Things to Consider When Building a Commercial Real Estate Portfolio

by CrowdStreet

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Key Takeaways:

Private commercial real estate (CRE) investments are high risk and generally only appropriate for informed and accredited investors with an appetite for and understanding of added investment risks.
Diversification within private commercial real estate involves spreading investments across different property types, geographic regions, property types, sponsors, and strategies. This diversification may potentially reduce concentration risk, potentially mitigating some portfolio volatility and enhancing the resilience of a commercial real estate portfolio.
Whether the goal is income generation, capital appreciation, or overall portfolio diversification, understanding one's investment objectives is essential for making informed choices when choosing which investments to add to a real estate portfolio.

Diversification is a fundamental principle of portfolio management, potentially mitigating some concentration risks. However, it's important to recognize that diversification extends beyond just allocating to different asset classes; it applies within the asset class itself. Within private commercial real estate, there are various ways to spread investment concentration and build a portfolio that aligns with an individual’s goals. In this article, we explore defining investment objectives, CRE strategies, and general guidelines for diversification.

Before investing in CRE and building a portfolio, it’s important to consider both the benefits and risks.

Benefits of Investing in Private CRE:

Diversification: CRE has historically demonstrated low correlation to global equity and bond markets, which makes it a common way to reduce overall portfolio volatility and risk.¹ While the benefit holds for public real estate investments as well, private real estate further has even lower correlations.
Current income: Some CRE investments may offer income potential as leasing income, net of operating expenses, is passed through to investors. Other investments may begin paying current income after capital improvements are made or a development is ready for occupancy. However, It's important to remember that distributions are never guaranteed for any investment.
Capital appreciation: Most real estate investment opportunities carry a targeted term and an exit strategy. The exit may give investors the potential to recapture their initial capital as well as a profit. It is important to remember that capital, up to the full value of the investment, can also be lost.
Inflation hedge: CRE has historically shown a greater ability to mitigate some effects of inflation than the broader equity and fixed income markets. It can potentially mitigate inflation through both income, if the project is able to raise rents in line with inflation, and capital appreciation. Capital appreciation results from an increase in the property’s value reflecting the higher replacement cost and, potentially, reduced market supply at the time of sale.
Potential tax benefits: In some cases, real estate investors may benefit from preferential tax treatment, including accelerated depreciation. Investors should consult with a tax advisor to determine if these circumstances apply.

Risks of Investing in Private CRE:

Liquidity Risk: Commercial real estate investments are illiquid, making it challenging, if not impossible, to sell or exit quickly, usually tying up capital for extended periods.
Economic Risk: Vulnerable to economic downturns affecting property values and rental income. Economic volatility can also lead to difficulties in securing financing for new projects or refinancing existing ones, potentially causing liquidity issues for investors.
Project Risk: Not all projects may perform as anticipated, and some may even underperform, leading to potential total losses for investors. Factors such as location, market demand, and the effectiveness of property management can significantly influence project performance.
Unplanned Capital Call Risk: May involve unexpected costs related to construction, maintenance, and management.

Investing in private commercial real estate can offer numerous benefits, but it also comes with certain challenges and risks. Understanding these risks, conducting thorough due diligence, and, if necessary, seeking professional guidance are crucial steps for investors considering this asset class.

Consider Your Investment Objectives When Building a CRE Portfolio

Investors need to consider their primary and secondary objectives, risk tolerances and investment horizon to identify which types of real estate investments are appropriate for their portfolios.

Investment objectives serve as a compass, guiding investors toward their financial goals while helping them stay in alignment with their preferred investment strategy and investment time frame. Clearly defining these areas is crucial because it lays the foundation for an investing framework, which helps guide informed investment decisions. Objectives help answer fundamental questions like why you're investing, what you hope to achieve, and the duration of time you’re willing to commit your capital into an illiquid investment.

CRE can play a pivotal role in supporting various common investment objectives investors have for their portfolios. Here are some example objectives and how CRE investments can support them:

Income: Some real estate strategies provide income generation through consistent cash flow from a strong, in-place tenant base to potentially generate returns, which typically have little to no dependence on asset appreciation.
Growth and Income: Some real estate strategies seek moderate price appreciation while generating cash flow in pursuit of a balanced return derived from both current income and asset appreciation.
Growth: Some real estate strategies aim for price appreciation through physical and operational property improvements and favorable market conditions, with the majority of the return being dependent on the asset price at the time of future sale.
High Growth: Some real estate strategies seek high price appreciation through extensive asset improvement or development and depend on favorable market conditions, with potentially the entire return dependent on the asset price at the time of future sale.

It's important to reflect on individual financial goals, preferred investment strategies, and investment time frames. Having a clear investment objective will guide your investment choices, risk management, and asset allocation. By defining these objectives, investors can better leverage CRE and other investment opportunities to create a well-rounded and tailored investment strategy that aligns with their unique financial aspirations.

