Investing Education

3 Must-Have Attributes of a Quality Commercial Real Estate Property

BestPrice-201812-Blog

How do we know which commercial real estate properties to buy and how much to pay for them? As a private real estate firm, our mission is to deliver high, risk-adjusted returns while keeping a keen eye on protecting investors’ principal at all times. This means finding the best opportunities available at the best possible price, which requires a rigorous and strategic sourcing process—and being mindful of timing. The value of any investment opportunity is relative to a point in time because the real estate cycle is always evolving.

For instance, in 2012 we bought a property in Atlanta that seemed pricey at the time. Yet we had conducted a wide property search, giving us perspective relative to the rest of the market; put it through a rigorous “financial workup,” or underwriting process, to assess potential risk and test our business proposition; and completed our due diligence before closing on it. We believed in the deal and acquired the property. In 2015, we sold the asset for 45 percent more than anyone familiar with the deal predicted. The sum was also well beyond our own expectations.

In private real estate, great deals are far and few between. You have to kiss a lot of “frogs” before you find a “prince.” And you must make your luck with strong business plans and equally strong execution.

Down the Deal Funnel: How Origin Sources Real Estate Properties

Properties with strong potential are hard to find. We reviewed our acquisition process earlier this year, and found that we had considered 1,051 properties over the last 15-month period. Fewer than 300 met our selection criteria, only 174 looked promising enough to warrant full underwriting and we made offers on only 26 of these properties. In the end, out of more than 1,000 prospects, we successfully acquired eight deals.

While we always search for properties that have better qualities than comparable options but are lower priced, every investment is different. Still, we have found that the best real estate investments—those at a fair price with the promise of long-term value—share the following three basic attributes and have:

High barriers to entry. This concept will be familiar to followers of value investor Warren Buffett, who searched for opportunities shielded from competition. “I want a castle with a moat around it,” Buffet often said. Projects with an economic moat are difficult to duplicate. Comedian Will Rogers had the right idea about investing in real estate—there’s only so much land, and they’re not making any more. In a city that’s largely developed, an infill location can present a unique opportunity to offer space with limited supply and built-in demand.

Barriers also can be regulatory, such as the time it takes to clear environmental, preservation or zoning review. Some towns are more restrictive than others—Boulder, Colorado, limits building height, density and parking requirements even in its downtown, and can take up to a decade to approve development proposals.

Price can be exclusionary as well. For instance, Boulder’s median home price is just under $1 million. And local controls have had the effect of raising the proverbial drawbridge to new development. In such situations, land use rules then favor existing buildings, or local real estate partners who can navigate building codes and steer projects to approval.

Amenities nearby. Amenities in the immediate area make a project more convenient and can truly enhance the tenant’s experience at the property. These features could be retail or entertainment destinations, public transit, or simply a walkable location, which puts everything close at hand.

For locations that need to retain a millennial workforce, quality schools are an absolute amenity. And in markets like Denver and Phoenix, where residents strive to balance work and play, natural features like walking paths, biking trails and access to nature that differentiate an asset are must-haves.

Fixable issues. When evaluating a potential investment’s location and amenities, there can often be shortfalls that can’t be overcome. The same goes for the properties themselves. Apartment renters today have more discerning taste than in decades past. For example, shorter ceiling heights and small windows don’t allow as much natural light, which many people enjoy. Because it’s difficult to increase ceiling heights, an apartment building with 7-foot ceilings will likely always be functionally obsolete. Similarly, an office building that is short on parking spaces will be difficult to turn around, unless more parking spaces can be added.

New owners can work wonders when they execute on a smart business plan. If the physical space is simply dated, or if there’s room for a new clubhouse or a bigger lobby, these are solvable problems through renovation and construction. If the current management team is missing the mark on leasing or maintenance, a new owner can make changes to operate more efficiently or justify higher rents. These steps increase the income of the property and drive the value higher.

Finally, a new owner can solve liquidity or debt service issues. Sometimes the real estate partners underestimate the magnitude of the turnaround, or one of them needs to exit an investment early for unforeseen reasons. Restructuring debt and infusing fresh equity can be a solution to these financial problems.

Over half of the properties we review are missing at least one of the three features outlined above. And along with its fundamental attributes, every deal has its own risks. Pricing for physical improvements are difficult to estimate accurately. Managerial issues need to be addressed quickly. Not all real estate partners will prove to be reliable.

The “gut reaction” of successful private equity real estate managers is the result of years of experience telling them whether prices for properties make sense, where there’s room to negotiate and when it’s time to walk away from a potential acquisition. They know when to take calculated risks and are confident in the range of expected returns thanks to following a disciplined property search to improve their chances of making a profitable investment.

This article is intended for informational and educational purposes only and is not intended to provide, and should not be relied on, for investment, tax, legal or accounting advice. The information is provided as of the date indicated and is subject to change without notice. Origin Investments does not have any obligation to update the information contained herein. Certain information presented or relied upon in this article may come from third-party sources. We do not guarantee the accuracy or completeness of the information and may receive incorrect information from third-party providers.