What’s the Best Way to Invest in Commercial Real Estate?

This article was originally posted on Origin Investments’ blog.

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Many of Origin’s partners are sophisticated investors and experienced at buying investment property. And as high net worth individuals, they have the means to invest in commercial real estate and understand its potential benefits and rewards. So why are they putting their money into private equity real estate funds?

After 15 years of successfully investing in commercial real estate properties that ranged from multi-family buildings to speculative industrial properties, “I learned enough to know that I can’t do it myself. It’s impossible to understand all the risks without being involved at a professional level and it pits me against experts like Origin, who have a knowledgeable team with a different skill set,” says Jeff Cardot, a California investor. Cardot came to this conclusion after a large investment he made in a retail building went south.

While many high net worth individuals continue to hold investment property, they have found it more advantageous to participate in private equity real estate funds and share their experiences here.

WHY COMMERCIAL REAL ESTATE?

Commercial real estate attracts high net worth investors thanks to its high potential return on investment. “When everything is said and done, I believe real estate will outperform the stock market,” says Sidney Jain, a Chicago radiologist.

High net worth investors favor real estate for its track record of resisting stock market cycles. “For me, real estate was a way to diversify my investments to reach my retirement goals. I felt I had enough money invested in equities and not enough in real estate,” Jain points out.

Besides rental income and capital gains when a property is sold, another way to realize a higher return on investment is through the tax benefits, which are structured to reward investors who have equity in a property. Depreciation lowers the basis on which capital gains are calculated at sale, while the gains themselves are taxed at a lower rate than ordinary income.

“It’s an alluring asset class,” Cardot says. “It is so efficient tax-wise. If you own a property, you get to write off the depreciation against the income, so the tax structure makes owning real estate beneficial versus other asset classes like stocks and bonds,” he says.

WHY DIY REAL ESTATE INVESTMENT? IT’S THE ROI

Jain looked at publically traded REITs, but “I realized that the profits weren’t as high as investing on your own, which offered greater opportunities to earn better returns,” he says. In 2013, he formed an LLC with four fellow physicians to pursue do-it-yourself property investments.

Initially, buying investment properties proved profitable for Jain and his colleagues, who hired a realtor that specialized in investment properties; handled both acquisitions and subsequent sales; and also served as their property manager and general contractor.

“There was a greater opportunity to make a better return on investment if we went out and actively participated in the real estate market. We realized that we wouldn’t be that successful on every flip, so we steered towards value add properties” — making renovations to maximize ROI.

Cardot held a similar assumption but focused on commercial properties. He bought and managed properties in several cities and business sectors, even building speculative projects, and focused on producing cash flow rather than the appreciation that lures property flippers. While the market was stable and appreciating, “my real estate investments seemed to perform well,” Cardot says.

HEADWINDS FROM 3 DIRECTIONS

Ultimately, both high net-worth investors came to rethink their real estate approach once their returns diminished.

“We did phenomenally well on our first few flips,” Jain says. “But then we went into multi-family units, first with six units and then with 30, and management inefficiencies cost us money and diminished our ROI. Our goal was to annualize returns at about 20 percent, but based on cash flow, now we are at 10 to 12 percent and this comes with a lot of work and stress.”

Finding good properties has also proven more difficult. “On paper, it sounds great, but the challenge is not having the connections, knowledge and expertise to acquire the best properties,” Jain says. “Real estate professionals usually get first crack at the best properties,” Cardot points out.

Real estate professionals also know what to look for in specific markets, a realization that came to Cardot in 2008 when the market went south and the lessee in one of his commercial properties went bankrupt. When it came time to find a new tenant, he got a surprise — rent rates fell from $12 per square foot to just $4. “After holding the property for 10 years, I sold it for 65 cents on the dollar and lost all my invested capital. A professional real estate firm like Origin wouldn’t have missed something as basic as that rate decrease. I asked myself ‘how much more was I missing by trying to invest in real estate myself?’”

The investors noted three basic issues with maintaining a DIY real estate portfolio:

1. Buying investment property is harder than it sounds. Jain and his partners parlayed limited contacts in real estate and banking. “We’re all physicians, and we partnered with a single consultant who brought us deals, but we had to vet them ourselves.” Cardot felt outgunned. “The country club deal isn’t vetted the same way a pro would look at a deal,” Cardot says. “Buying real estate is complex. Gaining exposure to stocks and bonds is more straightforward, but it’s not the same with real estate. If you find property to buy, you aren’t buying the same property as the professionals. They’re the ones selling it to you and it may be something they rejected. Or you may be competing against them and don’t have the same knowledge they do about structuring deals.”

2. Managing real estate is challenging and rigorous. “Our ROI could have been much higher if our property management was better,” Jain says. “Though we had a partner, he didn’t have the same kind of experience as a seasoned professional manager.” There’s also the time involved — which can be substantial. “On a weekly basis, I am approving maintenance, managing the books, writing all the checks, solving problems. It takes at least a couple of hours when nothing is happening and everything goes right — and even then it’s constantly on your mind and a burden,” Jain adds.

3. Investing with partners is challenging. Investing with friends allows you to spread out risk by buying more properties, but it can also lead to tensions when it comes to making strategic decisions about what to buy, dividing up the work involved and how much to improve a project. Relationships also impact exit strategies and profits because it can be harder to sell properties when the time is most opportune. “Some partners may want to sell and other partners don’t because there are different tax consequences for each, so it becomes an issue,” Jain says.

FUNDS VS. DEALS

Jain and Cardot are seasoned investors who are committed to buying investment property; Jain estimates one-third of his assets and Cardot estimates half of his assets are in real estate. But both investors are also participating in our recently closed Fund III. Jain appreciates that the fund’s multiple investments provides diversification, minimizing the risk of any single investment. “I have small chunks of money across 15 or 20 properties, so it’s easier to accept from a risk standpoint,” Jain says.

Cardot asks himself, “is Origin beating their peers in real estate investment at this timeframe? The answer is yes. Can Origin do it better than me? Again, yes.” Based on Preqin data, Origin’s first two funds rank in the top decile in terms of performance. Fund I is on track to generate a 28 percent net return; Fund II is on track to deliver a 19.5 percent return; and Fund III, which closed this past June after raising more than $150 million, will follow the same strategy and disciplined approach as the first two Funds.

“The problem is, there are not that many Origins out there,” Cardot says — “pros who are going to be transparent, have reverence towards the capital as opposed to using investor’s money to try and make money for themselves.” Also, “I know the Origin guys have put their own money in all the deals and all the funds,” he adds. “A lot of people try to do it on their own because it’s hard to find a company like Origin.”

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