For this installment of our CRE 101 Knowledge Series, we will dive into one of the most important aspects of any commercial real estate (CRE) investment – the duration in which you are invested, or what we refer to as the investment life cycle. Though the complete investment life cycle of a CRE investment can be broken down into numerous smaller phases, we’ll discuss the two primary and most significant:
CRE 101 – Investment Life Cycle of CRE Investments
Underwriting & Closing Phase (UCP)
Investment Hold & Exit (IHE)
The Underwriting & Closing Phase refers to the period when a property is identified, evaluated or underwritten from an investment perspective, and then ultimately acquired. The Investment Hold period simply refers to how long the property is held as an investment. The Exit is when the asset is sold. Unlike the UCP, which is a fairly standard process, different variables will come into play during IHE, depending on an investor’s underlying business plan and return objectives. As such, the complete investment life cycle can vary greatly from one project to the next. To understand further, let us discuss each phase in greater detail.
The Underwriting & Closing Investment Life Cycle Phase (60-90 days)
The process of acquiring a commercial real estate property in the traditional sense (meaning not through a bankruptcy, foreclosure or debt assumption) is similar to that of acquiring a residential property – with a few notable exceptions. Just as in residential real estate, a commercial property buyer will make offers and, upon acceptance, will conduct inspections to help determine what upgrades are needed or what deferred maintenance issues exist. The prospective buyer will work to obtain lender approval and engage a broker to help facilitate the closing. The notable exceptions in CRE acquisitions happen during the due diligence and closing stages. Before discussing these differences, let us start at the very beginning of the life cycle prior to underwriting.
Deal Origination and Underwriting
Commercial real estate investment buyers originate their opportunities from brokers, lenders, and industry peers based on their targeted property type, class, and category preferences. It is not uncommon for brokers to set up a competitive bidding process for quality assets in an effort to maximize earnings for their seller-client. This process generally involves the broker compiling all information into an electronic portal for buyers to review along with a predetermined date when final bids are due.
The basic framework of the underwriting process begins simply with the buyer’s determination of the subject property’s value based on its historical financials and performance. The primary goal at this stage is to answer basic questions:
- How is the property currently performing?
- Is it performing at its fullest potential, or is it losing market share?
- Why is the seller looking to exit the property?
- Are there any deferred maintenance issues that must be immediately addressed after acquisition?
The answers to these basic questions help the buyer understand what the current value, and potential future value, of the property is based upon certain assumptions.
If the buyer feels the asset is worth pursuing and their initial bid is competitive with the seller’s asking price and other bidding buyers, the seller’s broker will commonly initiate a “best and final” round of the bidding process. Once this round is completed, the seller and broker will review all final bids and associated buyers to determine which buyer has the highest probability of completing the transaction. Once the selected buyer receives notification that they have won the bid, the buyer will internally begin the formal due diligence phase.
The formal due diligence stage in CRE is a very thorough and serious process where major differences exist when compared to the same process in residential real estate. In residential, a home buyer is protected to a large extent by consumer protection laws. Unfortunately, similar laws barely exist in commercial real estate. This means that the buyer and its team are solely responsible for examining, inspecting, and reviewing the property to determine whether it is suitable for their needs. If something is missed, the responsibility is solely theirs to bear.
Most buyers use professional advisors, legal counsel, and consultants to assist during the due diligence process to ensure all necessary precautions have been taken in evaluating the opportunity. During this phase, buyers have access to the physical property to conduct inspections and access to all data relating to the property’s operations and interior, exterior, and structural condition as well as any legal, financial, and environmental information related to the property. The typical due diligence period for a CRE property acquisition lasts 30-60 days but can be extended if the buyer finds issues with the property that need further examination.
The closing process is the final stage in the Underwriting & Closing Phase and in CRE, is another aspect that greatly differs from residential real estate. The closing process in CRE is much more complicated due to the lack of federal regulations and the amount of equity required. CRE closings are less systematic and more fluid, which allows greater flexibility in how investor-buyers structure their transactions both legally and financially. In many cases, this results in complex legal structures with custom closing documents that require the expertise of skilled real estate attorneys. Given this approach, the closing stage alone can last up to an additional 30 days beyond the formal 30-60-day due diligence stage, which begins after the purchase contract has been awarded. Combined, this brings the total duration of the Underwriting & Closing Phase to roughly 60-90 days.
As it relates to the timeframe PERI and our Partners have to fund an opportunity, it’s important to note that there are two distinct scenarios that can dictate shorter or longer funding timeframes.
SCENARIO 1: Direct Sponsorship.
If PERI is pursuing a property asset directly as a Sponsor, meaning PERI is originating, underwriting, performing due diligence, obtaining the funding, and closing the transaction, we will generally have a 90-to-120-day period from start to finish.
SCENARIO 2: “Ready-to-Close.”
With our current portfolio strategy, PERI will more commonly receive opportunities in a “ready-to-close” state from Sponsors we are already working with. This means that the property is already under contract, formal due diligence has been performed, and the Sponsor is ready to close. Given the amount of due diligence completed by the Sponsor to get it to this stage, we already have a high degree of confidence in the asset’s potential before beginning our own evaluation process.
