The first step to achieving success for value investors in private-equity commercial real estate is buying an investment property at the right price.
Whether the investment is a multi-family apartment building, an office building or an industrial facility, the true worth of the asset isn't the income stream. Price appreciation is what builds wealth.
So how does one achieve price appreciation?
For real estate investors, it starts by understanding the difference between price and value. Price is what one pays, while value is what one receives. Buying investment property at too high a price isn't a good value.
Instead, it is the surest way to limit potential returns. But commercial real estate can double or triple in value for an investor who can spot hidden growth potential, develop a strategy to unlock that untapped value and execute that plan.
The highest returns come from buying commercial real estate investment property at a price that doesn't reflect its inherent attributes. Value investors follow strategies to find and mine those features.
They access locations' current and future potential, develop plans to improve properties that are rundown or missing significant features, or make changes to assure that they are well-run. The rewards for real estate investors who follow a well-researched strategy are returns that substantially exceed original investments.
Learning how to buy investment property at the right price means taking cues from both investment managers and property managers. During my 20 years in real estate, finance and asset management, I have developed these rules to buy an investment property at the right price:
1. Identify the sweet spot. Understanding a property's intrinsic value and when it is selling for significantly less gets much easier when limiting one's focus. How do a buyer really know what is under-priced until he or she knows the price-comparable properties and the factors that influence that price?
To dive into that level of detail, stick to your price range and focus on specific locations and types of property. Buyers should avoid sectors where they are working at a disadvantage and stick with what they know and enjoy.
That will help the buyer's business plan be more realistic and stand a better chance of executing it well.
2. Follow the fundamentals. A property's growth potential is tied to the growth of the underlying economy. Value investors watch social and job trends as well as real estate prices.
Census data, for instance, show heavy population change both in and out of the South, with professionals most likely to move between regions. Houston, Dallas, Austin and San Antonio combined have added more people in one year than any state outside Texas.
The Urban Land Institute's 2017 Emerging Trends study points to "opportunities waiting to happen" in urban centers as diverse as Chicago, Denver and the Raleigh/Durham area in North Carolina. They share an attractive quality of life and vibrant urban centers that attract the most desirable workers.
3. Find the path of growth. Hockey Hall of Fame center Wayne Gretzky is said to advise players to "skate to where the puck is going, not where it has been."
That is good advice in commercial real estate, where hot neighborhoods draw overheated prices.
Rather than buying investment property where competition is fierce, identify emerging sub-markets by watching the drivers of growth. Denver's light rail expansion, for example, has increased demand along its routes to Denver International Airport and Union Station and growth is likely to play out this year along the RTD's north-south extensions and the planned northwest, southeast and southwest lines.
4. Pick one's shots. Make choices about where to focus. The U.S. is a big country, and it is almost impossible to identify every opportunity in every market.
Buyers should narrow the focus to areas where they can understand the market building by building.
Along with a disciplined market focus comes a realistic look at investment tactics. Not everyone has expertise in value-added investing or the experience to know the opportunities and risks involved.
Investors who want to exercise the general partner's control over a project may not have the financial resources to take on liability for all its obligations.
5. Put boots on the ground. No real estate database takes the place of viewing properties and making relationships with their owners. Value investors should know every single asset that fits their criteria, on or off the market.
Knowing the owners, debt holders and major tenants will provide opportunities to make offers and suggest partnerships that will be mutually beneficial.
Success relies heavily on making sure that every scenario is evaluated. The price that a tenant will pay for space, future rent growth, interest rates, capitalization rates and exit pricing are all future assumptions but have a large impact on the current price.
Firsthand knowledge of a market gives real estate investors confidence in their due diligence.
6. Be prepared to walk away. Recently, a property owner who rejected my firm's bid on a property more than a year ago came back to us and asked if we could proceed at that price. We respected the owner and thought that a partnership would increase the project's chances for success.
By working with lenders and keeping the owner involved, we were able to restructure the deal.
The real estate investor's goal isn't getting every bid accepted but buying an investment property at a price where everyone involved has reasonable expectations for success. The right price allows the value investor to earn a predictable return, despite unpredictable events.
This article is commentary by an independent contributor. At the time of publication, the author was a principal in a private-equity commercial real estate investment firm.