Why NOT to invest in Commercial Real Estate?

We’ve seen the reasons to invest in Commercial Real Estate (CRE) in a previous article. Though we believe that every investor should have access to Commercial Real Estate as an asset class, it may not be a good asset class to invest in for some investors due to certain characteristics of the real estate asset class. The purpose of this article is to go through the major reasons NOT to invest in real estate. This way an investor can evaluate for herself the pros and cons of investing in real estate and make an informed decision about real estate investing.

Long term horizon and illiquid

First and foremost, Real Estate is the least liquid of the major asset classes i.e. you may not be able to take out your money immediately when you need it. This applies to real estate private equity, syndicates, or investing directly in the assets (not through REITs). You could sell your stocks or bonds and cash it in a matter of hours, in real estate it will take months.

Real Estate also has evolved over the decades and the liquidity problem is solved by public REITs. REITs maybe an ideal vehicle for investors who want to invest in real estate, but want liquidity. REITs behave like securities and hence investors can buy and sell like any of their favorite stocks. REITs in turn have to buy and sell capital and illiquid assets which may take months.

Source: https://equitymultiple.medium.com/illiquid-assets-an-introduction-eede56c1e947

The above chart from EquityMultiple real estate platform goes into the various offerings and the liquidity aspect. If an investor doesn’t have the appetite for the long-term and illiquid nature of the real estate, it is best to think of alternatives.

Capital intensive

Real Estate, by definition, is capital intensive. Though real estate can use leverage, an investor may still need to layout significant capital for many real estate types. Here are the top three CRE sales in NYC in 2020 to give an idea of the capital-intensive nature of CRE:

424 Fifth Avenue | $978 million
Buyer: Amazon
Seller: WeWork, Rhône Group
Brokerage: N/A

410 Tenth Avenue | $952.5 million
Buyer: 601W Companies
Seller: SL Green Realty
Brokerage: CBRE

330 Madison Avenue | $900 million
Buyer: Munich RE
Seller: Abu Dhabi Investment Authority
Brokerage: CBRE

Source: The Real Deal

All of us will agree that raising $978 million is no small capital raise even for large institutions though there will be multiple sources of capital including debt. There are options for investors to invest in real estate without a large capital commitment (e.g. REITs), but we need to keep in mind that real estate projects and assets are very capital intensive directly or indirectly.

Risk tolerance and scars from global financial crisis

The first rule of investment is don’t lose money. And the second rule of investment is don’t forget the first rule. And that’s all the rules there are.

Warren Buffett

Is real estate a good investment for a risk-averse person? All asset classes have varying levels of risk, but let us address real estate in this article when compared to other asset classes. The chart below from Smart About Money illustrates the risk of loss of principal and increasing potential for capital appreciation in the chart below.

Source: Smart About Money Determining Your Risk Tolerance

There can be a wide variety of risk level within the real estate property types and deals, but real estate as an asset class falls somewhere in the middle of the risk spectrum i.e. there is a probability that you could lose your entire money and even more. For e.g. you could lose your equity money and a lot more if you’ve provided a loan guarantee and the deal goes way south.

The residential Real Estate sector was a trigger for the Global Financial Crisis and it affected millions of people. People who remember it well may not have a good association with real estate and may have developed a risk-aversion. If you’re one such individual, there is a lot of preparation and groundwork that needs to be done even before you invest your $ in real estate.

Investor Takeaways

This article is the yin to the yang of ‘Why bother to invest in Commercial Real Estate?” We’ve looked into three major reasons NOT to invest in real estate. First, the illiquid nature of real estate for private placements and direct holding of assets. Second, the capital intensive nature of real estate outside of REITs. Third, is the relatively higher risk tolerance needed for investors compared to some other asset classes. It is best for an investor to consider their financial situation, understand the risks involved before proceeding (or not) with investing in real estate.