Basic and important principles when co-investing in Real Estate

Investing in real estate is a great way to build wealth. Commercial real estate investing, in particular, is known to provide some of the highest and most predictable income streams. For many families, the objective of investing in commercial real estate is for future wealth and security; others utilize it for tax benefits and investment portfolio diversification.

The trend is here: Family offices prefer co-investing alongside other families with aligned interests. Funds are out, REITs are out. The main reason for this trend is: Yes you guessed it right; fees, transparency, nonalignment of interests, and the blind pool nature that funds provide.

Now that COVID is creating a once-in-a-lifetime opportunity to invest in real assets, here are my thoughts on how to do it.

1. Track record

Far too many Family offices and investors want to save money by investing themselves. However, working with an expert team is unequivocally better than working alone. While you may appear to save money on the surface, chances are you are losing both money and time by working alone. A competent team knows more about each and every process. Especially in similar types of deals, property types, and geographic markets. Access to amazing projects is rare. Especially as a lot of the most interesting transactions are off-market deals.

A partner needs to have an extensive history, consistent returns in multiple cycles. Furthermore, a clear fee structure that is fair for all involved and finally no conflicts of interest vis-à-vis managing and leasing the properties.

Partnering is a great way for families to minimize some of the due diligence that is required to invest directly into an opportunity. Underwriting of the GP is the priority, and the deal is secondary.

2. Price

Everything starts with and depends on the price. There are times when certain types of investments are “hot” and other times when they are not. The key with any investment is to evaluate its true intrinsic price and buy it below it. As Warren Buffet famously says, “it’s hard to go wrong when you buy a dollar for less than a dollar”.

So the mission becomes how to sort out those components which allow for a sober assessment of an asset. In fashionable sectors and frothy markets, such a disciplined analysis is first slowly and then quickly abandoned in favor of optimistic projections. These tend more and more to rely on “capital appreciation” with no basis other than an expectation that a buyer will come along with even more optimistic assumptions. Some refer to this as “the greater fool theory”. Everybody can repeat the “buy low and sell high” mantra, but when it comes to execution most will “buy high” and hope to “sell higher”. This is a certain formula for capital demolition which we have seen played out over and over again, sector after sector, from tech to debt to real estate to everything in between.

3. Location location location

A deeper analysis shows that beyond the reasons cited above, there are more subtle causes for the availability of such low prices in markets such as the Midwest, the Southeast, and other “unloved” smaller localities in the U.S. We observed a phenomenon applicable to secondary and tertiary markets when we bought almost all our earliest assets in Quebec; when the mood is bad, assets tend to be discounted far further than similar properties in larger markets. Parenthetically, many U.S. secondary markets have larger GDP than most major cities around the globe!

4. Assessing the risk

What in fact is your risk? A lease from a credit tenant in NYC or Kansas City or Columbus is equally binding and equally safe. Therefore any risk there is illusory, but nevertheless offers a further discount.

The knee jerk response then is “liquidity risk”. The answer to that is that liquidity is a risk only if there is a promise to sell the asset by a specific date. If such a date did exist, it might wind up being a horrible time as it was for those who had to sell in NYC in the mid-seventies, early nineties or now during COVID. Now that the pandemic has caused values of hotels and retail properties to tumble, investors are lining up to cash out of funds. So fund managers have to sell property into a stormy market to raise that cash...

Therefore the only real and legitimate risk comes from overpaying.

5. “Nobody got fired for buying IBM” a.k.a. the herd mentality

There is still a further and complementary reason why discounts can be so high in secondary markets. It has to do with the somewhat uniform investing behavior exhibited by REITs, pension funds, private equity groups, and institutional investors in general.

For quite some time now, large institutional investors have been focusing their attention on certain big and “safe” markets. No manager will be fired for buying a 4 cap in NYC with little upside simply because all the others are doing it and therefore the strategy has consensus. However, ironically, institutional managers can get in trouble for buying into a small market at a 10 cap with upside-only because no other manager is doing it and it is therefore not considered a “consensus” approach.

6. Finding the right deal

That is why sellers tend to write off (or let go of an asset at a huge discount) in secondary and tertiary markets, not because it is a wise economic move on their part, but rather because it takes an “embarrassment” off their portfolio. It is better for the portfolio manager when he can say at his next conference call that he “got rid” of the Fort Wayne, Indiana asset which for them was a rounding error in any event.

For those who understand the fundamental economics of real estate and are clear-headed in their mathematics, the next little while offers an opportunity that does not come around very often – particularly in the world’s greatest economy. This does not mean that it is easy to find the jewels. In fact, these now seem to be restricted to very large office portfolios sold by institutions for reasons unrelated to the economics of the disposed assets. Even at the best of times for bottom feeders (that is during the most pessimistic times for most others), much dirt needs to be sifted through and then examined by experienced and cautious eyes before nuggets of opportunity are found. Pickings are getting slimmer by the year as optimism returns and time is running out.

Disclaimer: All investment opinions expressed here, are from my personal experience which derives from co-investing with RMC, a Family Office with a strong focus on Office Real Estate. Over the last two decades, RMC has managed to build a US$2,1 Bn portfolio and consistently generate strong immediate cash-on-cash returns and an IRR north of 18%. However, what works for RMC, won't necessarily work for other investors.

If you are interested in discussing more about Investing in Real Estate or RMC's Investment Strategy and success record, don't hesitate to ping me on LinkedIn