Investing in private real estate may provide certain portfolio benefits, such as income, diversification and the potential for outsized return. However, on the flip side, every portfolio has a finite amount of capital, and the potential opportunity cost of getting tied up in a long-term illiquid investment with unrealistic return expectations can be frustrating. Framing your analysis within the following five factors can help you make the right decision about private real estate offerings.
Two key considerations when looking at the structure are the sponsor’s alignment of interest with the offering and the fees charged by the sponsor. In short, how much equity is the sponsor putting into the deal net of its fees?
Further, understand the fees outlined in the offering document and the intended recipient of these fees. Fees could include acquisition fees, disposition fees, financing fees, property management fees, asset management fees, performance fees and others.
Other considerations, such as timing of capital calls, requirements to fund additional capital and restrictions on redemptions, are important as well.
It is important to look at the underwriting and understand the key assumptions that drive the projected returns. Look at the projected cash flows compared to historic performance at the property and note the key discrepancies. Those discrepancies set a framework for key questions and for understanding the business plan. If the projected cash flows are drastically different than historic numbers, then it is important to understand how the business plan is driving the growth.
Another key aspect of the underwriting is the financing of the transaction. Is the debt level consistent with your risk tolerance? What are the key covenants of the underlying debt that might impact the returns of the investment? Does the term of the loan give time to execute the business plan?
Finally, some of the biggest factors that drive return projections are the exit assumptions. Two important metrics to evaluate are the capitalization rate that the sponsor is assuming and how the sale price on a per-square-foot basis (and per-unit basis for housing assets) compares to replacement cost and current comparable sales in the market.
Another important component of the analysis is determining whether the property(s) in question is being purchased at an appropriate price.
One way to gauge fair market value is to compare the price to other sales that have occurred in the submarket. Very rarely are two buildings built exactly the same when looking at comparable sales transactions, so adjustments should be made to account for such differences.
In addition to looking at the sales comps in the market, look at the price of the subject property compared to its replacement cost. There are many factors that could drive a purchase price premium or discount to replacement cost, but a discount may provide more downside protection should the market decline.
The other component to look at is the initial capitalization rate or, in other words, the net operating income divided by the proposed purchase price. Sometimes it is hard to judge whether the initial capitalization rate is appropriate because there might be operational deficiencies that are correctable at the property. However, if you can analyze a deep enough, comparable sample set, you can see the general range and trends of capitalization rates and how they compare to the subject property.
The fourth consideration when evaluating a private real estate offering is the health of the market where the subject property is located. Here are some considerations when evaluating an offering:
• Diversity of the market’s employment base, including industry concentrations. Are there any issues with those industries?
• Job growth and types of jobs in the market. Employment and the health of real estate markets are highly correlated, so understanding the job environment is crucial.
• Consider what some of the key demographic indicators are that could impact the market position of the subject property and/or support the proposed business plan. For instance: population growth/migration trends, household income growth, population density, crime rates and school ratings.
Real Estate Market Dynamics:
• Although there are many areas one could consider when looking at the health of the market, the four considerations that should paint a decent picture of the health of the market are average occupancy trends, average rent trends, absorption trends and the supply pipeline.
Ultimately, you need to be comfortable that the sponsor can execute the business plan and generate the returns you expect to receive from the investment.
The first aspect to consider is the experience of the sponsor. Does the sponsor have the expertise and resources to execute the business plan? Next, focus on the track record of the sponsor. Look at transactions in the same market and property type as the subject property. Has the sponsor had success in similar investments in the past? Finally, when evaluating the sponsor, it is important to consider its viability and potential longevity.
As you consider your next private real estate offering, take these five factors into account to make an informed decision.
The information provided is the author’s opinion for informational and educational purposes only and is not investment, legal or tax advice, nor a security, strategy or investment product recommendation.