How Investing in Commercial Real Estate Works

Wealth Creation & Preservation

Real estate provides investors with an effective and risk-adjusted way to build, manage and preserve wealth, and save for significant life events such as retirement and children’s education. Specifically, real estate investments can build wealth through equity build-up, asset appreciation, and cash flow distributions. This three-pronged approach effectively increases investors’ after-tax returns when compared to traditional stocks and bonds.

Inflation hedge

Unlike most annuities, bonds, and fixed income products, real estate offers protection against inflation. Historically, real estate investments have outpaced inflation and, as such, helped investors maintain purchasing power during their retirement years.

Low correlation to public securities markets

Real estate investments are backed by tangible, hard assets thereby limiting their downside risk. Real estate investments are independent of many of the factors that cause volatility in the public securities markets. This is a key advantage for stability in a well-diversified portfolio. Adding real estate to a portfolio helps investors increase their diversification and allows them to participate in a market cycle that can complement the stock and bond market.

In real estate, a preferred return (or “pref”) describes the claim on profits given to investors in a project. The preferred return is a priority distribution of revenues to investors until they receive returns up to a certain percentage, generally 6 to 8 percent. Once they reach this percentage, the excess distributions are typically split based on a predetermined percentage. This is most common in real estate investments.

There are two important questions to understand when talking about a preferred return and how it is calculated. First is to understand if the preferred payment is compounded or non-compounded? Compounded means that the calculation of a preferred return comes from the amount of invested capital plus all previously earned but unpaid amounts.

Second is to understand whether the payment is cumulative or non-cumulative? Cumulative means that all the money earned in one period that is not paid out at the end of that period are carried forward to the following period.

There are certainly no single, pre-defined structures used by all investors. In fact, there are many structures sponsors will use depending on the project type, hold period, risk and reward potential.

There are many methods that investors use to evaluate the potential profitability of an investment, but there are two methods most use for quick “back-of-the-napkin” evaluation. In real estate, the first is the Internal Rate of Return (IRR); in all other scenarios, most use Return on Investment (ROI). Although they are both used interchangeably to evaluate the potential outcome of an investment, there are significant differences between the two.

IRR and ROI are both used in determining the future potential performance of and the backward evaluation of a completed investment. However, the difference is that one measures the total gain while the other measures both the amount and the time value of the investment. Let me explain.

Return on Investment (ROI) is a metric which calculates the total return of an investment relative to the total investment’s cost. It is simply calculated by taking the net profit divided by the total investment. Most investors use this method because it is simpler to use but is limited in what it tells you. Although it tells an investor HOW much they made, it does not show them WHEN their returns were made. This is an important piece to understanding the merit of any investment investors consider. Consider this:

What is a Waterfall and Promote Structure in Commercial Real Estate?

You may have heard these terms used when discussing the return guidelines for investors involved in commercial real estate. These terms are used when describing the distribution of cashflow and potential profits between the General Partner, also called the “sponsor” (the party responsible for identifying, underwriting, acquiring and/or managing the property) and the investors. It’s called a “waterfall” structure because in order for the waterfall to take place, there needs to be certain return hurdles achieved before the “waterfall”. The waterfall shows investors how the profits are distributed in each phase after the investor has made certain returns. This is known as the “promote” or “carried interest). It’s a way of incentivizing the sponsor to exceed their projections and more favorable for investors. The more the investors make, the more the sponsor share in the profits.

How it Works

A very simple way to illustrate is to assume a waterfall model where a sponsor offers an 8% preferred return with a return of invested capital and a 70/30 split thereafter. The first waterfall is the 8% preferred return. The sponsor is telling investors that they will receive their proportionate share of distributable cash flow equal to an 8% return on their investment. When this “waterfall” bucket has filled, all remaining cashflow is distributed until all investors have been paid any accrued or unpaid preferred return and a return of their initial invested capital. After that, the investors will split all remaining cash flow distributions 70/30, 70% to investors (LP’s) and 30% to the sponsor (GP). The 30% represents the sponsors “promote.” To illustrate this, let’s take a look at this table: