Clifton McCrory, Vice President – Investment Advisor
The commercial real estate (CRE) market spans a wide range of asset classes. Segments like industrial, multifamily and office each have distinct risk and return profiles, and as market conditions shift, an asset class that appeared stable in one period may seem less so a few quarters later. For new investors, it can be hard to determine which opportunities merit further evaluation.
Whether a deal is right for an investor often comes down to how comfortable they are with the risk it entails. This is a personal decision that will vary significantly from one investor to another. As such, it helps to have a clear picture of their own risk tolerance before they begin reviewing specific opportunities.
Working With a Trusted Advisor
There are several steps an investor can take to better define their risk appetite. The first is to work with a trusted advisor who has experience in the location and industry they plan to enter. A seasoned advisor is a valuable ally at every stage of an investor’s CRE journey. If an investor is just starting to explore the space, they can help them parse out their risk tolerance and determine which asset classes might be a fit. If they already have a specific deal in mind, they can walk the investor through its structure, potential upside and the risks involved.
Understanding The Deal
A useful rule of thumb for any investment is to avoid deals that cannot be clearly explained. Before committing capital, investors should make sure they understand how a deal pencils out. In the net lease sector, for example, a deal’s strength typically depends on three factors.
- Tenant Credit: As a CRE investor, income will be driven by rent from the tenant(s), so their financials must be sound.
- Lease Structure: Whether a lease is absolute triple net or gross, how long it runs and where rents sit relative to the market, will all influence the scope and stability of the income stream.
- Asset Location: Location affects demand, which can impact returns, especially if the investor needs to re-lease the asset in the future.
Together, tenant credit, lease structure and location provide a solid baseline for assessing an opportunity. If a deal compares favorably across these three factors, they can then work with their advisor to review the underwriting in more detail and determine whether it aligns with their risk tolerance.
Deciding on the Level of Involvement
Another key consideration is how active a role the investor wants to play in managing their asset. Some CRE deals require significant involvement from the investor; some are entirely passive. For example, if you invest in a small multifamily property, you’ll likely be responsible for handling repairs, interfacing with tenants and filling empty units. In contrast, if you purchase a property with an absolute triple-net lease, the tenant will be responsible for taxes, insurance and maintenance. In this scenario, your role will largely be limited to collecting rent and re-leasing the space if the current tenant moves out.
An investor’s role in a deal will affect both risk and return. Opportunities that require greater day-to-day involvement tend to offer higher potential returns. Meanwhile, more hands-off deals will involve less engagement on the investor’s part, but often yield more modest results.
Researching Live Deals
Once the investor understands the basic mechanics of a CRE deal, review some live opportunities with their advisor. Look closely at the metrics and underwriting, including how returns are generated, how much capital is required and what debt terms may be available. From there, the investor should consider how the deal aligns with their individual investment preferences. Like risk tolerance, these preferences are highly personal. One of the best ways to identify the right opportunities and asset classes is to focus on deals that reflect personal goals.
Starting Small and Scaling Up
It’s easy to assume there will be one “best” asset class for a risk profile. The reality is that CRE is cyclical, and the performance of any given asset class will change from year to year. For instance, in the aftermath of the pandemic, the healthcare sector saw major gains. A few years later, however, demand had cooled. In contrast, shopping centers were depressed during the pandemic, but have since rebounded.
For this reason, it’s important not to over-extend. The most successful CRE investors are generally those who concentrate on asset classes they understand, and when branching out, learn how new segments work before allocating too much capital. That means speaking with different operators, reviewing different deals and getting familiar with how CRE investments are structured. Over time, that process will make it easier to identify opportunities that align with an investor’s risk appetite.
Want to discuss which CRE investments fit your risk appetite? Connect with a SIG Advisor.
