Back when we were young, fresh-faced students coming out of school and entering the real world we likely had a basic understanding of investing that was limited to publicly traded stocks. Then, as we matured, we all came to realize that investing in publicly traded stocks was only one of the many ways that we could invest our money in the hopes it would grow. Such options are now more diverse and more available than ever and are no longer the exclusive domain of large investors and financial institutions.
One such investment is commercial real estate. This investment class typically takes significant amounts of capital and historically has been a relatively illiquid investment. Over the years, however, those features have significantly changed, and now there are more ways to invest in commercial real estate than ever before.
But before we discuss the ways you can invest in commercial real estate, it must be emphasized that all investments in commercial real estate are not equal. It stands, as with all efficient markets, the greater the risk, the greater the reward (or loss). Commercial real estate is no different. And those risk profiles have designations that are common among most investment classes: debt and equity.
Debt vs. Equity
In a single commercial real estate investment, where your investment sits in terms of its exposure to loss has a direct relationship with the projected yield. For example, if you make a debt investment, your investment has a higher priority than the equity investors. Therefore, if a loss occurs, the equity would typically absorb those losses first before any of the debt. However, the debt typically receives a lower return in exchange for that enhanced security, irrespective how successful the investment may turn out.
Conversely, if you make an equity investment, you likely sit in a position with a greater exposure to loss than does the debt. This means that your investment has the lowest priority, and, should the project suffer a loss, the equity investors would be the first to absorb it. However—and this is why equity investments are attractive—if the investment exceeds projections, the equity stands to make substantially more on a percentage basis than the debt investors. This is because unlike debt investments, the upside is unlimited and the downside is typically limited to a total loss of your investment.
Having covered that basic concept, below you will find five ways you can invest in commercial real estate.
1. Sponsor Investment
We’ll start with the most complex, and potentially the most profitable, of all investment methods: serving as a commercial real estate investment sponsor. This means that you are going to lead the commercial real estate investment as the deal sponsor, the one responsible for executing the business plan. If you’re taking this path, you probably have some experience in the field already and you have identified a property which you believe would be a great investment. You may have come upon it because of a personal relationship with the seller or the tenant, or you are aware of changes that are going to positively impact the value of the asset. To successfully execute this plan to capitalize your investment, you will need to contact a commercial mortgage broker to assist you in finding a loan and you will need to raise the equity from friends and family, an outside investor, or use your own capital. By investing in this fashion, you greatly increase your level of involvement and commitment, but if you’re a competent sponsor and able to perform, you will capture the greatest available upside. However, this method of investing is not for the faint of heart. It requires some basic competency in the field, otherwise, there is significant potential for losses. Unless you have that basic competency, I would not advise you to attempt this unless you have experienced professionals to help guide you.
2. Equity Investment
Another way to invest in commercial real estate is through a direct equity investment in a single asset. The term “direct”, used in this context, is a measure of how close your investment is to the source of the investment. So, a direct investment is one in which you have a direct equity relationship with the sponsor. A less “direct” investment is one in which there are one or more intermediaries between you and the source of the investment. There are various ways one can make a direct investment in commercial real estate and various forms it can take. Some of those methods would be to invest through:
- A direct relationship with the investment sponsor.
- A relationship with an equity investor looking for other equity investors to make a direct investment.
- An equity broker who is aware of your desire to make a direct investment in a commercial real estate asset who pairs you with a sponsor.
The various forms this investment can take include:
- Co-invest equity that is provided alongside sponsor equity.
- Common or JV equity, in which returns are entirely dependent on the final outcome of the investment but has “voting” rights.
- Preferred equity, which receives its principal prior to other equity holders. This also receives a periodic dividend during the investment period in exchange for capping their potential profit but has no defined “voting” rights.
As you look at these options, evaluate which structure best meets your preferred risk profile and desired level of involvement.
