With countless online real estate investment opportunities available, it can be hard to differentiate between offerings. This article serves as a guide to highlight what to look for in these investments to help identify what can make one offering stand out from the rest.
Sponsor – one of the most important aspects of a real estate deal is the team running the show. Here are some things to consider about the party solely responsible for your project’s success.
Track Record: Has the sponsor completed many successful deals? Have they worked with this asset type in the past? What are their historical returns? How long has the sponsor been in business; have they experienced a market downturn? Have they ever lost investor capital? Case Studies are a great way to examine the past work a sponsor has completed.
Capabilities: Is the Sponsor vertically integrated (Hosts in-house teams for project aspects like property management, construction management, and financing) or do they outsource project management work to a third-party? Vertically integrated sponsors reduce third party risk and are more aligned with investors.
Geographic Focus: Does the sponsor operate in a specific region or do they work on projects in varying cities? The more focused a sponsor is on one area the more they can use their local knowledge, relationships, and market specialization to their advantage.
Location – everybody’s heard of location, location, location, but what are the aspects behind LLL that matter most? Here are some critical location factors.
City: The metro in which a project is based will have a significant impact on the long-term success of a project because the local economy will impact the demand for space. Look for a city with a strong, diverse economic base. Ideally, the core industries will be expanding and important within the global economy. The cities with the sharpest rise in land values over time tend to have geographical barriers that limit supply so that when demand increases so do prices. A clue for finding this fundamental market dynamic is to examine the availability of vacant land.
Neighborhood: Big city neighborhoods can vary greatly, and only a few miles can be a world apart when it comes to culture, demographics, crime, affordability, and desirability. Choosing a prime location within your project’s city is important for long-term value as the best areas tend to appreciate the most over time.
Building: The specific plot on which a project sits is vitally important. Identical buildings can be valued differently if they are on opposite sides of the street. Consider traffic flow (both vehicular and pedestrian), parking, zoning and governance, corner lots, and even the sun’s angles. This is where local knowledge is most helpful.
Strategy – having the right aim when approaching a project will allow the sponsor to maximize value for investors right from the start.
Deal Sourcing: Many sponsors will advertise their deals as off-market, but what’s really important is that the investor is sure they are purchasing the property below fair market value. One way to check is to think about the seller’s motivation. A seller facing distress from external events not related to the property will often be a great source for a bargain deal.
Business Plan: Buying a building and constructing one are two different animals, and ground-up development often entails more risk. For existing improvements, the sponsor will likely have a plan to enhance the building, yet the more drastic the improvements the more risk is inherently involved. When a business plan involves significant repositioning, the necessity of large-scale renovations and leasing may add upside, but they also add risk. Whether the project is development or renovation-based, always be sure the business plan seems achievable and reasonable.
Financing: It’s very common to see financial leverage applied to real estate projects. Although leverage will enhance returns, it also adds additional risk since debt sits in a higher priority within the capital stack than equity. To minimize this risk, sponsors should source the best possible loan terms. Ideally, the sponsor will have access to low interest rates, fixed rates, interest-only periods, and will utilize a safe amount of leverage (70% LTV or lower). The loan term should be at least the length of the project, including a buffer period for delays. Be cognizant of loan maturities as refinancing ability is tied to the greater capital markets.
Exit Plan: Even the best ideas need a backup plan. Having multiple paths to monetization is a great way for the sponsor to mitigate downside risk. Executing on one strategy while simultaneously considering and working towards another is the sign of a great sponsor. An easy illustration is the ability to rent out condos if the sales market is slow upon unit delivery.
Structure – the profile of an offering can have significant impact on investor returns.
Distributions: It’s common to see real estate deals arranged such that the sponsor gets an outsized share of the profits (a “promoted interest”) as they achieve a higher rate of return for investors. These “waterfall” structures often include a preferred return, which is when the investors get the entirety of the distributable cash until they reach a set threshold which begins the profit split. However, since this preferred return is not guaranteed investors should be wary of this figure and not compare it to a set dividend. While good investments incentivize the sponsor, waterfall structures can be complicated or overly generous to sponsors, so it’s important to fully understand what you are entitled to before investing.
Taxes: Real estate investing would not be as lucrative without the tax benefits granted by the government. Although land cannot be depreciated the improvements on top of it can be, along with any personal property included in the purchase. Through the application of non-cash losses from depreciation, and loan amortization, real estate investments often generate passive losses which can be used to offset passive income or gains. Unutilized losses can be suspended and carried forward; however, many investors prefer to purchase a portfolio of real estate so that they can offset all of their losses in a current year. Remember, proceeds from debt financing are not taxed as income.
Capital Calls: If a project hits a cash flow shortfall, the sponsor may look to the investors to add additional equity into the project. These call provisions often stipulate that investors who choose not to fund will be diluted, which is not ideal for those investors. Finding an offering without capital calls beyond the initial commitment is the best way to avoid this issue.
Term Length: The key to building wealth through commercial real estate is long-term ownership. Timing the market is challenging, especially when you have unexpected events like a pandemic, but if you can maintain ownership through multiple cycles, well-located real estate is almost certain to appreciate. Many offerings feature business plans that intend to hold a property for only a few years, which does not maximize total value for investors. Project length also impacts management’s options when it comes to capital events, and the lack of strong extension options may result in untimely dispositions, lowering overall returns. Picture a five-year, 2016 offering of an office project based in Manhattan with no extension options. Not ideal.