DIVERSIFYING YOUR COMMERCIAL REAL ESTATE PORTFOLIO: WHY and HOW
Commercial Real Estate (CRE) investment provides savvy investors a wealth of advantages. Tax benefits, cash flow, and leverage among them.
Commercial real estate is generally considered one of the best ways for individuals to grow their net worth. That doesn’t mean commercial real estate investing is foolproof. One of the ways that some investors get tripped up is that they fail to do their due diligence before investing their hard-earned dollars.
Investing in commercial real estate is complex, partially because there are so many ways in which to invest. There are different asset types to consider, such as office, multifamily, industrial and retail. Then there are different class types within each asset class, from Class A, B and C to properties located in primary vs. secondary or tertiary markets. You can be an active or passive investor, with the former taking more time and resources.
You can invest individually or alongside others, putting your trust in the deal’s sponsor to run the show. Those who want to preserve their liquidity may alternatively decide to invest in real estate investment trusts (REITs), shares of which can be bought or sold similar to stocks.
How do you make sense of which commercial real estate investment strategy is best for you? To make this decision, start by asking yourself a series of questions. We’ve outlined these questions below.
Related: DIVERSIFYING YOUR COMMERCIAL REAL ESTATE PORTFOLIO: WHY and HOW
City Center | St. Petersburg, FL
At the most basic level, you’ll want to determine whether investing in commercial real estate is a wise financial decision. This is entirely dependent on your investment strategy, the allocation of your other investments, your time horizon, your risk tolerance and more.
Are you qualified?
There are a few ways to interpret this question, and it depends on how you define “qualified”. Most people interpret “qualified” to mean they have a basic understanding of commercial real estate, and therefore, feel competent enough to buy commercial property.
But in commercial real estate, when someone asks if you’re “qualified,” they’re likely referring to whether or not you’re an accredited investor. An “Accredited Investor” means that an individual investor must have an income in excess of $200,000 in each of the two most recent years and a reasonable chance of making the same this year ($300,000 if filing as a married couple) or have an individual net worth of at least $1 million (not including the value of one’s primary residence). Those who qualify as accredited investors are more likely to be able to invest in larger commercial property deals than would otherwise be available to average individual investors.
What are your motives?
Consider your motives for investing in commercial real estate: Are you hoping to invest in a property that will appreciate? Are you investing for cash flow? Are you attracted to the tax advantages of investing in commercial real estate, such as depreciation and the mortgage interest deduction? Are you looking to invest in property that will how amortizing mortgage, which over time, will be fully paid down – thereby leaving a cash flow producing asset for your heirs? Or maybe you’re just looking to invest in commercial real estate as a way to diversify your retirement portfolio, which may otherwise be heavily allocated toward stocks and bonds.
Whatever the case may be, it’s important to evaluate your motives prior to buying commercial real estate. Your motives will inform your future decision-making process, including where to buy, what asset class to buy, whether to invest individually or alongside partners, and whether to invest in an active or passive capacity.
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Successful investors will often downplay their success by saying things like, “I bought at precisely the right time,” or “I caught the market at the bottom.” The timing of your investment certainly matters, but a point in time will not be the sole reason an investment performs well or doesn’t. There are other “timing” considerations to contemplate – beyond just market conditions.
Related: Recessions: Why They Happen, and How to Prepare For Them
Do you have time?
Investing in office buildings, as we do here at Feldman Equities, is inherently more complicated and time-intensive than, say, buying and operating apartment buildings. The deals are more complicated and frankly, it’s a world few people have a lot of experience in (unlike individual homes, where most people at least have the experience of living in.
When considering which asset class to invest in, and the strategy for doing so, it’s important to consider your time. Do you really have the time to find, conduct the due diligence on, renovate, market, lease up and fully stabilize an office building? Most people don’t have that time or ability, at least on their own. If you decide that investing in an office building or other type of commercial real estate is the direction you want to go in, consider investing with a highly-qualified sponsor who will lead the day-to-day activities related to the property.
Do you have expertise?
People often buy commercial real estate with great intentions. They decide that they’re going to learn how to renovate an office building, for example. But the fact of the matter is, life gets in the way – and unless you have deep experience in commercial real estate, you can quickly find yourself in over your head. It’s best to partner with professionals – those who dedicate their lives working in the commercial real estate industry, and ideally those who have decades of experience. This is what’s known as being a smart passive investor.
Is it the right time in the market cycle?
Just like the broader economy, commercial real estate markets are cyclical. The CRE cycle is generally described in terms of four phases: 1. Recovery. 2. Expansion. 3. Hyper-supply. 4. Recession. The Great Recession of 2008-09 isn’t so far in the distant memory for investors to have forgotten. Real estate cycles typically last +/- 10 years, so it’s never a matter of if a market will soften, but when.
