Have you thought about the first thing you notice when you shop for an item? It is very likely that you look for the price tag. We look for the price tag even if money is not a concern. Let us suggest a mental exercise. Please think about an investment (any) and take note of the first few things that come to your mind.
Many of us will think of profit first i.e. how much money will we make off the investment? After all, isn’t that the purpose of investing? Here’s where investors differ in their sophistication. When it comes to real estate investing, price or valuation is an important factor, but not the only factor. Outside of valuation, there are four key factors that are key to real estate investing: Time horizon, Liquidity, Risk Tolerance, and Property Type. We’ll get into each one of these in detail.
Time Horizon and Liquidity
What is your time horizon to invest? Are you looking for monthly returns or can you wait for years or decades as you build your retirement money? If you’re looking for monthly or quarterly returns you can get it from dividend yielding REITs or stabilized assets that provide monthly cash flow from operations that can be distributed to investors.
Would you be dipping into the investments for emergencies? Many real estate investments are illiquid in that it may take months or years to get out of the investment. For e.g. if you’re investing in a private real estate fund or syndication it is likely that you’d have to hold the investment for 3-7 years. You do have some options, limited though, if you’d like the RE investments to be liquid. For e.g. Publicly traded REIT securities.
Location, Location, Location
Your are sure to have this common refrain in residential real estate that it is all about the location. This is true across the entire asset class and the location will determine the risk, price and quality of assets. The key differentiator for an investor is to identify the next hot location rather than the ones already popular. That is how an investor will make money by betting on new up and coming locations.
Property Types
Property types have different risk/reward profiles and hence it is important to understand and appreciate the property type in question. It is key to understand the different types of property types, not to just understand the lay of the land, but also to form your investing approach and nail down the basics. The following chart from NAREIT captures the different property types. The major property types are Multi-family, Office, Retail, Health Care, Specialty, Hospitality, and Industrial.
It is common to start with one property type, learn the basics, and then add other property types to diversify. Many of the CRE concepts are applicable to all property types and each property type will have its specialization, differentiators or nuances. We will start seeing that there are many similarities, but there are also differences across property types. The key investment criteria is that they will have different risk profiles that the investor needs to understand. Multifamily has a different risk profile than Office, with different factors affecting the rent and prices. Commensurate with the risk, the investment rewards will also be different across property types.
Risk tolerance
We have discussed risk tolerance in prior posts as risk/reward is the bedrock of investing. Your tolerance of risk is going to make or break many investment decisions to see if you get to enjoy it or regret it. Combined with the above factors, like low liquidity, one bad investment can make you suffer for months or years. There is no stop loss on real estate like stocks.
The property type will dictate the risk, IRR, cap rate etc. and determine your returns and hence it is very important. For e.g. you may have heard about the retail “apocalypse” in all of main stream media and intuitively understand that retail property type is working through some issues. At the same time, you may have heard about the affordability crisis in many cities and may understand that there is not enough supply of houses.
Quality of Assets
A given asset in a property type can be further sub-categorized and the category may have its own nuances. You may have heard class A, B or C for multi-families. In general,
- Class A – Newer properties in desirable “hot” locations. Rents are the highest and therefore prices are the highest.
- Class B – Middle of the road properties, usually more than 20 years old, in solid locations. Rents are middle range and hence prices are also similar.
- Class C – Older properties in neighborhoods, may not be in great condition and less desirable than Class B locations. Rents are the lowest and prices are also the lowest.
It is important for investors because as mentioned in the description, risk, rent, price and returns vary by the class of property in big ways.
Takeaways
Even within the asset class of Commercial Real Estate, an investor has multiple considerations to evaluate risk and do the due diligence. Some are common across the entire asset class and some are different across the property types within the CRE asset class. The common key considerations are the long time horizons and illiquid nature of the asset. The other considerations are risk tolerance for each property type and the quality of assets within the property type.