If there’s one thing to be found in the overall investment strategy of very wealthy people, it’s commercial real estate. In recent years, commercial real estate investments have achieved average annual returns that beat the S&P 500 by about 4%, thanks in part to cash flow, appreciation, and the tax advantages. So it should come as no surprise that more and more people are investing in commercial real estate every year with the goal of building wealth.
Kent Ritter is an experienced multifamily syndicator and operator helping you to build real wealth through real estate investments. Learn More
If you’re wondering how to invest in commercial real estate, it’s probably because you’ve already decided that it makes sense for you to do so. You know that you want to enjoy the tax advantages and wealth-building potential that investing in commercial real estate offers. Deciding how best to achieve those benefits is a little more complicated and requires that you are aware of and understand the options.
Will You Invest as an Individual or With Others?
The most fundamental question for someone contemplating an initial real estate investment is whether to invest on their own, as an individual, or buy a share of a portfolio that’s invested in real estate. The answer, as it often is for questions about investing, is “it depends.”
Going solo can be daunting for someone lacking prior experience in the world of commercial real estate. Even those who have previously invested in single-family residential real estate can find themselves in over their heads when investing in commercial real estate as individuals. Acquiring, managing, perhaps improving, and at some point, selling a commercial property at a profit requires different skills than flipping a single unoccupied house. Buying a commercial property with the idea of learning as you go can lead to disappointing returns or possibly a loss.
Fortunately, there are a few options for investing in commercial real estate that leverage the expertise, funds, and connections of others and diversify your risk.
Option: REITs
Real Estate Investment Trusts are publicly traded companies that purchase and operate income-producing commercial real estate, usually in a specific sector, such as hospitality, retail, healthcare, or industrial properties. Investors purchase shares of the trust’s portfolio of real estate assets and receive passive income in the form of dividends, with the potential for long-term capital appreciation. The IRS requires REITs to distribute 90% of their taxable income to shareholders, so dividend yields tend to be high.
Most REITS are publicly traded on a stock exchange, which eliminates one of the biggest drawbacks of purchasing individual properties—illiquidity. REIT shares can be bought and sold nearly instantaneously, while it can take weeks or months, even years, for a large commercial property to trade hands. That being said, there are downsides to REITs. You don’t receive many of the tax benefits of direct ownership in real estate. Furthermore, REITs are highly correlated with the stock market, meaning if the stock market goes down your REIT investments will typically be hurt as well.
Option: REIT ETFs
REIT ETFs are exchange-traded funds that are invested primarily in equity REITs and managed to mirror REIT indexes such as the Dow Jones U.S. REIT Index. Like REITs, REIT EFTs offer high dividend yields and enable investors to participate in commercial real estate without the high capital outlay and the complexities of owning and managing individual properties. REIT ETFs have the same downsides as normal REITs.
Option: Real Estate Mutual Funds
Some mutual funds invest in real estate-related securities, such as REITS, and the stocks of real estate operating companies, offering greater diversification than REITS alone can provide. They tend not to have as many tax advantages as REITs and to cost more, but they are actively managed by professional portfolio managers Additionally, you are exposed to the risk of the operating company’s performance. Real Estate could do well, but if the company is poorly run then the stock will fall. Finally, these mutual funds will move up and down with the rest of the stock market, so they don’t diversify your risk like true real estate investments.
Option: Passive Investment in a Commercial Real Estate Syndication
All of the options discussed to this point involve investing in a portfolio of multiple real estate assets selected and managed with the aim of achieving certain projected returns from dividends and appreciation. They provide a way for investors who lack the means to participate more directly in the real estate market to obtain some of the advantages of investing in commercial real estate. They also give those with little or no experience in commercial real estate investing an opportunity to gain some.
For some investors, that may be enough. Others may want something more, something that’s a little closer to actual property ownership and gives a better return, with tax benefits. They might want to consider venturing into commercial real estate through a syndication, which invests directly into a property or portfolio of properties
Investing in a syndication as a limited partner is as close as you can get to owning real estate without taking on any personal liability or operational responsibilities. It provides a window into the world of commercial real estate and an opportunity to experience the life cycle of a syndication deal from beginning to end.