For anyone considering investing in commercial real estate, it’s important to consider where we are in the market cycle. Prices usually decline when the economy shrinks. Properties and rents typically appreciate when the market is strong. Great investments can still be made at the height of the market (and terrible deals can be had at the trough) – investors should just carefully weigh the risks of investing depending where we are in the current market cycle.
Castille at Carillon / St. Petersburg, FL
How much liquidity do you hope to gain?
One reason why some shy away from investing in commercial real estate is because commercial property, as a whole, is considered illiquid. You cannot buy and sell an office building, for example, with the click of a button the way you could when you want to buy or sell a stock, bond, gold, or other security. Yet real estate returns have historically proven to outstrip those of more liquid assets such as stocks and bonds and so enjoy what is known as the ‘illiquidity premium.’
The inverse of this is the idea that certain types of real estate investing carries with it considerably more liquidity. Shares in real estate investment trusts (REITs), for example, can be bought and sold at the click of a button and so they tend to perform in greater alignment with the stock market overall than does direct real estate ownership.
Furthermore, the ability to be able to instantly trade what is intrinsically a non-liquid asset comes with it a downside; often you pay more for the underlying real estate than you would have to pay if you purchased the real estate privately. This is known as the ‘liquidity premium.’ When Feldman Equities went public in 1997, we discovered that our private real estate was actually worth more on Wall Street than it was on Main Street.
There are, however, ways to create some degree of liquidity in an otherwise illiquid asset class without having to resort to investing only in the public markets. Some investors (like Feldman Equities) do this by buying Class B or Class C properties—properties that are sold at a discount relative to their Class A counterparts.
These properties usually need renovation and often need lease-up. An investor willing to put in the work to reposition the property can gain liquidity once that asset is renovated and leased. Following the renovation and lease up, the building becomes more desirable to be acquired by institutional buyers who favor Class A office buildings. In other words, the building will go from liquid to liquid
Are there potential tax benefits?
Commercial real estate is a highly tax advantaged asset class. Depreciation is the biggest tax benefit. For example, a property that generates $50K in net cash flow each year might actually show up as generating a loss on a K-1 tax form. How is this possible? Because of depreciation! A project sponsor can use what’s known as a “cost segregation study” to accelerate depreciation. The depreciation can then offset the revenue generated by the property, even though the property didn’t lose any of its actual value.
Other tax benefits include the mortgage interest deduction and 1031 exchange option. The latter is most beneficial to buy-and-hold investors who have experienced appreciation over time. Upon sale of their property, they can reinvest the proceeds of the sale into another commercial property, thereby deferring payment of capital gains tax. This is the primary way commercial real estate investors grow their portfolios and protect their net worth, passing on income generating property from one generation to the next.
What is your risk tolerance?
When determining whether to adopt an active or passive investment strategy, it’s important to understand that active real estate investors carry more risk. Active real estate investors tend to have more of their personal capital tied up in projects. They are responsible for mortgage payments and taxes. They bear the costs of project over-runs. They still have to pay commissions to brokers upon a sale of the property – even if the market tanks. Those with less experience can mitigate their risk by investing in a syndication with a highly qualified project sponsor who has the experience and the track record to know how to mitigate these kinds of project risk.
Similarly, investing in a syndicate allows for broader portfolio diversification. Instead of buying a property individually, using your own equity for a 25% down payment, you could co-invest with others to share that risk. For example, instead of spending $1 million to buy a Class C office building worth $4.5 million, you could invest $200,000 each in five different projects by partnering with others and sharing that risk across the board.
Do you have a contingency plan?
Even those with decades of experience and a refined due diligence process will inevitably encounter issues at a commercial property. This is why it’s critical that investors have a contingency plan, because again, commercial real estate cannot be liquidated as quickly as other asset classes.
At a minimum, an investor will want to carry a substantial reserve (at least 3-4 months of expenses, including mortgage payments) to cover any unforeseen expenses. In fact, most banks will require some version of this as a condition of a loan.
Sophisticated investors will know how to mitigate risk through a variety of strategies, such as leasing office buildings to multiple smaller tenants instead of one or two large tenants. This is built into their business model as part of a broader contingency plan. In a case like this, if one tenant stops paying rent, the impact is less severe and the property will remain solvent.
First Central Tower / St. Petersburg, FL
Where will you invest?
Markets are generally classified as primary, secondary or tertiary markets. New York, Boston, San Francisco and Los Angeles are examples of primary markets. These markets tend to draw national and international investment, often by institutional investors looking to safeguard their equity. Secondary markets tend to be smaller, with 2 to 5 million people in the metro area. Examples of secondary markets include Atlanta, Dallas, Denver, Minneapolis, Seattle and Tampa. Tertiary markets tend to have less than 2 million people and include places like Columbus, Ohio and Providence, RI.
