The Best Way to Profit from U.S. Commercial Real Estate? Think Funds

05/11/2017 11:04 am ET

A mountain cannot turn, the Chinese proverb says, but a road can. Investors who have bought and sold buildings know that real estate can build substantial wealth. But they also know the road can be complicated, time consuming and uncertain. Because of this, many investors are turning to private equity funds for two reasons: to help navigate the traditional process of property investing, and to create access to real estate investments and management expertise that was previously only available to institutions.

Why funds?

Buying commercial real estate can reward investors well for taking on uncertain prospects—which economists call high risk-adjusted returns. Buildings are expensive and mistakes can be costly. The bigger the property, the more resources are required for maintenance and repairs. And a large single investment raises the stakes should anything go wrong, whether it’s unexpected repairs, low occupancy rates or meeting obscure legal requirements.

Yet investors derive significant benefits from the cash flow, price appreciation and tax advantages of real estate.

The obvious solution invokes another proverb: don’t put all your eggs in one basket.

One way to lower costs and spread the risk is to invest in a private equity real estate fund that does not stake everything on one shot. Instead, it pools investor resources to buy and sell many properties, each with well-reasoned business plans and experienced property managers. There are several ways private equity real estate funds can give investors a more secure route to real estate success.

Private equity funds minimize risk exposure. The best feature of a well-managed private equity fund is diversification. A high net worth investor may have the resources to buy a few buildings. However, by investing the same money in private equity funds, shareholders will have stakes in many more commercial properties that differ and can range from apartment buildings to industrial complexes.

A private equity fund can own properties in many cities at once, which lets it take advantage of thriving market conditions. That limits the risk of a downturn in any single city.

A well-run fund operates each of its properties as a separate business. Thanks to this strategy, if one property underperforms, it doesn’t impact the others and drag down profits across the board. Deal by deal investments do not offer this same benefit. If a deal fails, investors suffer substantial loss.

The wide array of carefully vetted property types, geographic locations and business plans limits risk for investors.

Funds have access to better properties. A well-managed fund has local experts in every market where they invest, something we call “boots on the ground.” The experts are familiar with both properties for sale, and real estate that might become available. This insight shows them how much to bid and how much to expect from a purchase. In acquiring this knowledge, they cultivate trusted relationships with owners. Eventually, opportunities for buying commercial real estate “off-market” or directly from the seller come to them first due to these relationships, which is why the best deals rarely hit the open market.

Fund managers do the hard work for you. Buying commercial real estate is a complex task, and managing a property is demanding. Keeping grounds attractive, tenants happy and the ledgers balanced are day-to-day jobs that require constant attention. A private equity fund takes on all these tasks, and more. If a problem arises, the investors are shielded from liability.

In truth, experience does not shield even fund managers from missteps. High net worth investors must choose a private equity fund wisely. When people ask me how to choose a real estate fund, here are the three things I suggest:

1. Pick the right asset manager: Selecting a good real estate manager is the single most important decision an investor can make. The manager decides what to pay for an asset, how to build its value, how to fix problems when they occur and when is the best time to sell. In every deal, the investors rely on the asset manager to make good decisions in every step of the process.

Any real estate manager should be able to answer your questions, not only about how the venture will succeed but what could go wrong. Not only should written materials be clear, but you should also be able to ask questions. The most experienced managers will have thoughtful answers.

2. Look at the fund manager’s track record. To better gauge how well a private equity fund will perform, it also helps to see if other investments met their goals. Preqin, an industry leader, tracks performance of private equity fund managers.

3. Consider whether the manager shares your goals. According to Towers Watson, a leading global advisory company, the most effective way for managers to align interests with investors is to invest their own money in the deal.

In the competitive market for commercial real estate, investors are on their own. At Origin Investments, we have learned how to vet and bid on properties successfully and choose trustworthy partners on our own. Our mistakes have helped shape our risk management practices and investing philosophy. By discussing the problems of commercial real estate investing, we hope individual investors will see how real estate funds provide a path around these roadblocks.

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