How Commercial Real Estate Syndications Work
Some syndications are put together by a single sophisticated investor with the knowledge and connections to spearhead the deal and act as sponsor, while others are the creation of an LLC or limited partnership that will purchase the property and hold the deed. The sponsor does all the due diligence to identify a suitable property, often one that is already occupied and producing revenue from rents, with the potential for increased rental income and appreciation over a period of a few years, at the end of which it will be sold for a profit if all goes as expected.
The sponsor sees the potential but doesn’t necessarily want to, or can’t, put up all the money needed to make the purchase, and therefore puts together a deal to bring in other, passive investors as limited partners. Limited partners make a capital investment (typically in the $50K – $100K range) and become shareholders. Limited partners receive regular—monthly or quarterly—distributions of income from rents and an eventual capital gain distribution from the sale proceeds. The sponsor does all the heavy lifting and usually has skin in the game as well.
Many deals involve value-add properties that will be renovated, expanded, and/or otherwise improved to command higher rents and a higher selling price after a few years. Some deals are designed primarily to produce high current income while others put more emphasis on growth and capital gains. Participating in a successful commercial real estate syndication deal as a limited partner can whet the appetite for deeper involvement as an individual commercial real estate investor or as a sponsor of a commercial real estate syndication.
Option: Sponsorship of a Commercial Real Estate Syndication
The first time out of the box, it’s probably not a good idea to try to put together a syndication deal on your own unless you have the skills, knowledge, and connections to make your vision of success a reality. Even experienced, sophisticated investors may lack the necessary knowledge of real estate, construction, property management, and the legal aspects of commercial real estate syndication. And if you’re considering improving a value-add property, that requires some degree of contracting experience and collaboration with experts in a variety of construction trades and interactions with zoning authorities, building inspectors, and other local officials.
Syndication enables multiple sponsors to pool their resources and talents, share their knowledge, leverage each other’s strengths, tap into each other’s networks, and shepherd a deal through from the initial concept to the sale of the property a few years later. This is how most sponsors get started.
Taking the First Step
Let’s assume that you decide to move ahead and get started with a passive investment in a real estate syndication. How do you do that? How do you know a particular deal is right for you?
The Offering Package
The primary source of information about a new syndication deal is the offering package created by a securities attorney for the deal sponsor. It specifies all the terms of the deal in writing to enable investors to evaluate the opportunity.
The package includes a Private Placement Memorandum (PPM) that serves the same purpose as a prospectus for a new security, disclosing information about the structure, operation, and management of the company and providing important details about the deal itself: projected distributions, fees, the anticipated hold period, and so on. The offering package also includes the Operating Agreement (for an LLC) or Limited Partnership Agreement that spells out the details of the relationship between the sponsor and the passive investors in the deal. This is where you’ll find an explanation of the rights and responsibilities of all participants in the deal. The Subscription Agreement in the offering package lays out the criteria that potential investors must meet to ensure the suitability of the investment and captures such investor details as the amount of the investment. Finally, there is a business plan or other marketing material that presents the deal’s financial details and projections
Returns
When evaluating the offering package, you will, of course, pay particular attention to return projections and the anticipated hold period, to get an idea of the income distributions you will receive and the profit you can expect when the property is sold.
- One common metric is the cash on cash (COC) return, which is a measure of cash flow: pre-tax net profit that is divided up and distributed to limited partners throughout the property’s hold period.
- Another is the internal rate of return (IRR), which is an annualized return that smooths out month-to-month fluctuations in revenue from rent, adds in the appreciation expected at sale, and accounts for the time-value of money by discounting the future cashflows
- Last is the Equity Multiple which is how much cash you will receive from the investment divided by your initial investment. This is a good indicator of the overall return of the investment.
Takeaways
The relatively large size of an investment in commercial real estate warrants some caution and due diligence before making a commitment, regardless of how you choose to become in commercial real estate investing. But if you can afford it and don’t have a problem tying up your funds for a few years, becoming a limited partner in a real estate syndication could be the right move for you. And who knows, that could be the first step toward deeper involvement in real estate investing.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.