Primary markets tend to be considered the “safest” places to invest, but real estate in these areas is more expensive, has higher barriers to entry, and tends to generate lower returns on the whole.
Before looking for commercial real estate investments, consider your risk tolerance and where you might want to invest in commercial property.
Should you invest in Class A, B, or C buildings?
The distinction between Class A, B, and C buildings is somewhat arbitrary. There is no standard definition between these property types. However, generally speaking, Class A properties tend to be of the highest caliber, in the best locations, and attract institutional investors like pension funds, life insurance companies and endowments. Meanwhile, Class B and Class C properties are older in nature, lack the amenities offered in Class A properties, and tend to be located on the periphery of the core market.
Class A properties are considered to be the “safest,” and therefore, have the lowest returns. Class B is riskier, and Class C even riskier than that, with the potential returns increasing as a result. In other words, the greater the risk, the greater the (potential) reward.
That said, the reason we say this distinction is somewhat arbitrary is because you can invest in a Class B or Class C property, and through thoughtful value-add strategies, convert that property to a Class A investment – a strategy we employ here at Feldman Equities.
Are the fees logical?
Anyone who’s considering investing passively in a syndication will want to thoroughly vet the project sponsor. One thing to look at is the sponsor’s fees. Most sponsors will charge a small acquisition fee (approximately 1%) for finding a deal. Other fees will range depending on the type of deal. Construction fees for a development project, will generally range from 3 – 5% of total project costs. Be sure that the sponsor’s fees are in line with industry average.
Does my investment manager have a good track record with commercial real estate investments?
A fool-hearted mistake of many novice investors is to invest in a deal based upon a sponsor’s fees alone. “This sponsor only charges 3% and promises a 12% cash-on-cash return!” Well, 3% might not seem like a lot – but it could turn into a fortune if the investment manager (the sponsor) doesn’t know what they’re doing.
It’s important to work with sponsors who have a long track record in commercial real estate. Probe and ask about the sponsor’s experience with that specific asset type and in that specific market. For example, if you want to invest in a value-add office building in the Greater Tampa area, you wouldn’t want to put your money with a developer whose only experience is repositioning multifamily apartment buildings in Chicago. Look back at the sponsor’s track record over the past two market cycles to see how they’ve fared during the good times and the bad.
What amenities, building services and extra maintenance can you afford?
The thought of repositioning a building on your own might sound exhilarating, but step back and ask yourself: can you really afford the investment it will take to stabilize this property and bring it in line (or exceed) market standards? Many investors often underestimate how much amenities, building services, and extra maintenance will cost and don’t budget accordingly. Partnering with an experienced real estate development company is one way to mitigate this risk; they’ll have a better handle on the true costs given prior experience.
Can you trust the developer?
When investing your hard-earned dollars, it’s important to trust the person (or group) who will be managing the project on your behalf. Get a better sense for the developer by asking them some hard questions about the project, including project risks. Every project has risks, so a developer who tells you otherwise isn’t being straightforward (or is being callous with your money). Ask the developer about how they managed projects during the recession when the market last collapsed, and what they’ve learned from those experiences. Ask about exit strategies and why they’ve selected a specific exit strategy for the opportunity you’re looking to invest in. And of course, don’t be shy about asking for personal and professional references.
Check out our portfolio of commercial real estate at Feldman Equities.
Morgan Stanley Tower / St. Petersburg, FL
Commercial real estate investing can prove to be highly lucrative, but it’s not without its downsides. Managing commercial property is an intense time commitment—you can’t be an absentee landlord and hope to maximize returns. With commercial real estate you can expect lower risk, greater stability in income flows and a higher likelihood of building wealth than in other asset classes. However, to enjoy these benefits, you’re usually dealing with many complicated commercial leases, annual CAM adjustments, maintenance issues, public safety concerns and more. In a nutshell, you have more to manage than you would if you were to invest in other asset types or asset classes.
Commercial real estate also requires finding talented professional help. Even those who choose to self-manage will need to find a trustworthy broker, attorney and contractors who are available on short notice. Those who prefer taking a backseat will need to find even more help, be it a development partner, property manager, asset manager and the like.
Ultimately, the decision to invest in commercial property is a personal one. It is a decision that should be made in the context of your other investments, and in consultation with your tax and/or retirement advisor.
Related: Price Vs. Value: Strategies for the Next Recession
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Commercial Real Estate (CRE) investment provides savvy investors a wealth of advantages. Tax benefits, cash flow, and leverage among them.
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