Commercial Real Estate Strategies Explained

Different investment strategies in commercial real estate cater to various financial goals, and understanding them can help investors choose an approach that aligns with their specific investing goals.

Core

Core real estate consists of existing assets generally with little need for capital improvements, typically in major metros, with high occupancy, longer weighted average lease term (WALT), creditworthy tenants, and rents near or above market rate.

Core-Plus

Core-plus encompasses existing assets with typically attractive occupancy rates, but also with the potential to increase cash flow or property value through light improvements, operational efficiencies, and slight increases to the number or quality of tenants or rental rates.

Value-Add

Value-add projects require significant investment, improvement, and oversight to achieve goals, likely including interior and exterior renovations, operational efficiencies, leasing risk, increasing undervalued rents, and higher leverage.

Opportunistic

Opportunistic projects can require heavy redevelopment, full development, or repositioning to reach their highest potential value. Other situations include distress, major tenancy issues, or other issues requiring drastic intervention from a new sponsor.

Each of these commercial real estate investment strategies can serve a specific purpose in a diversified portfolio. Investors should carefully evaluate their investment objectives, strategy preferences, and investment time frames when selecting a strategy, as well as how they fit with any existing investment positions. Additionally, market conditions and economic factors can influence the performance of each strategy, making ongoing assessment and adaptation important for real estate investment.

General Guidelines for Building a Commercial Real Estate Portfolio

Numerous studies and historical data have consistently demonstrated that diversification tends to outperform concentrated investments in the long run. Diversifying across various dimensions within the commercial real estate sector can help enhance portfolio resilience.

Property Type Diversification: One fundamental approach to diversification in private commercial real estate is spreading investments across different property types, including office, retail, industrial, multifamily, and niche sectors. Each property type behaves differently in response to market dynamics and economic cycles. For instance, while industrial properties may thrive during e-commerce booms, retail assets might face challenges. Diversifying across property types can help offset the risks associated with any one sector's performance.
Geographic Diversification: Geographic diversification involves selecting investments in different regional markets. Real estate markets can vary significantly by location, with some areas experiencing rapid growth while others face stagnation. Investors can help mitigate geographic risk by investing in regions with diverse economic drivers and growth potential. This approach may potentially help protect the portfolio from localized market downturns.
Sub-Sector Diversification: Within property types, sub-sector diversification further helps potentially mitigate concentration risk. For example, in the retail sector, diversifying between single-tenant and multi-tenant properties can provide a more balanced exposure to different tenant risk profiles.
Sponsor Diversification: Diversifying across sponsors and operators can reduce concentration risk. Partnering with experienced sponsors who have a proven track record is essential. It's crucial to research their performance, the quality of their management teams, and their ability to execute the chosen investment strategy.
Strategy Diversification: Strategy diversification involves considering different investment strategies, such as core, core-plus, value-add, or opportunistic. Each strategy aims for specific objectives, and diversifying across these strategies allows investors to potentially mitigate their overall risk exposure in terms of strategy concentration.

Due Diligence

Due diligence is essential when building a commercial real estate portfolio because they help investors identify and potentially mitigate risks associated with property investments. Thorough due diligence ensures that investors have a comprehensive understanding of the properties, markets, and sponsors they are investing in, reducing the likelihood of unforeseen challenges and enhancing the chances of making informed investment decisions.

During the due diligence process, several key factors should be considered:

Property Analysis: Evaluate the property's physical condition, occupancy rates, lease terms, and potential for improvements.
Market Research: Assess the local market dynamics, including supply and demand, economic indicators, and competitive forces.
Financial Analysis: Evaluate the property's financials, including cash flow forecasts, expenses, and debt obligations.
Sponsor and Operator Track Records: Research the sponsor's past performance and their ability to execute the chosen investment strategy effectively.

Conclusion

Private equity commercial real estate investments are high risks and generally more suitable for accredited investors with a thorough understanding of the associated complexities. While these investments carry higher risk, they can potentially offer advantages like diversification, current income, capital appreciation potential, an inflation hedge, and potential tax benefits.

Clearly defining investment objectives, such as income, growth and income, growth, or high growth, serves as a compass guiding investors toward financial goals. Diversification across property types, geographic regions, property types, sponsors, and strategies may help enhance portfolio resilience. By aligning investments with objectives and building well-rounded portfolios, investors can potentially leverage CRE's advantages while managing risks.

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¹ Private real estate is, by nature, generally less volatile than the stock market. This lack of volatility does not necessarily translate to private real estate not fluctuating in or losing value. Further, the value of private real estate investments will fluctuate, and the value of real estate often lags behind general market conditions.

²Tax aspects of such investments can be complex and may differ depending on the property or offering and on individual tax circumstances. Neither CrowdStreet or its affiliates offer tax or legal advice. Investors are strongly encouraged to seek advice from qualified tax professionals and/or legal experts regarding the tax consequences based on their particular circumstances.

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