There’s good and bad news about Duluth’s commercial real estate market, depending on your perspective. The good news involves large expenditures planned

What are the main metrics that real estate investors look at when deciding in which property to invest?

It varies wildly by asset class, size of deal and type of investor. The metrics used by investors include rate of return AKA cash-on-cash return / ROI, IRR – internal rate of return as well as many qualitative factors. Rate of return formula is as follows:

((Return – Capital) / Capital) × 100% = Rate of Return

Systems and data are generally used by larger and more complex investors that have analysts on staff and use specialized software and reporting to provide them with market data. Much of the time the data is provided informally through real estate brokers that specialize in a certain geographic area as well as appraisal and market study companies that publish reports that include vacancy rates, average rents, asking prices and other real estate data.

I will try to break down the typical type of investor and provide an example of how they achieve their returns. There are many and some certainly do not fit in to the criteria listed below, especially if they are individuals of high net worth or smaller investors that have their own metrics. I will go through these in the order of perceived risk and return, starting from safest to most risky.

Institutional / Pension Fund

This type of investor focuses on providing stability and diversification to their investment portfolio and mostly will invest in publicly traded real estate companies and real estate investment trusts, REITS, and depend on steady dividends and cash flow. Since the companies are publicly traded there is much more scrutiny with how they represent their balance sheets and financials, value their assets and make investment decisions. They typically use specialized software to value their exposure and many times the investment decision depends on the investment’s impact on the portfolio. The yields on REITS depend on which asset class it specializes in. Recently REITS and the entire real estate and investment world has been the beneficiary of cheap money, high liquidity and high levels of lending by banks (Bubble!). There is little sign of this coming to an end right now, but eventually all bubbles pop. The rates of return that REITS have experienced have been relatively healthy, especially ones that concentrate in multifamily in stable metropolitan areas.

Real Estate Investment Trust (REIT)

REITS are publicly traded or private investment vehicles that by law have to pay out 90% of their net income to investors. It is considered a fixed income asset and provides a steady cash flow to investors. REITs are highly liquid and provide an opportunity to invest in specific asset class or market without having to actually own real estate directly. Here is a great article on what a REIT is all about: @Investing In REITs Instead Of Property
REITS mostly focus on large safe assets, but this field has grown tremendously in recent years and has become much more diverse. The asset classes include residential, retail, office, health care and mortgage.

The traditional / family money investor

Especially in New York, there are several family dynasties that have built up small and large real estate empires that have been passed from generation to generation. They look to maintain a low level of leverage (low debt on their properties, holding companies and overall balance sheets) and focus on longer term cash flows and future value of the property. Generally they will settle for a lower cash-on-cash return (3-4% yielf) in class-A office or multifamily properties in Manhattan or other very stable areas that are not expected to decline in value. They also buy up “prize” assets (think Empire State Building) that have significant historical and tourism value.

The Tax Haven Investor

These investors  do not seek cash returns but achieve their yield through investments that provide tax benefits / breaks. These include various types of tax credits (energy, low income housing, historic, new markets). In a typical structure of a low-income housing tax credit deal, the tax credit investor buys into a limited partnership and owns 99.99% of the real estate, even though they may only collect 10% of the cash flow. In return for investing capital into the deal, they write off the building’s depreciation, accounting losses and the tax credits that are earned, depending on the type of program and project. In addition, if the investors are large banks, they also earn CRA (Community Reinvestment Act) credits. CRA link: @Community Reinvestment Act

These investors include large corporations (Google, Verizon, Bank of America, Citibank, Capital One, etc.) and their metrics for investment involve financial modeling that takes into account the timing of the credits / tax benefits and the timing of the equity being paid in. They typically invest through third-party investment banks / syndicators that handle the underwriting and asset management and their main investments are in low income housing projects (new construction and acquisition / renovation). Their yeilds vary with market conditions and can range from 6-7% to 10% during times of uncertainty.

The “Value-add” investor

These investors can be larger private equity groups and smaller real estate investors and developers. The basic concept is that they buy an existing asset (can be a building or undeveloped land) and invest additional capital to improve (build up, renovate, demolish/rebuild) the property. Real estate developers, large and small achieve their returns through earning various fees during the development stage (development fees), through long-term cash-flow, (if that is their goal) and through a sale after the improvement is completed and the asset is stabilized.

It is assumed that the value generated from the improvement of the asset will be greater than the cost of improvement and the appreciation in the property value will provide the return to the developer / investor. Many times developers partner with private equity groups where the developer is the operator / managing member and carries out the responsibility of the improvement, and the investor has a passive role and provides the developer with capital, and a balance sheet (on leveraged transactions). The rates of return vary wildly on a project by project basis.

The Leverage Operators

These investors generally take on a tremendous amount of debt (levarage) in order to maximize their returns. They layer their financing with various tiers of debt and preferred equity, which generally increase in its cost as you go down the priority ladder. These include commercial construction loans, hard money loans, bridge loan, mezzanine loan. They can achieve close to 100% loan-to-cost and take a sliver of the pie for little capital at risk. The downside is that personal guarantees are generally involved in the riskier financing, so if a project does not work out, the investor is on the hook and can lose their house, car, and other assets. There are many investors that have amassed tremendous fortunes and built up portfolios using these methods (Trump being one of them) and have survived downturns by restructuring, repositioning and declaring bankruptcy. Trump went bankrupt four times. Here’s an article on how he’s made it work: @Fourth Time’s A Charm: How Donald Trump Made Bankruptcy Work For Him

They earn their returns through management fees and cash flow. I personally detest the irresponsibility that comes with higher leverage and risk and ends up hurting not the operator that focuses on short term gains but the investors that actually pump money and back these guys.

I am sure I’ve left out some obvious and now-so-obvious metrics and types of investors but I hope this provides a good primer to those interested in this field.

Cheers!