Throughout history, if financial advisors didn’t have personal connections with commercial real estate property sponsors, single-asset investments were more or less out of the question. Real estate investment trusts were the best and only option for fulfilling a CRE allocation within a client’s portfolio.
Researching REITs is a relatively simple and straightforward process. REIT fund managers offer limited — yet sufficient — big-picture data to illuminate whether a particular trust fits into someone’s overall investment strategy and goals.
Recently, however, the passing of the JOBS Act drastically changed the CRE investing environment. Property sponsors are now legally permitted to market single-asset investment opportunities to the masses, and they are using online platforms to do so. Furthermore, they are accompanying these opportunities with deeper, more complex levels of data that may seem foreign to many financial advisors.
CRE’s Information Age
The digital investing era has created a much more informed pool of investors. According to a recent study conducted by Accenture, 90% of advisors say clients are more educated about investing than they were five years ago.
That’s because online platforms foster data-rich climates. Building sponsors can easily distribute thorough reports regarding specific opportunities as well as their overall investment philosophies. Investors are empowered to conduct their own research while building lucrative portfolios of individual properties.
However, even in this DIY-friendly arena, financial advisors still play a pivotal role in analyzing single-asset investment opportunities and providing expert guidance. In order to do so, they must educate themselves on the following five metrics:
1. Capitalization Rates. The cap rate can be defined as the net operating income of an asset divided by its purchase price. Inversely, if you know the NOI and the cap rate, you can determine the appropriate value for an asset. Many capital markets professionals use cap rate metrics in setting values.
The cap rate is then used to set an initial cash-on-cash yield, or the net cash that remains after debt service, divided by the amount of equity invested in the deal. Your cash yield will often be higher than the cap rate, if favorable debt financing is used.
2. Cash Flow. Cash flow is the amount of cash available to be distributed to the investor, and it is revenue less operating expenses, debt service and capital expenditures. Most of the time, building owners will distribute the majority of the cash flow to their investors on a monthly or quarterly basis, but they’ll reserve a portion of it to cover upcoming capital needs.
In a CRE investment, cash flow is one of the most important metrics because it’s a direct result of an effective business plan. More cash coming in typically means the owner is running an efficient and profitable operation.
3. Capital Improvements. An annual capital improvement plan indicates that a sponsor is serious about boosting the property’s appeal and overall value. However, it’s important to dive deeply into these plans and assess just how much impact they may have.
Major renovations and upgrades will boost tenant retention, lease rates and the building’s NOI — thus adding tremendous value and profitability to an investment. Routine maintenance to existing infrastructure over the next year, however, may not.
4. Occupancy and Lease Rates. National occupancy and lease rates are relatively easy to find, but prior to CRE’s digital revolution, an individual asset’s rates were typically kept in-house. Today, however, investors and advisors have a great opportunity to see how an asset’s rates stack up to the regional and national markets.
Lower-than-average occupancy rates could indicate that the property is in desperate need of upgrades — which would then bring the capital improvement plan to the forefront. Strategic upgrades can attract new tenants, which would boost revenue, NOI and, most importantly, yield for the investor.
5. Leverage. Debt coverage of most assets is between 50% and 70% of the asset’s value, and it impacts the amount of cash available for distribution. Because debt service is an outflow of cash, lower rates and longer amortization periods will determine how much cash remains for investors.
Leverage is an important metric for investors who are thinking about the future. An overleveraged deal may not survive an economic downturn or a long period of unexpected vacancy.
Single-asset CRE investments have become far more accessible in recent years, but that doesn’t necessarily mean they’re easier to navigate. Smart, data-driven investing still requires a level of expertise not very many investors possess, so they will turn to their advisors for help.
To offer clients the best advice possible, start by mastering the most crucial CRE metrics.