We are grateful to have the opportunity to republish this exceptionally insightful post written by Michael Episcope, a cofounder of Origin Investments. This post, which explores important principles to consider when evaluating a real estate investment, was originally published as a guest post on White Coat Investor , a website committed to helping doctors to understand their personal finances and investing. While I do enjoy sharing my commercial real estate investing advice on this blog and elsewhere, I find Michael’s recommendations to be excellent and worth sharing with you. Enjoy. ~Robert Kantor

Private commercial real estate investments can help investors protect and grow wealth. The combination of rental income and price appreciation gives real estate attractive rates of return over other long-term investments, and hard assets have historically acted as a hedge in inflationary environments.

 

Private commercial real estate investments can help investors protect and grow wealth. The combination of rental income and price appreciation gives real estate attractive rates of return over other long-term investments, and hard assets have historically acted as a hedge in inflationary environments.

With the passing of the JOBS Act in 2012, accessing private real estate deals has never been easier. Opportunities previously only available to institutions or the ultra-wealthy are increasingly being offered to individual investors through online platforms and other channels. But with this new opportunity also comes new challenges.

Today’s investor needs to figure out how to sift through the vast amount of information presented for each deal. But for most prospective private commercial real estate investors, it’s the projected returns that guide their investment choices. And what traps many private equity investors is a tendency to reduce all real estate opportunities down to a few numbers. Most real estate crowdfunding sites or deal syndicators cite only a few profit estimates, such as internal rate of return (IRR) and the equity multiple.

These estimates should be only a starting point. The goal of every investor should be to maximize returns while also minimizing risk. In many cases, a property with a 15 percent projected IRR may be a better investment choice than one that promises 20 percent, after adjusting for risk. And key statistics such as IRR and the equity multiple can be misleading. Here’s why.

When a 15 Percent Return Is Better Than a 20% Return

Real estate investors aim to maximize returns and minimize risk over time. But all returns also come with their own set of risk factors, which is different for every private commercial real estate investment. Every investor needs to consider the following question: How much risk is being taken to generate each unit of return? A property that is expected to generate 20 percent annual returns with twice the risk of one that generates 15 percent return is a worse investment choice.

There is no standard in the world of private equity real estate and there are innumerable inputs that go into creating projections. Projections are subjective in nature, and this is the basis for why it doesn’t make sense to focus on this metric. The exact same deal underwritten by two different managers will yield entirely different outcomes.

There are other metrics of greater importance and understanding them will help lead to better investment decisions. Here are four to consider when you evaluate private commercial real estate investments and attempt to compare one to another:

# 1 Manager Risk 

If there is one takeaway from this entire article, this is it: who you invest with is the single most important decision in real estate. A top tier manager will put you in a great position to succeed and protect your capital in all cycles. They behave rationally and responsibly. An inexperienced manager without infrastructure, discipline or their own capital will take outsized risks that benefit them at your expense.

What to consider: Before a deal is ever considered, spend your time talking to the manager and vetting them. Do they have a track record of generating consistent returns? Do they have a quality team? Do they invest significantly along with you? Inquire about the worst deals they’ve ever done, what they learned, and how they incorporate that knowledge into how they operate. Call and speak with references and never be afraid to walk away.

# 2 Leverage RiskBorrowed money is a risk-reward magnifier. In commercial real estate, risks and rewards rise with the amount of debt needed to buy and improve a property.

What to consider: Leverage is commonly used in private real estate and high leverage is not a non-starter, unless it violates your own risk parameters. However, high leverage needs to produce high returns. An investment that is capitalized with 80% debt generally should produce substantially higher returns than one capitalized with 60% debt.

Also, beware of structures that involve preferred equity and mezzanine debt. Potential investors should understand the “capital stack,” or layers of financing — particularly who gets paid first in the event assets need to be liquidated. Make sure that your return is commensurate with where you are in the capital structure. If you get paid first, the return will be less than those who get paid second or third. Run a quick stress test on every deal: What happens to your investment if the total asset value deteriorates by 10%, 20% and 30%?

# 3 Asset-type Risk

Some types of real estate face more inherent challenges. Apartments and office buildings lock in tenants with yearlong or multiyear leases respectively, while a hotel must rely on short-term, seasonal traffic. Hotel demand also incurs far greater volatility than apartment and office demand, and hotels incorporate much more operating leverage in their model.

The hotel investor should expect a bigger return to compensate for the more unpredictable revenue. A healthy economy will help both properties, but a deteriorating economy will have a greater impact on the performance of the hotel business. The application of this risk assessment applies to every sector from retail to self storage. Even within these industries, risk is not created equal. The risk of a multi-tenant strip mall will be far different than that of a retail building occupied by a single tenant.

What to consider: Prospective investors should understand the risk factors for each type of property, and look for risk mitigators. For example, the proportion of occupied units and the credit scores of the tenants will be signs of a predictable revenue stream for apartment and office buildings. The economic health of a city’s business and tourism markets can be an indicator of its ability to attract hotel guests.

Demand is the key to filling up a building and generating good investment performance. Make sure that demand is real and achievable. What happens if demand falls short? What happens if occupancy falls short by 10% and rents also fall short by 10%? Once you’ve seen these stress tests, you’ll start to get an idea of how much risk you are taking.

# 4 Project-level Risk

Business plans vary greatly in risk and complexity. Ground-up construction has a much different risk profile than an asset that is 80% occupied. Ground-up development adds to the complexity: Construction requires architectural and permit reviews, poses foundation and structural concerns and requires marketing and leasing activity that starts from ground zero.

The complexity of the business plan is highly correlated to the risk of the project. An asset that needs to be fully repositioned and improved has a much larger risk profile than one that has a light value-add planned. In the first case, the demand is unproven.

What to consider: In general, the further out an asset is from generating cash flow, the more risk to the investment. Cash flow mitigates downside in real estate just as dividends do in stocks. A long timeline also carries a higher risk that market or economic conditions could deteriorate.

Keep a Property’s Financial Model in Mind

Real estate is complex and trying to narrow it down to a few variables to make a smart decision is incredibly challenging. When accounting for risk adjusted returns, it’s all about the ability to meet or exceed the assumptions in the underlying financial model. Investors also need to consider things like fees, growth rate assumptions, exit pricing, barriers to entry, aesthetic appeal, capital improvement costs, supply, and asset history, to name a few. These all have a material impact on the risk return profile and the decision to move forward.

Also keep in mind that any deal can be underwritten in a way that makes it look appealing. I’ve never seen a deal that didn’t work on an excel sheet, and I’ve also yet to see a deal follow its business plan precisely. This is why finding a manager who is aligned with you should be at the top of the hierarchy when making a decision. Look for a manager with experience and one that invests significantly side by side with you.

Investors should understand risk-reward profiles so they can better ask the right questions. While offering memorandums will have a great deal of information to help evaluate both the status of an asset and expectations about its future performance, real estate investors should look beyond the estimated returns for details that will alert them to the potential pitfalls and validate a sound business plan.

What do you think? What due diligence steps do you undertake when evaluating a real estate investment? How have your investments done? What have your actual returns been in comparison to the original returns? Why do you think they differed? What mistakes have you made? Comment below!

Connect with me on Linkedin, and with Headwater Capital on Linkedin, Twitter and Facebook.

To learn more about the possibility of earning long-term, reliable cash flow with Headwater Capital, contact me at RAKantor@HeadwaterCapital.com.