Investing in Commercial Real Estate

Includes: HRP, LOOP-OLD
by: Lloyd Sakazaki

A reader asked: "Could you recommend any investment group where small investors can pool their money to purchase investment properties such as shopping centers, apartments, etc.?"

What you appear to be looking for is a reputable national or regional real estate syndication company through which to invest, relying on their deal-sourcing and management expertise to achieve solid returns in commercial real estate. I will assume for the sake of this discussion that as a small investor you are looking to invest anywhere from a few thousand dollars to a few tens of thousands of dollars, but not much more than about $100,000 to begin with.

Basically, there are two primary avenues for achieving exposure to commercial real estate:

1. Direct investment in properties as a self-guided investor either individually or through small partnerships, LLCs or tenants-in-common [TIC] arrangements; and

2. Indirect investment in real estate by purchasing shares of publicly listed and traded REITs.

By doing their own due diligence, small investors can invest directly in a variety of commercial real estate properties, such as free-standing retail locations, apartments, small office buildings, mobile home parks, etc. Loopnet (Nasdaq: LOOP) is a good starting point for seeing what properties are available in markets throughout the U.S. The commercial property brokers who post their listings on Loopnet can provide additional listings and local market information. Since you expressed interest in retail properties, you might also try Net Lease Exchange for listings of triple-net, single-tenant investment opportunities.

The other common way to achieve exposure to commercial real estate is through REITs. The National Association of Real Estate Investment Trusts [NAREIT] offers information about investing in REITs on their website and tracks various REIT indices and the performance of individual REIT stocks across the retail, office, industrial, apartment and other less traditional sectors. More information on individual REIT stocks is, of course, available via their ticker symbols on Yahoo! Finance and other financial websites.

Between these two popular extremes--small investment groups set up locally and publicly listed REITs with thousands of investors--there tends to be a void dictated by securities laws aimed at protecting unsuspecting small investors from fraud and other financial chicanery. Private-equity investment vehicles do exist for so-called "sophisticated" investors with at least $1 million of liquid net worth, typically with minimum investment requirements of $100,000 or more, and there is an active wealth management industry catering to the growing number of such millionaires. However, for small investors with less capital to invest, the practical alternatives are really the two I have outlined.


So, if you are eager to invest in commercial real estate and apartments, here is what I suggest:

1. As I have done over the years, strive to adopt a do-it-yourself attitude and go out and look for commercial real estate and apartment buildings for sale in your local market. Try to identify properties that you believe are attractively priced and offer generous upside potential. If you find a property that you want to buy but cannot because it requires a larger down payment than you can afford or a larger loan than you qualify for, try to find an investment partner or two of like mindset to pool funds with.

2. Using typical financial operating ratios (gross rent multiple, cap rate, cash-on-cash return, price-to-FFO, etc.), compare the direct investment opportunities you are finding in your own local market with publicly listed REITs invested in the same property type, analyzing the income statement and balance sheet of a REIT as if you were buying its entire portfolio of properties. If you find that REITs offer more attractive ratios than you can achieve by investing directly in properties locally, you might be better off buying REIT shares.

Over the years I have achieved exposure to investment real estate both through forming partnerships with small groups of local investors and through buying shares of publicly listed REITs. In 2002, following the dot-com bust when stock prices were depressed and office vacancy rates rose to double-digit figures in many metropolitan markets (where I live in Bellevue, Washington, the office vacancy rate soared to above 25%!), I performed the type of financial ratio comparison I mentioned above and concluded that office REITs were more attractive than any office buildings or apartment properties I could buy directly anywhere in the Pacific Northwest. As good fortune would have it, two of the REITs I invested in--Equity Office Properties run by Sam Zell and Trizec Properties managed by a former Equity Office CEO--were recently bought out by the Blackstone Group at significant premiums to where the shares had been trading prior to the private-equity buyout offers, providing very healthy returns over my five-year holding period.

If you happen to reside in the Seattle-Bellevue area and wish to exchange views on real estate opportunities you are seeing locally, I would be happy to share further information and opinions. For anyone looking to gain exposure to commercial real estate and particularly for those who reside outside of my local market in Washington state, I offer an alternative suggestion: Although most REITs appear to be fully valued following their sequential double-digit returns over the past few years, I believe that a few are worthwhile considering at current price levels.

One such REIT is HRPT Properties (NYSE: HRP), an office REIT now trading at about $11 per share, 17% below its dividend-adjusted all-time high of $13.31 reached in February 2007. With shares priced at below book value (price-to-book ratio is 0.98) and forward price-to-FFO of 9.2, HRPT looks relatively cheap compared to the other major office REITs. Based on its stable long-dated lease portfolio of high-quality government and medical-related tenants and presence in markets offering incrementally higher cap rates and cash flow, HRPT offers very good upside potential with limited downside risk at present price levels. Also, its dividend yield of 7.6% (at $0.84 per share annually) should be appealing to anyone seeking current income beyond money market and bank CD rates. (I do not currently have a position in HRPT but will consider establishing one the next time I rebalance my portfolio.)