The U.S. commercial real estate (CRE) market is valued around $20.7 trillion down from a recent peak of $22.5 trillion. While substantial by any measure, it pales in comparison to the $94 trillion residential market. Combined, the U.S. real estate market is valued at more than twice the S&P 500 Index. What happens in the sector may be just as important to investors even if it doesn’t get the daily headlines of the stock market.
With single-family homes and the types of commercial real estate all performing differently in this inflationary environment, understanding how it all works is a challenge. In our view, the key is to break it down into manageable parts. Although real estate can be complex, there are proven methods to guide investment decisions.
This article highlights three essential elements of due diligence applicable to everything from an 100,000 square ft warehouse to a free-standing Wendy’s down the street. While not exhaustive, these tools are practical and powerful, and aimed at making you a more informed and potentially successful investor.
1. Property Types: Not All Real Estate Is Created Equal
Real estate is often described as an asset class, and understandably so. However, there is a reason we go through the trouble of categorizing stocks based on their market capitalization (e.g. large cap), industry (e.g. oil and gas), growth trajectory (e.g. value or growth), and geographic exposures (e.g. an international blue chip). Without these guardrails, investors must start from ground zero when trying to understand what the company does and how they do it.
Source: The Cauble Group
The same principle applies to real estate. Different types are linked to the health of various segments of the economy. Industrial real estate like logistics facilities and distribution centers, for example, rely heavily on the popularity of e-commerce and the demand for warehousing and shipping hubs from companies like Amazon (AMZN), Walmart (WMT), and FedEx (FDX). If those three companies are outperforming Wall Street estimates, it’s a safe bet that the rents for the logistics facilities they all compete to lease will increase over time.
In contrast, retail real estate is more closely tied to the consumer. Fast-food chains are historically resilient and tend to perform reasonably well in weak and strong economies. Luxury retail space in Las Vegas or New York City, however, may show the first signs of weakness in an economic decline. The occupancy and rent growth of multifamily properties are usually most correlated with the local job market and economy. The rent a landlord can charge for an apartment in Miami has nothing to do with what’s going on in Seattle or Denver.
There are also specialty sectors that don’t fit neatly into a single category. This includes the cell towers powering your iPhone, many of the country’s most popular amusement parks, and the advanced data centers enabling the growth of cloud computing and artificial intelligence. Other real estate funds don’t own physical real estate at all. Instead, they specialize in the mortgage debt tied to the buildings. The result is potentially greater current yields with the tradeoff being less potential for capital gains. Just as with stocks, understanding the characteristics of each real estate category is crucial to making the optimal decision.
Your risk profile and investment goals will determine which categories are most suitable, and fortunately, there are over a dozen to consider. Most institutional investors tend to own multiple sectors for better diversification, and we believe that’s wise.
2. Debt: A Critical Factor
Real estate has long been a successful asset class in part due to its greater potential for leverage. That and other characteristics can be advantageous with the IRS code. Lenders are drawn to real estate because they can easily verify property ownership (and even acquire insurance to protect them on that subject, called title insurance) and inspect the property quickly and at a low cost. Properties can be insured against most losses like fire and storms, adding a layer of security that’s either difficult or impossible to achieve in other common asset classes.
Unlike luxury items or many commodities, real estate is not easily stolen or resold. A well-maintained property can also have a long useful life of 50 or more years, making lenders comfortable with long-term mortgages. For example, the Empire State Building is expected to last 7,000 years if properly maintained.
These factors are largely unique to real estate, which is why low-cost mortgages are readily available in most countries. Additionally, real estate often generates steady income through lease agreements that are difficult for tenants to escape. Lenders recognize this, and it’s reflected in the terms they offer to landlords. With reliable income backing the property, borrowers are more likely to make their mortgage payments.
Most commercial and residential real estate is purchased using debt for these reasons and others. In the U.S., the government even subsidizes the cost of debt for residential properties. That includes single-family homes, townhomes, and most apartments. Fannie Mae and Freddie Mac are effectively arms of the federal government that issue lower cost mortgages to these property types. That doesn’t always work out perfectly (e.g. the Great Recession), but overall it reduces the borrowing costs of property owners.
Let’s talk about how you are likely to see the debt associated with a property described. Leverage in real estate is most commonly measured using ratios. The loan-to-value (LTV) ratio is the most common. It compares the mortgage amount to the property’s value. For example, a property valued at $1 million with a $650,000 mortgage would have an LTV of 65%. If you are a homeowner, you are familiar with this math when you selected a down payment.
Another important metric is interest coverage, which assesses whether rental income can cover mortgage payments (and any other debt on the property). A healthy interest coverage ratio leaves a cushion for unexpected expenses or problems with a tenant.
The interest rate and term of the mortgage are also important. Commercial real estate loans typically range from five to 20 years (Fun fact: the U.S. 30-year fixed rate single-family home mortgage is an anomaly globally). If the mortgage matures before the desired hold period ends, refinancing may be necessary. This can pose risks if market conditions are unfavorable and is very relevant in today’s market. If a real estate owner purchased a property when rates were lower and the mortgage matures today, they could see up to a 100% increase in the interest rate. There is no guarantee they’ve been able to raise rents enough to offset the extra expense. This is a real problem today in the office sector where rents and occupancy are weaker than other sectors.
When evaluating a private fund, especially if it’s focused on a small number of assets, consider if the mortgages mature before the manager states they expect to sell. If so, that’s a risk you should investigate.
3. Cash Flow: The Foundation of Success
“Cash flow is king” applies to most asset classes, but none more so than real estate. There are a couple reasons for this.
First, because most real estate used debt as we've discussed, dependable cash flow is how the property owner safely covers interest, principal, and tax payments. From a risk perspective, this makes cash flow for real estate investors key. It's tough to achieve a strong return if the bank or county forecloses on the property.
Second, historically half of the returns from real estate investing comes from cash distributions. While capital gains are also important, distributions make up a larger share in real estate compared to most other asset classes. For instance, the historical return from stocks is about one-fourth dividends and three-fourths capital gains.
Also, don't just focus on the current cash flow from the property. Consider the potential for growth, which is often tied to the lease structure. For most triple-net leases, where the tenant covers most expenses instead of the landlord, a 2-4% annual rent increase is common. While not guaranteed, it’s a reliable indicator of possible income growth.
However, if you expect inflation to remain high, the inflation-adjusted change in cash flow for a lower-yielding triple-net property could be minimal or even negative. In that circumstance, self-storage, apartments, and other sectors with more rapid lease turnover could be advantageous.
Final Thoughts
There are almost unlimited aspects to real estate investing. But as an investor, there are a few that outweigh the rest. We discussed three today. Knowing the fundamentals of the property type alone can explain a ton about an individual building or portfolio’s potential upside and risk. Understanding why leverage works so well with real estate compared to most other asset classes, and also creates unique risks, is another major component to real estate due diligence. Lastly, focusing on cold, hard, cash flow rather than relying heavily on speculative capital gains can potentially smooth returns and lower the probability of defaulting on the mortgage loan.
And best of all, these lessons apply to all types of real estate investments. Whether it’s a single asset tax related offering, a publicly traded REIT, or a private real estate fund, you can now start your due diligence process on a stronger foundation.
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