Commercial Real Estate Investment
What is commercial real estate investment
An alternative to investing in residential rental properties is commercial real estate investment. Commercial real estate assets include many types like hotels, apartment community, self storages, office buildings and industry warehouses. The purchase of commercial real estate properties has higher entry barrier since the price usually runs from 1M to 100M. It's hard for an individual investor to acquire and manage a commercial real estate property solely by himself or herself. But investors can participate in commercial real estate investment in the form of private equity. Experienced operators, aka sponsors or principals acquire and operate large commercial real estate assets in the capacity of general partner while investors participate in the deals as limited partners. Investors contribute money, get private equity shares and receive profit distribution from regular operation and eventual disposal of the asset.
Commercial Vs Residential
So why invest in commercial real estate deals? Compared with residential properties, commercial real estate deals offer a few distinct advantages. First of all, when you invest in commercial real estate deals, you don't have to get a loan by yourself. There are a lot of documents you have to prepare and a lot of criteria you have to pass when you apply for a mortgage. If you participate in a private equity deal, the sponsor will apply for a commercial loan backed by the property being acquired. The sponsor or any management company they hire is responsible for managing the property. You have a lot less to worry about. Also, you get no liability issue as a limited partner. With single family rentals, landlord potentially faces many legal liabilities if things get ugly between the landlord and tenants. On the other side, residential rental properties offer the best transparency if you manage it yourself. You will know all the details and personally manage all the cost. With private equity deals, transparency is usually low and you mostly have to trust the principals to do a good job and get you a good return on your investment.
Types of Commercial Real Estate Asset
There are different types of commercial real estate assets. Apartment complexes are by far the dominant type in terms of total transaction volume. It also exhibits one of the lowest risks among all the types. Other types include self storage, manufactured homes, offices, retail buildings, hotels and industrial buildings. Self storage category has been gaining popularity over the last 10 years due to its good recession resistance. Manufactured home is the most recession resistant type among all the categories and offers the best risk-adjusted return due to limited supply. The other categories like offices, hotels and retail buildings are more liable to the boom and bust cyle of the economy.
The return of commercial real estate is usually measured in terms of IRR (internal rate of return). The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. This metric gives more weight to distribution paid earlier than what is paid at a later date. There is another similar spec called AAR (Average Annual Return) which doesn't consider the time of the distribution. ARR is basically the sum of all the distributions divided by the number of holding years. In most cases, AAR is higher than IRR. Another spec to measure the total return is equity multiple (EM), which is the total return of capital dividied by the original investment. An equity multiple of 2 means you get twice the money back after all the cash flow distributions and the final sale, which is 100% return from your investment.
Profit Sharing Mechanism
If the sponsor doesn't invest a lot of capital of their own, usually they offer a preferred return in terms of IRR to give priority distribution to investors. For example, a preferred return of 8% means the general partners won't get any profit sharing before investors reach 8% return. After preferred return is reached, sponsor will get a higher ratio of profit sharing, usually 30% in addition to their original profit sharing ratio as limited partners. Some of the sponsors also invest a lot of their own capital (>10%) to get more trust with investors. If they do that, most probably they will not offer preferred return. They will get more profit sharting right at the beginning. For example, the sponsor can invest in 10% equity but get 40% profit sharing.