With the Sponsor closing a short time away, PERI and our Partners will only have a limited window of opportunity in which to co-invest and participate alongside them.
Once our own internal evaluation has been completed, PERI and our Partners will typically have less than 30 days to create an investment entity, send out documents, complete funding and then provide our capital commitment to the Sponsor. To accomplish operating within this timeframe, it requires each of us to remain in a ‘ready’ state to evaluate, approve, and invest. Understanding Ready-to-Close – and the scrutiny it took for a property to reach this stage – is important because it defines the reasoning for quick action on our part to co-invest. Depending on the Sponsor and property, funding timeframes can be as short as 10-14 days on the low end and 20-30 days on the high end.
The Investment Hold Period (Variable)
From the moment the property is closed, the Investment Hold period begins. There are no set guidelines in CRE investments for how long a property is held, or when to divest or exit the property. The Investment Hold period is generally predetermined based on the Sponsor’s overall strategy. Going into an initial evaluation, a longer-term or shorter-term investment goal can be generally assumed depending on which “Category” the underlying property falls under.
Longer-term vs. Shorter Term
Core and Core+ assets are generally acquired for stable cash flow as opposed to upside potential through appreciation. Because income generation is their typical objective, they can be held for longer-term periods – up to 15 years or more prior to being sold.
On the other hand, Value-Add and Opportunistic assets are typically held for shorter-periods defined by adequate time to realize significant upside through repositioning. PERI Capital has seen shorter hold periods as little as 1-3 years, with 3-5 years being most common. For new development, the hold period can be 7-10 years or more. Determining where a shorter-term hold falls into that vast time scale all depends on when the property achieves its value creation strategy. For existing properties with very little or no needed improvements or deferred maintenance issues, they will generally fall on the lower end of the scale. New development or existing properties that need extensive renovation and/or repositioning would fall into the higher end of the scale. Once the property’s Investment Hold period begins, the exit timeline is further defined through proactive asset management, which includes both property-level and external factors as they play out in real-time.
During the Investment Hold period, Asset Management is the process of overseeing and monitoring all aspects of the property’s performance to ensure its potential is fully maximized throughout the hold period. This requires ongoing monitoring of the property management company, analyzing revenue performance versus proforma, and minimizing expenses to drive revenues upward. Effective asset management also includes keeping track of industry, capital market, and broader economic trends, as well as preparing quarterly financials and partnership K-1’s at the end of the year. Asset management plays a critical role in any commercial real estate investment as its function serves as the active generator of property-level performance and investment returns.
On a Side Note – Ground-Up Development
Investors who are newer to commercial real estate are sometimes surprised to learn that ground-up development is classified as Opportunistic, which has a shorter Investment Hold period. Because the property is new, many investors assume that it should fall under Core where longer hold periods of 15-30 years are common or, in some cases, the property is intended to be held indefinitely for cash flow. New development is considered Opportunistic because of unknown factors associated with future performance and the ramp-up period required once they are open for business; Core properties have known income-producing histories. Needless to say, the underlying assumptions that drive the economic modeling on new development must be highly favorable or the property development would not be undertaken. However, due to the associated ‘unknowns’, new development assets are placed in the opportunistic category simply because there is a need to create substantial upside value once construction is completed. The CRE professionals specializing in these types of properties are highly skilled at the process from beginning to end. Ultimately, the Investment Hold period is defined by the buyer, who could be a developer, investor, or group, and is based on the underlying strategy for the property from an investment perspective.
Generally, most commercial real estate acquisitions follow the same investment life cycle where the two primary phases discussed above are completed. In the more routine Underwriting & Closing Phase, once a contract is awarded following the origination and bidding process, the buyer has up to 90 days to close. This timeframe provides buyers adequate time to complete extensive due diligence, receive lender approval for debt, and to raise funds internally and through co-investment partnerships with private-equity companies like PERI Capital Group.
The duration of the Investment Hold & Exit Phase, however, depends greatly upon the property category and underlying investment strategy. The basis for the hold period and eventual property exit depends on whether the investor-buyer is seeking long-term cash flow or significant upside through appreciation. Each strategy has a place in a well-diversified CRE portfolio. Investors in all sectors need to understand the risk-to-reward profiles of each strategy to determine which best compliments their own investment goals.
We hope you have enjoyed this segment of our Knowledge Series and we look forward to sharing our next installment in the coming weeks. If you have any questions, we invite you to reach out to us anytime at 972-805-5936 or at partnerservices@PERIcapitalgroup.com
The views expressed herein are exclusively those of PERI Capital Group, are not meant as investment advice, and are subject to change. This information is prepared for general information only does not consider the specific investment objectives, financial situation, and the particular needs of any specific person or entity. We recommend that you seek financial, tax and legal advice regarding the appropriateness of investing in any investment strategy discussed or recommended in this article.