In Chapter 2, we presented the investment selection matrix, which outlines your alternatives when choosing the kind of real estate investment to make. You can choose to invest in the following types: public equity, private equity, public debt and private debt. In this chapter, we will expand on these structures with a particular focus on equity real estate investments.
Public equity is made up of real estate securities such as standard equity REITs or publicly traded real estate operating companies. Because investments are traded on a stock exchange, they tend to exhibit return patterns that are similar to equities, even though the underlying assets are real estate.
At any point in time, these public securities will be trading at a discount or a premium to their net asset values (NAVs), meaning that the value of the company is different than the sum of the underlying real estate values. This occurs as a result of the stock market valuation of these securities, which incorporates things like investor sentiment and psychology. It is important to be aware of this characteristic when making an investment in a real estate security because such investments can perform very differently than the underlying real estate that these public companies own.
One of the benefits of buying a security is the relative ease of acquisition. You buy it in the same manner as you would buy a stock – phone your broker, make the order and pay the relevant commission. You also achieve good liquidity with these investments, because they can be sold on short notice into the market with none of the usual delays that take place in the private market.
Private equity real estate investing is the traditional ownership method. If you own a home, you’ve participated in this market.
There are a number of things to keep in mind when looking for deals, here are a few tips to follow:
- The key to locating investment opportunities is to be in touch with the various deal sources. You should get to know various real estate brokers and dealers. It also helps to have a network of other real estate owners, so you can keep up with an ever-changing market. You can find deals in unexpected places, such as your banker, lawyer, mortgage broker or through foreclosure records.
- Over time, your reputation becomes very important in maintaining a reliable flow of investment opportunities. If you are a person that people want to deal with, opportunities will come to you easier.
- Take your time to find the investment that meets your desired characteristics. You’ll be better off waiting for the right investment than rushing into a questionable one.
- Look for positive fundamentals in all of your investments. Always ask yourself what drives tenants to want to be in the building you’re considering, and what could happen in the future to affect the desirability of the property. Consider things such as quality of tenants, building configuration, location, condition and ability to finance.
When you find the right deal, always complete a financial analysis to make sure the returns meet your investment criteria. If you need financing, speak to a lender or a mortgage broker to determine what type of mortgage is available, and then include the financing in your financial model.
It is also worthwhile to complete a thorough due diligence on your prospective investment. This process can include having reports completed on the physical and environmental condition of the property, and having an appraisal performed. Your lawyer will be able to obtain a variety of search results and will assist in examining the title. Depending on the complexity of the purchase, there are many other tasks that may be required.
There are many costs related to due diligence and the purchasing process, so be sure these costs become part of your financial analysis. Some typical costs include lawyer’s fees, financing fees, appraisal costs and other administrative fees.
Don’t think that your job is done after your purchase; here are some things you need to consider after purchasing your piece of real estate:
- You should determine how you are going to manage the investment. Will you do it yourself or hire a manager? Remember that cost accounting will be required.
- Tenant relationships are critical, so always respect their requirements and maintain a working business relationship with them.
- Remember that if you hire a property manager, they are not managing the long-term strategy of the property, unless it is specifically agreed upon that they will handle that role. It is up to you to ensure the long-term viability of the investment and to instruct the property manager with respect to strategy, such as redeveloping or selling the property.
- The decision to sell is as important as the decision to buy, but remember that there will be trading costs associated with completing a sale.
Public and Private Debt
A common example of public debt is a commercial mortgage-backed security (CMBS). A CMBS is a pool of mortgage loans that are assembled by a lender, and then sold in tranches to the public market. As borrowers make their regular mortgage payments, the proceeds are pooled together and then are paid to the owners of the debt securities in a priority dictated by the rating of the security.
The security’s rating is determined by a third party rating service such as Moody’s, Fitch, Standard & Poor’s and Dominion Bond Rating Service. The rating process involves the agency reviewing the pool of mortgage loans, including an examination of the underlying collateral assets, to determine the quality of cash flow that is likely to be derived from those loans.
If the loans are of a very high credit quality, a larger proportion of the mortgage pool will be assigned an AAA rating. The rating categories are consistent with bond rating categories, so for instance the A tranche is subordinate to the AAA tranche, and the buyer of the B-piece will be subordinate to all of the more senior tranches. Usually, all the holders of the more senior securities must receive their principal and interest payments before the subordinate pieces receive theirs. As such, tranches with lower credit quality are riskier, but have higher return potential.
Because each tranche of the loan pool has a different set of risks, maturity, sensitivity to changes in interest rates and return, your investment decision should be based on the type of exposure you require for your portfolio. It should also incorporate your assessment of the interest rate environment and any likely changes. CMBS securities can be purchased from a broker of such securities. It is recommended that you consult with an advisor prior to purchasing such securities because they can behave differently depending on the interest rate environment.
Private debt is not so much purchased as it is issued. That is, if you would like to invest in private debt, you should provide mortgage financing to an owner of real estate. In return for your mortgage loan, you will receive a fixed or floating interest rate, and a priority claim on the real estate assets in the event of default on the loan. A common example of investing in private debt is a vendor take-back mortgage (VTB). If you own a commercial property and sell it to a purchaser, you could choose to accept all or part of the payment over time. Just like a conventional mortgage received from a financial institution, the purchaser would pay interest on the borrowed funds over the length of the term, and you would register your claim to receive the payments on the title to the property.
Another alternative is to make a contribution into a private mortgage pool, which is a pool of capital that is invested in a variety of mortgages. Such an investment would require diligence to determine its risk, because there is no third party rating agency to depend upon. A benefit of a mortgage pool versus a VTB is that a default of one mortgage will have less of an impact on your investment if it is combined with other mortgages to balance the risk. To purchase units in a private mortgage pool, you should contact an investment manager who assembles such pools, or a broker involved in the private mortgage market.