized the project in joint venture partnership with New York life insurance Company.
Unlike the institutional investor who just wants to come in and buy a stable, Class A office building, we take on the risk of repositioning buildings, which typically includes renovations that cost millions of dollars. We are also not afraid to take leasing risk. We have the best leasing team in Tampa Bay and spend hundreds of thousands of dollars a year in marketing our properties.
Think of it like an assembly line. We buy a big, underperforming property in a Class A location. The office building is physically rundown. We might spend $10 million on top-to-bottom renovations – what we affectionately call The Radical Officectomy. Our renovations might include installing a new high-speed elevator system, a new building lobby, a state-of-the-art on-site fitness center, shared conference rooms, shoeshine, carwash, a 24/7 laptop chill zone and more. The amenities are enough to lure a strong mix of new tenants, including larger credit-worthy tenants willing to sign longer-term leases. Now, a building that an institutional buyer would have never touched is suddenly highly attractive.
By taking on the risk earlier in the assembly line process, we generate interest from institutional buyers that are willing to pay us a premium to exit our investment or recapitalize it, which generates liquidity for us and our investors. We can stay in the deal to the extent we and our partners choose—or not. Importantly, we can also cash out and exit the deal by selling to a deep-pocketed institution looking for a stable, safe asset that will perform well over time.
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Cap rates are not an all-encompassing measure of the true value of commercial real estate. It’s common to lean very heavily on cap rates as an indication of value, but it’s only a broad measure that doesn’t take into account the specific circumstances of the building, its tenant mix, length of lease terms, the in-place rents versus the market rents, and the supply demand factors in the local market.