Making Your First Investment in Commercial Real Estate as a Private Investor

Wednesday, January 4, 2017

Real estate indicators by Managing Director Jules Sherwood of HFF's Denver office. 

This article is written to frame the benefits and risks of a private individual or wealthy family investing in commercial real estate (CRE). Understand that we are not attorneys or accountants, and this should not be taken as legal or tax advice, so please consult your appropriate professional advisors before making any investments.

We assume for this discussion that, since you are reading this, you are an educated investor with a high income and/or net worth, do not work in commercial real estate as your primary profession and already have a diversified portfolio of investments (stocks, bonds, etc...). The intent here is offer a primer before making your first direct investment in commercial real estate and to increase your awareness of this asset class as another investment alternative.

Commercial real estate is generally defined as income-producing property that contains more than four residential units under one roof. That means that basically every other property, such as office buildings, retail properties, apartment complexes, medical office buildings, industrial facilities or warehouses, student housing properties, hotels, mixed-use properties and self-storage assets are all examples of commercial real estate.

The most common drivers for investors to pursue commercial properties are to realize a more substantial and direct regular cash flow from their investment and the ability to use debt to leverage their returns. Some of the main benefits that attract investors to CRE are:

  • Cash flow:  Commercial real estate assets typically receive rents from their tenants on a monthly basis. Depending on the expenses at the property and occupancy, you are likely going to receive a significant amount of cash every month. This regular income stream is typically substantially greater than a typical bond or stock dividend payment. Many investors plan to replace or supplement their ordinary income with this cash flow or earmark the dollars for retirement or estate planning.
  • Leverage:  Commercial real estate lenders are extremely professional and typically are very willing to help you leverage your equity to purchase an asset of a much higher value than you could purchase with cash alone. This allows you to realize a much higher return on your invested cash, as well as allowing you to buy more asset for your money.
  • Asset Appreciation:  You are likely thinking that, similar to your home, the market will lift property values with time. While this is a true external factor, you can also improve the value of CRE through intrinsic improvements, including lowering expenses through improved operating efficiencies at the property or attracting higher paying or higher quality tenants.
  • Inflation Hedge:  Depending on the type of CRE you own, the lease structures of the tenant or tenants at your property will typically have durations of three to 20 years. Due to this longer-term nature, most leases will have contracted increases in the rent to offset for expected inflation throughout a tenant’s term. As an owner, you can strategically elect to pursue shorter-term leases so that you can adjust for market rates and/or inflation more frequently, or, on the other extreme, you can pursue longer contract terms to guarantee your long-term income up front.
  • Hard Asset:  While there is intrinsic value and pride in being able to point out your property to your friends and family as you drive by, CRE has multiple components to its value. The property’s land and structure each have value, so, even if you vacate the physical structure, you will likely have value left in your property depending on its location alone. You will also likely see less volatile swings in the value of CRE, especially if compared to the historical stock market performance purely due to the physical permanency of this asset class.
  • Tax Advantages:  Here is where every accountant and attorney reading this stands up to get a word in; let them speak and listen to your trusted professional advisors! Depending on your individual situation, CRE may provide beneficial mortgage interest and depreciation deductions to shield a portion of your income stream from the property. Additionally, when you sell your property, there may be the ability to defer paying capital gain taxes through a 1031 tax deferred exchange. Again, please consult your tax and legal professional for more details on these potential benefits.

Now for the fun part: Risks

As with any investment, an investor should understand his or her risk tolerance before considering buying commercial real estate and consult with legal, tax, financial and other professional advisors before investing. With that said, CRE is not risk free and, generally, there are four risk/return profiles that CRE investments will fit into:

  1. Core:  Low risk, low return (typically yields four to six percent annually)
  2. Core Plus:  Medium risk, medium return (typically yields six to 10 percent annually)
  3. Value-Add: High risk, high return (typical anticipated return on investment of 10 to 18 percent)
  4. Opportunistic:  Extremely high risk, high anticipated return (typical anticipated return on investment of 18 percent+)

These general classifications are a sliding scale of risk and return, with core properties carrying the lowest risk, in place stable cash flow but also the lowest relative returns. At the other end of the spectrum, opportunistic properties carry very high anticipated returns, typically due to a sale after fixing the property. These types of properties may not even have any current cash flow and often require significant expenditures in leasing and/or the property and hence carry a very high risk that these returns may not be realized.

CRE is different than other investment vehicles, and this inherent unfamiliarity may create risks for some investors, specifically:

  • Specialized Knowledge:  While returns are generally higher than in other traditional managed asset types (e.g. stocks, bonds), most CRE investments will require some, if not a lot, more focused knowledge in order to make the investment successful. Most investors will hire a dearth of experts, such as property managers, leasing agents, general contractors, attorneys, accountants and mortgage brokers. Contrary to buying a stock where there is usually little you can do to directly impact that stock’s performance (and dividend), a CRE asset allows you to be as hands on as you like and to be rewarded (or penalized) accordingly. The more that you engage professionals familiar with the commercial real estate space and your asset in particular, the more confident that you should be in your investment.
  • High barriers to entry:  CRE typically requires a large amount of equity to purchase a property due to the inherent size of the investment. Most lenders will expect the buyer to put between 25 and 40 percent of the purchase price down and then also require that appropriate reserves are kept for the age, tenancy and condition of the property. Depending on the initial condition of the asset, cash may also be required to retain and acquire tenants, upgrade operating systems or improve other building components (e.g. parking lot, roof).
  • Liquidity:  CRE is not a liquid asset class and may take months to sell depending on a variety of external and internal factors effecting the property.  

High-net-worth individuals and wealthy families have a dearth of options to invest their money, and we hope that this brief overview helped educate you on the risks and benefits of directly acquiring Commercial Real Estate in your portfolio. We hope that you will inquire further into the space and ask a commercial real estate professional for more detailed information about how to select a property type that fits your risk profile, how to finance that acquisition and for recommendations as to how to best operate that property.

About Jules Sherwood

Jules Sherwood is a managing director in HFF's Denver office and has more than 11 years of experience in commercial real estate. He focuses primarily on commercial middle market investment sales transactions throughout the Rocky Mountain region, works closely with the national loan/REO sales group and provides online auction expertise to clients of the firm. During the course of his career, Mr. Sherwood has completed in excess of $850 million in commercial real estate transactions.

Mr. Sherwood joined HFF in 2015. He joins HFF from Rockwood Real Estate Advisors, where he was opened the Denver office of the firm, which is a wholly owned subsidiary of Additionally, he was lead broker for the office and broker of record for more than 20 states and more than 100 transactions during a two-year period. Prior to that, he was the regional director of real estate for the western United States for Trigild and also held development positions at J.F. Shea Company and KB Home. A lieutenant in the United States Navy, Mr. Sherwood earned his Bachelor of Science degree from Cornell University and his MBA from Arizona State University.

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