Passive Investing in Commercial Real Estate - 2020 Part Three of Four

Part Three: Sponsors, Deals, and Strategy

As the year continues, more investors are reaching out to me to understand the benefits of commercial real estate investing. While the market has always had ups and downs, this is an unprecedented time with ample opportunity for savvy investors. Contrary to popular opinion, economic downturns are the exact time to begin planning your business-oriented commercial real estate investment strategy. There are a few reasons for this:

• Bear market prices and property valuations will decrease
• Investors will seek returns in assets viewed as stable and secure
• The supply of available properties will increase due to business closures or relocations

While there are some contradicting elements in this list, I want to note the opportunity that comes from a market downturn. Today and tomorrow may be uncertain, but what we know historically is that investments in commercial real estate, when done right, provides safe, stable, long-term returns.

In this part, I want to talk about the two core elements of business-oriented commercial investments. They are:

1. Syndication and Sponsors
2. Deals Components

The following sections will provide an overview of these elements. This part concludes with my general investment approach, including the questions I ask myself when beginning a new investment.

Syndication and Sponsors

As a passive investor, your goal is to invest in a property and to avoid the day-to-day management. Passive investors seek returns through investing capital into properties that are then managed and operated by others. While some business-oriented commercial real estate investors may purchase a property themselves, and have it managed professionally, many will begin by investing in a syndicate run by a sponsor.

Syndication is the pooling of funds from many investors to purchase a property. Sponsors find properties, raise funds, purchase the property, manage the property, and deliver investment returns.

While I could write at length about sponsor and syndicate specifics, I want to provide you a few tips for finding the best sponsors, based on my experience. Vetting a sponsor is especially important during market downturns.

Tip #1: Tenure and Track Record

How long has the sponsor been in business and how well have they done? Look at more than promotional materials. Ask for references. Talk to others in the market or on BiggerPockets, a popular real estate social networking platform. Try to understand if the sponsor is professional, organized, communicative, transparent, well-respected, and how successful they’ve had been in investing.

Tip #2: Assumptions, Forecasts, and Underwriting

New investors often forgo taking a deep enough look into the philosophy and strategy guiding a sponsor. Sponsors should be both principled and conservative, willing to analyze a deal thoroughly and provide you insight into metrics such as Internal Rate of Return (IRR), Gross Operating Income (GOI), Net Operating Income (NOI), and Cash-on-Cash Return (CCR). Most important, the sponsor needs to be clear about any future projections about the property and market, and any and all underwriting associated with the investment.

Tip #3: Sponsor Fees

Acquisition and asset management fees are very important when assessing a sponsor’s involvement and general profitability. The acquisition fee is the cost of finding a property, conducting due diligence, and creating the deal. This can range from 1% to 5% of the acquisition cost. The asset management fee is the price to manage the property, often approximately 1% of gross revenue. Another optional fee is the property disposition fee, typically 1% of the sale price which is paid to the sponsor.

Tip #4: Asset Management and Property Management

As a passive investor, you are uninvolved in the day-to-day management of both the investment and the property. This means it is critically important to understand how the property will be managed and who will do the day-to-day property management.

General asset management is done by the sponsor. What is the business plan? How will they handle the property management team? Sponsors will be involved in the day-to-day operations, but the property management team will really drive the value of the investment over time. Good property management should have a strong reputation, excellent tenant relations, and a proven ability to grow the value of the property over time.

Deal Basics

Now I want to turn to the structure of a deal. After you have identified a syndicate, sponsor, and assessed the property, you’ll want to consider how the deal is structured for investors.

A model deal has a number of key elements:

• IRR of 10% to 20%
• Cash-on-cash return from 5% to 10%
• Average five-year target hold
• Preferred return around 8%

I also look to make sure the financial assumptions are conservative, loan terms are clear, the lease terms are appropriate, and that the deal is backed by a solid business plan.

When looking at a deal, you’ll want to consider the following five components.

#1: Offering Summary and Private Placement Memorandum (PPM)

The offering summary is where you will find the important numbers of a deal, such as return projections, financial distributions, and deal timing. The PPM is a legal document detailing the risks, objectives, and terms of a deal, similar to an investment prospectus.

#2: Financing of the Property

Some syndicates will use debt financing to purchase a property. Make sure to understand the Loan-to-Value (LTV) ratio, which is a ratio of the amount of the loan divided by the property’s appraisal price. 65% to 80% LTV tend to be average in commercial real estate. Also important are the type of loan, the terms, the length, and the amortization rates.

#3: Financial Analysis and Sensitivity Test

These are two projections that try to understand the value of the property over time. Financial analysis is used to project cash-flow five years into the future. You’ll want to know what the sponsor is expecting and the assumptions for why they expect a particular cash flow. Sensitivity analysis tests how well the property will do under certain conditions, such as with 80% occupancy or falling rental rates. The test will provide a breakeven point for profitability.

#4: Repositioning and Rebranding

A single property with, say, a Walgreens, won’t likely have any rebranding. However, if a property is trying to attract a Walgreen or other single-occupancy business, a rebranding or repositioning of the property may follow after significant renovation. You’ll want to know how the sponsor intends to develop the property throughout the investment.

#5: Exit Strategy

This component goes without saying. How will the sponsor and investors exit the deal? Make sure to understand how the sponsor will approach having to sell early or a possible refinance.

My General Investment Strategy

As we get deeper into passive investing in business-oriented commercial real estate, I want you to begin thinking about how to create an investment strategy. Commercial real estate is a complicated investment topic, and passive investing requires a sound investment strategy to be successful. I won’t lie to you: people can and do lose their shirt investing in commercial real estate. This includes both active investors and passive investors. I have seen my fair share of investor successes and failures. What you will learn in this book is how to become one of the winners.

An investor looking to invest in business-oriented commercial real estate needs to consider these five elements: Time, location, knowledge capital, and risk. Ask yourself the following five questions when approaching investing in commercial real estate.

1. Do I have the time and patience to find the right deal, at the right price, with the right sponsor?
2. Do I know the value of the location the property is on, including forecasts for the future of the location?
3. Do I understand if the property is a good deal, and if not, can I educate myself adequately?
4. Do I have enough capital to invest in this property?
5. Do I understand the risks of investing in this property and can I afford to lose money on this deal?

These questions will point the way towards what you need to understand about any commercial real estate investment. 

Part four next.....