Only rigorous underwriting can determine the quality of a real estate investment. However, these 5 basic factors are the first things to look for:
- Track record
- Quality of the building
Commercial real estate investing can be complex. The industry lingo and due diligence of most deals is often intimidating for the everyday investor with little experience. While all investments require unique examination, in our experience at Fundrise, there are 5 key factors that we consider when thinking about making a real estate investment.
1. Location, Location, Location
While it may seem overstated, the old adage 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 did not 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 the surrounding neighborhood. 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 current condition of the market, is this investment property in a location that I would want to own 10 years from now?”
2. Developer Track Record
After location, the quality and track record of the developer is our next 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 of a project. 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 in the development deal after construction had already commenced. Despite that, Gallery Place has an impressive retail lineup - Clyde’s, Regal Cinemas, Lucky Strike, and Urban Outfitters - and has successfully spurred the redevelopment of downtown Washington DC. This is due in large part to 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 one that focuses 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 (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, which means that it is in limited supply, because there is a finite amount of land in the world. So, if you can buy property today at a good value price (e.g. less than what it woulds cost to build the same thing today), then over the long term, at some point the price will rise.
4. Quality of the Building
It happens that another component of Warren Buffet’s investment strategy is to purchase quality assets. Like a good location, a quality building is one that is well-designed and constructed pays dividends, especially over the long term. High quality buildings not only require less ongoing maintenance and repairs, 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 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 investment property will have approximately 65% debt (e.g., for every dollar of equity that 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 competitive and decides to increase the amount of debt that they are willing to lend, 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 liability. In the last example, if you are 90% leveraged, 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 lies 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 have not mentioned other factors such as tenancy, market competition, debt terms, inflation, transportation and other public infrastructure, operating agreements, or market risks, to name a few. Investing in real estate normally requires more capital, expertise and time than the average investor has.
Fundrise takes the complexity out of real estate making it possible for the everyday investor to invest in the first ever low-fee, low-minimum, diversified commercial real estate investment portfolio. Using a proprietary technology stack and new federal regulations, we’ve engineered a new investment approach designed to outperform the stock market and help everyone earn better returns, more consistently.