
Commercial Real Estate: A Hedge Against Uncertainty, Recession and Inflation
War-clouds over Russia, soaring oil prices, domestic inflation—all that is needed is a disco beat to bring back the 1970s to America.
Investing in commercial real estate is a great way to earn passive income and to diversify your portfolio. That said, it can be daunting for the first-time investor. In fact, it can also be intimidating for someone who’s invested in dozens of deals! Many one-off developers and project sponsors routinely tout their ability to generate double-digit returns for investors. Sorting through who’s legitimate and who’s not is no easy task. There are many factors to consider beyond the nature of the deal itself. The opportunity might be reliable, for example, but unless it has an experienced sponsor to execute the development plan, actual returns may prove lackluster.
In this article, we look at how to analyze various commercial real estate deals. Specifically, we dive into what sort of underwriting is necessary. Understanding the numbers behind a deal is crucial for any investor—experienced or not.
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When people refer to “real estate underwriting,” they’re usually talking about one of two different things: the first is the process by which a sponsor and individual investors evaluate deals. In this instance, the term is used broadly to describe the vetting process when looking at any deal.
The second use of the term “real estate underwriting” is more technical, and refers to the process a lender uses to determine the creditworthiness of a potential customer. A lender will typically do a preliminary screening of the borrower’s credentials, such as its experience, equity contribution, and the deal’s anticipated debt-to-income ratio. Most banks will start with this pre-screening before sending the package to their underwriting department for a more thorough review. It is through this process that a bank determines whether it’s comfortable moving forward with the deal, in which case it will then issue a term sheet as part of the full underwriting process.
Feldman Equities can turn undervalued real estate into upscale profit
As indicated, both investors and lenders will typically do some preliminary vetting of sponsors and the deal under consideration. That process typically looks at the following:
Questions to consider when evaluating a sponsor’s credentials: How much experience does the sponsor have in the local market place and with that asset class? What is the reputation of the general partners? How has this team weathered economic downturns (if at all)? Who else is on the sponsor’s team, and what experience do they bring to the table? How have the sponsor’s deals performed in the past?
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As mentioned above, once an investor (equity or debt) has completed its preliminary underwriting, it will want to go through a secondary, more detailed vetting process. This process typically includes the following:
It can sometimes be difficult to find relevant comps depending on where the investment is located and the property type. For example, there may only be one 150,000 square foot office building in a given market. There may not be another for 10 or 15 miles, in which case the demographics or other local economic conditions may vary, thereby requiring an adjustment to the comp prices (upward or downward) based on those market-specific considerations.
To calculate cash-on-cash returns, use the following calculation: cash-on-cash return = annual pre-tax cash flow / total cash investment x 100%.
An alternative way to crunch the numbers is by looking at the property’s “cap rate.” This is a formula that is used to estimate the potential return an investor will make on a property. A cap rate is expressed as a percentage, usually between 3% and 20%, though it can be higher or lower. Cap rates have an inverse relationship to the property value; the more valuable the property, the lower the cap rate and vice versa. A detailed pro forma is needed to help calculate the cap rate.
Feldman is a longtime sponsor of value-added real estate deals in the Tampa Bay area. Our underwriting philosophy always errs on the side of conservative. We’d rather under-promise and over-deliver, generating returns for our investors higher than they’d initially anticipated. Ultimately, we find that this approach helps us broaden our network. Our investors, having realized “surprise on the upside,” they tell their friends about what a great investment opportunity they got into, and their friends then approach us about investing in future opportunities. It’s an approach that has helped us grow over time while maintaining a best-in-class reputation.
It’s essential to have both conservative and meticulous underwriting. As a sponsor, we take a first pass at putting together realistic numbers for our value-add deals. We then pass these numbers along to investors and lenders for further vetting. We are careful to account for any potential cost, including all capital improvements and tenant improvements. We build in a healthy contingency in the event of unforeseen expenses. This level of detail is what ultimately translates into high-performing projects that meet (and often exceed) the returns as pledged to investors.
Meticulous underwriting is especially important when trying to attract capital to a deal. All investors want to have full faith in the numbers before them. They’ll want to be sure that they can live with any potential downside scenario, which is why it’s important to stress test numbers before setting out to raise funds. It is through these numbers that an investor determines what level of risk to assign to a deal, or in the case of a lender, how much debt to provide and at what terms. The more detailed the underwriting, the more confident your partners will become with the transaction.
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It is easy for investors to get excited about a specific opportunity. A sleek set of marketing materials can overshadow the actual numbers behind a deal, which, when investigated in more detail, might prove that the deal is more lackluster than the prospective investor had expected. This is why a multi-step underwriting process is so crucial to any deal: no investor should blindly trust a real estate sponsor. Instead, investors should carefully vet all numbers. What are the project’s most significant risks? Has the sponsor accounted for those risks, and how? Before making a substantial investment, it is crucial to understand all aspects of the business plan – from the sponsor to its underwriting – to minimize risks and maximize potential returns.
Related: Commercial Real Estate Jargon Explained
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War-clouds over Russia, soaring oil prices, domestic inflation—all that is needed is a disco beat to bring back the 1970s to America.
People who have been in the commercial real estate business for any length of time have heard of an Offering Memorandum (OM). While marketing flyers and brochures are publicly distributed to the general investment community, a good commercial real estate OM is used to generate interest from the most qualified prospective investors and bring them to the deal table.
The state of Florida and Tampa has one overriding major industry that is senior to all other industries. I call it the “population growth industry” 😊.