Deeper dives on diversification, wealth-building, and making the most of every investment
April 30, 2019
With all the different types of real estate to choose from, investors are often left wondering where to start. We explain the step by step process that goes into finding and acquiring high-potential real estate and best practices for investors to source real estate opportunities to add to their portfolio.
The first step is to identify what real estate property type you want to focus on. The four main property types in real estate are multifamily, industrial, office, and retail. All of these property types have their merits but today we will focus on multifamily acquisitions.
Multifamily investing is the most popular investment choice for most investors who want an extra source of monthly income along with slow and steady appreciation in the value of their portfolio. Additionally, multifamily has performed the best of all the different property types through different market cycles on a risk-adjusted basis. However, many of the sourcing information we’ll share can be applied to industrial, office and retail real estate investments.
The next step is to determine where in the risk-return spectrum you want to invest. There are four strategies of real estate investing within each property type. Ranked from least to most risky they are:
– Core plus
These strategies are characterized by both the physical attributes of the property and the amount of debt used to capitalize a project. Whichever type of investment you choose will depend on your personal appetite for risk and your long-term financial plan.
Core real estate investments are characterized by stable income and low risk. Typically these properties are in high demand primary markets, have low vacancy rates, creditworthy tenants, low leverage, and are the most expensive to purchase. Core properties require very little asset management and are as close as one can get to a passive investment when purchasing real estate directly. The majority of the potential return is expected to come from cash flow rather than appreciation. This type of return is synonymous to dividend income in the stock market.
Core plus real estate investments are very similar to core except that they are not quite as high quality. These investments are for investors who generally want a safe return but are also looking for a little bit of upside potential. These properties may be in suburban areas or secondary markets. They typically require minor enhancements such as repositioning, re-leasing or light property improvements. They also tend to have higher levels of leverage than core and often times require some additional capital investment. The potential return of these investments is a mix of cash flow and appreciation.
Value-add real estate investments are associated with less stable income and more risk than core plus. Typically these properties are located in suburban areas, secondary or tertiary markets. They are usually cash-flow positive but tend to underperform compared to similar nearby properties due to factors such as high vacancy rates, management issues or deferred maintenance. They may also require extensive enhancements, such as redevelopment, releasing and repositioning. Value-add investments have slightly higher levels of leverage than core plus and require more capital investment. Owners of this type of multifamily property should have a deep knowledge of real estate, strategic planning and be prepared to provide daily oversight of the project. The objective of such an investment is that the property will produce significantly more cash flow once improvements are completed, which will also raise the value of the property.
At the end of the risk-reward spectrum, we’ll find opportunistic real estate investments. These properties are either highly distressed, new development or in emerging markets. In most cases, these properties are generating very little or no cash flow and are highly leveraged. The majority of the potential return on these investments comes from increasing the value of the property through major enhancements or long-term market appreciation.
After you have decided on the “what” (property type), you need to decide on the “where.” Another part of this decision is based upon how actively involved you want to be in the management of the property. Ask yourself these questions:
– Are you are planning on being involved in any type of property management yourself?
– If the property you select needs some work; do you enjoy managing every step of the process, from redevelopment to repositioning to releasing?
– Are you experienced enough to do all of this on your own? Do you have the time and a flexible enough schedule?
If you say yes to these, it probably makes more sense to focus on properties close to where you live. If not and you are thinking of taking a more passive approach in your real estate investment strategy then the whole world is open to you.
Many investors prefer to focus on properties in their own country or in a geography that is familiar to them because they have more knowledge and information about those areas. Once you have a general area in mind it is important to compare the demographics of the areas you have identified. These factors include average age, income, school quality, crime rates, migration patterns, population growth, job growth, and unemployment.
If you are interested in a smaller market it is also important to look at employer diversification. For example, if you are looking at a small market where a single manufacturer employs the majority of the population, you should be cognizant of the fact that if that manufacturer moves or goes out of business it will have a drastic effect on the demand for rental units in the area.
The supply and demand of the local market is also very important. Factors to look at include:
– Are there a large or small number of new building permits being granted? Is the trend going up or down?
– Is the vacancy rate increasing or decreasing?
– Is the average rent trending higher or lower in the past five years? How do these trends compare to the general market?
Once you have identified from a macro perspective which target market you intend to invest in, it is time to start sourcing properties.
A good starting point to find available properties is to check the local listings on LoopNet, the MLS for commercial properties, to get a pulse of the market. You can view important information such as the capitalization rate (‘Cap rate’), number of units and the class of the building (A,B,C and even in some cases class D).
Another valuable piece of information you can get from LoopNet is seeing who the most active agents are. If you are not a professional investor, a well-connected agent can be a valuable resource. However, don’t discount the lesser known agents who may have more time to work with you.
It is up to you whether you engage a buyer’s agent or not but there are several benefits to working with a local professional:
– A commercial agent will save you time by looking through listings, researching properties that fit your parameters, scheduling tours, and drafting offers.
– They may be able to save you money by negotiating the price and terms of the transaction.
– They may have access to off-market properties, which leads into our next section.
Similar to looking for listed properties you can either work with an agent or do it yourself. The first thing you might ask yourself is: why would anyone not want to publicly list their property? It seems counterintuitive that a seller would not want their listing in front of as many people as possible, which would lead to more bids. However, there are a variety of reasons why a seller may not want their property in the limelight. Real estate is a locally fragmented, relationship-driven business. Most successful brokers have a large pool of buyers who love to buy properties off-market. The seller is able to test the market, keep control over the selling process and also maintain their privacy because often times the impetus for a sale could be a partnership gone sour, divorce, estate sale, etc.
A good network is the key to getting access to off-market opportunities. Local brokers and potential sellers respond to investors who are well prepared and most importantly, ethical. Preparation includes being knowledgeable about what you are looking for and being pre-qualified if you are using debt to partially finance your purchase. Your goal is to be on the short list if any properties come up. Brokers are often motivated by the path of least resistance, and not always by getting the highest possible price. Arranging debt financing is the longest part of the purchase process so if a broker knows you are pre-qualified, they know you will be able to close quickly and are more likely to work with you.
Beyond the brokers there are several other channels for potential deal flow:
Now you should have a solid framework to jumpstart your journey in investing in multifamily commercial real estate. If the process seems tedious and complex, that’s because it is! Investing in the right properties and driving long-term positive cash-flow is a commitment, and our team of investment specialists knows it.
For individual investors, accredited or not, who are eager to enjoy the benefits of investing in multifamily CRE but prefer to take a more passive approach to their portfolio, DiversyFund has the solution. We offer high-quality real estate investment opportunities, all through our automated online platform.
About the Author:
Mike Mitchell is the Capital Markets Manager at DiversyFund. He has over 15 years of experience in financial research and sales, asset allocation and portfolio management on both the buy side and the sell side. He has consulted with and raised capital for almost the entire spectrum of traditional and alternative investments, with an emphasis on real estate funds, private equity funds, hedge funds, and private placements.
Over the course of his career, Mr. Mitchell has raised over $200 million of equity. He received a BA from UCSD in Economics and holds the Chartered Financial Analyst (CFA) and Chartered Alternative Investment Analyst (CAIA) designations.