Commercial real estate investing can be complex. The industry lingo and analysis of most deals often proves intimidating for the average investor with little experience. While no investment is easy, in our experience there are 5 key factors we consider when thinking about making a real estate investment, whether on Fundrise or through other means.
1. Location, Location, Location
While it may seem obvious, the old saying is true and many people underestimate the power of well-located real estate. During the run-up to the 2008 recession, many financial institutions invested in places where demand didn't yet exist, like the remote suburbs in Southern California. When the housing boom stopped and the bubble burst, the real estate itself had very little inherent value due to its location. One advantage of investing in local real estate is that you know the property's location and understand what is going on in the surrounding area. Additionally, the internet has given rise to many tools that help investors learn about a real estate market. A simple way to think about it is: "Regardless of the condition of the market, is this a location I would want to own 10 years from now?"
2. Developer Track Record
After location, the quality of the developer and their track record is our most important measure. An ethical, competent developer is critical to the success of any real estate development. Like with any company, an experienced entrepreneur has the ability to manage the inevitable ups-and-downs and can make all the difference between failure and success. For example, during the development of Gallery Place at 7th and H St NW in Washington, DC, four retail tenants - AMC Theatres, Jillians Bowling, Borders Books, and Virgin Megastore - either went bankrupt or fell through after construction had commenced. Today, however, Gallery Place has a great retail lineup - Clyde's, Regal Cinemas, Lucky Strike, and Urban Outfitters - and successfully spurred the redevelopment of downtown in large part because of the experienced development team of Akridge and Western Development.
Like Warren Buffet's motto when it comes to stock investments, we believe the most reliable real estate investment strategy is to focus on value. Buying value means purchasing properties at or below their replacement cost (the cost to build the same building today). If it costs $350 per square foot (NYSE:PSF) to build a new building and you can buy an existing one for $250 PSF, then you have made a value investment. Real estate is a hard asset, a commodity, which means that there is a limited supply. Unless we start building new islands, ultimately there is a finite amount of land in the world. So if you can buy property today at a good value price (i.e. less than what it costs someone else to build the same thing), then over the long term, at some point the price will rise.
4. Quality of the Building
As it happens another component of Warren Buffet's investment strategy is to purchase quality assets. Like a good location, a quality building that is well designed and constructed pays dividends, especially over the long run. High quality buildings not only require less ongoing maintenance and capital repairs, but they also tend to lease faster and at higher rents. The best quality buildings are unique, LEED certified, and create a sense of place, which in turn can bring crowds. Crowds = demand, which in real estate is almost always a good thing.
5. Leverage (Debt)
The amount of debt on a property will magnify both your investment returns and risk. To give you a sense of just how powerful leverage is in real estate, let's look at an example of a real estate deal under normal conditions. Typically, a real estate deal will have approximately 65% debt (i.e., for every dollar of equity you put in, the lender will give you roughly two dollars in debt). Imagine now that the real estate industry starts to boom and bankers begin to compete to give out real estate loans. If the lender gets aggressive and decides to increase the amount of debt, your equity can buy a lot more real estate. For example:
- 75% debt - lender gives you 3 dollars for every 1 you put in
- 80% debt - lender gives you 4 dollars for every 1 you put in
- 90% debt - lender gives you 9 dollars for every 1 you put in
As you increase your leverage and total debt amount, you increase the amount of property you can purchase and therefore potentially profit from. But increased leverage also exposes you to much greater risk. In the last example, if you are 90% levered, a minor 10% swing in the property value or annual income can wipe out your entire investment! We believe that a healthy amount of debt is somewhere between 60% - 75% depending upon the individual deal. It is also important to understand the capital stack, and if there is any money senior to your equity other than the senior lender-which is the case with deals that involve preferred equity and mezzanine debt.
These are just a few things to look for when evaluating real estate investments. We did not even mention tenancy, market competition, debt terms, inflation, transportation and other public infrastructure, operating agreement terms and fees, market growth and risks, among many others. Learn more about our rigorous underwriting process here.