3. Syndicated Investment
There are many names for this type of investment, including syndicated, clubbed, pooled, comingled, crowdfunded, etc. While these may imply modest variations, the common thread is that it represents multiple equity investors that hold an equal position in a commercial real estate investment or investments. There are different ways to invest utilizing these structures and several ways these structures may hold their assets. A couple of the most common investment strategies are below.
“Friends and Family” Syndication
This occurs when someone in your network presents you with an opportunity to make an equity investment with others in a specific commercial real estate asset or assets.
You can invest through a professional syndicator who is paid by the sponsor to aggregate equity investments for specific commercial real estate asset or assets. Currently, those professional syndicators are being displaced by crowdfunding platforms, which allow sponsors to capture a much wider audience of investors and perhaps raise the total amount in smaller increments.
Sponsor Direct Syndication
You could also invest directly through a sponsor who offers equity investments in specific commercial real estate assets owned by the sponsor through a direct offering model. Another way in which these can work is the sponsor can syndicate equity for one or more specific real estate investments. The sponsor could also syndicate capital for a blind pool that is intended for a single, or a portfolio of, commercial real estate investment(s) as defined by the sponsor. The majority of equity raised from individual investors in this type of syndicated structure is for a specific predetermined asset or portfolio of assets. On occasion, it could happen that these syndicated investments could be arranged for a yet-to-be-named asset or portfolio of assets, but that is far rarer and generally reserved for investment in funds.
4. Private or Non-Traded Commercial Real Estate Fund Investment
These investments take on many forms and many names. They are occasionally referred to as private equity, equity funds, private real estate investment trusts (“REIT”), non-traded REITs, private debt funds, private mortgage REITs, non-traded mortgage REITs, etc. The one thing they have in common is they are all private and/or non-traded offerings. The single defining factor of this group of investments is their limited, or lack of, liquidity. This means when you want to sell your investment, you are typically restricted from doing so, or may only do so during specific periods of time and likely with a penalty. However, as in most cases, there is an offset, which is that these funds are typically able to outperform their publicly traded peers. This is because their capital positions are more certain and their ability to time their acquisitions and dispositions is superior to that of traded securities.
For the individual investor, these investments are offered through numerous channels but are most often accessed through your wealth manager’s investment platform. If you are serious about making an investment in this kind of structure, be sure to do your homework. Many do not have the same transparency requirements as their publicly traded counterparts. That is not to say they are bad investments—in fact, most are very well run and high performing funds. But be sure you understand all the ins and outs of this type of investment and that you are comfortable committing your funds for a defined period. Work with your financial professional to find one that’s right for you if this is your preferred method of investing in commercial real estate.
5. Public or Traded Commercial Real Estate Fund Investment
In terms of ease of investment, this method is king of the hill, but in terms of how direct it is, it’s looking up at all the others. These types of investments take on many forms and names as well such as: REITs, commercial real estate mutual funds, commercial real estate ETFs, traded commercial real estate companies, commercial mortgage REITs, commercial mortgage debt mutual funds, commercial mortgage lenders, commercial mortgage-backed securities (“CMBS”) or even hybrid REITs, which hold a combination of both equity and debt. You can even focus on sectors such as hotel REITs, medical office REITs, retail REITs, student housing REITs, self-storage REITs, etc. Additionally, there are Mutual Funds and ETFs that hold any combination of these investments in a fund structure. It seems today the ways in which you can invest in commercial real estate through the public securities is only limited by your imagination. And there are many other ways you can invest in commercial real estate debt through the bond market as well which can be equally as diversified. In the end, the real upside of this method of investment is its accessibility, low cost of participation, and liquidity (ability to get out when you want). The downside is its potential volatility and cost inefficiency due to the layers of expenses required to offer this investment as a public security.
Commercial real estate investing can be complicated, so we always encourage you to contact a financial professional before making these types of decisions. However, if you choose to make the commitment, the rewards can be considerable. If you are interested in learning more about the different types of commercial real estate investments, or have a commercial real estate question, please feel free to contact us.