Three steps I use to analyze real estate investment in REITs and commercial property
How do you invest in commercial real estate without becoming a full-time analyst? How do you know if an investment fits with your property portfolio?
It's one of the hardest questions for main street investors. Few asset classes create as much family wealth as real estate but finding the best deals means getting deep into the numbers. That's something most investors just don't have time to do.
In this video, I’ll show you three ways you can use to analyze real estate investments for solid returns and to reduce your risk.
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Analyzing REIT Investments – A Process Built on Experience
We’ve spent the last two videos talking about one of my favorite new types of real estate investments, online REITs. These professionally managed funds seek to hold a diversified portfolio of properties and pass cash flows on to investors.
You’ll remember that listed REITs are easy to buy because they trade like stocks but they’re difficult to follow and share prices are more volatile than you’d expect from a real asset.
Since online REITs are closed funds, the price isn’t as unpredictable as REITs, plus while the funds are still diversified they hold fewer properties so it’s easier to keep track of quality.
Now I want to show you how you can analyze individual commercial real estate properties, their place in an online REIT and how it all fits with a portfolio. We’ll start by looking at three things to watch when analyzing a property and then I’ll show you an example with a property in the Streitwise 1st Streit Office online REIT.
Building Your Real Estate Portfolio
It’s important to remember in all of this that even though you’re looking at an individual property, your goal is to find how the properties in the REIT fit together and how everything fits with your overall real estate portfolio.
Combining listed REITs, online REITs and even direct property ownership means filling those gaps in property type, region and your own constraints on time. If you’re managing your own residential rentals, you probably don’t have a lot of time to manage a lot of commercial properties but you need those properties to smooth out the risks in those rentals. So when you’re looking at an exchange traded REIT or an online REIT, while you’re analyzing the investment value, also make sure that this group of properties is rounding out your portfolio.
But all this has to start somewhere. It doesn’t matter much how a property fits with your portfolio if it’s a bad investment, right?
Now I can’t make you a real estate analyst with one video but what I can do is give you three places to look that are going to be critical to the success of a commercial property. It’s these three things that I always looked for immediately when analyzing a deal and it’s here that you’ll be able to spot the flaws in bad investments.
Analyzing Tenants in Real Estate Properties
First here is tenancy. If you’ve owned residential rentals, you know how important it is to have good tenants. Good renters can make real estate investing nearly passive while bad tenants can make your life a living hell.
It’s no different with commercial properties and there are a few things to watch for to judge the quality of tenants.
Do cash flows rely on one or a few tenant for the majority of rents or is it more diversified? Most properties have an anchor tenant or two that pay a majority of the rent but watch out for properties that rely completely on one.
What is the mix of tenants by sector? Are all the tenants in the same line of business, in the same industry? Even if all the tenants are offices for companies, if those companies are in different sectors then you’ll be better protected against hard times in any one part of the economy.
What’s the mix of property type, i.e. are all cash flows from office space or retailers? You can’t get too caught up on this one because most properties are almost all retail or office or residential but those few mixed-use properties add another level of diversification.
What’s the financial health of the anchor tenants? You don’t need to be a financial analyst or look over the financial statements of all the tenants but you don’t want to jump into a property where the most important tenants are facing bankruptcy.
Finally, what are the lease terms for anchor tenants and on average? How much time is left in the lease for tenants and what are lease rates compared to market rents? Leases expire but it’s good to know that you have a few years of stability and rents that make the property attractive.
How to Analyze Investment Property Financials
Next is what I call a sanity check on financials and cash flow. If there is one place where investors fail in their due diligence or just outright avoid, it’s here with the financials.
And I get it. Opening the financial statements to a property or a fund can seem like opening that 9th grade algebra book all over again.
You don’t have to be an accountant to invest in commercial real estate but you do need to catch some of the glaring problems with some properties. You’re just looking at a few numbers; things like rents, expenses and cash flow to make sure management isn’t being overly optimistic on projections. That’s why I call it a sanity check.
You’ll start with rents or gross rents. Here you make a little bit of a judgement call from your analysis of tenants. Weaker tenants might mean you reduce rents a little for potential vacancy. Then you look at the properties expenses over time if available or you can compare them with expenses for similar properties in the area. This should include an estimate for insurance and taxes as well.
Rents minus expenses is going to give you something called net operating income (NOI). This is where the rubber meets the road. This is where you’ll be able to calculate a cap rate to tell if the return on the property is good for the market and where you’ll be able to find cash flow after debt payments.
Analyzing Projected Returns for Real Estate
Your last check on a property is going to be on the projected price and cash return. How much are you going to see from property price returns and how much from annual cash return?
A lot of this will come from your check on the financials but it’s what this is ultimately coming down to, right? So it should be its own step.
For the potential price return, you can look at market rates for similar properties and the cap rate. The cap rate is that net operating income divided by the price, so a percentage return on the investment. Is the cap rate higher or lower than the average for that property type in the market?
Looking at similar properties in the area, you want to find an average price per square foot and an average rent per square foot. You also want to look at growth in these prices over the last few years. This is all going to give you a sense of any potential price return in the future.
For looking at the cash return, check management’s numbers like debt service and expenses. How much is management estimating it can return to investors every year and is this realistic given regular expenses plus maintenance?
Analysis in Practice on Streitwise REIT
Now let’s look at putting this in practice. We’ll look at the 1st Streit Office REIT offered on Streitwise as an example and specifically at the Laumeier property. This is a class A office park in Sunset Hills, Missouri comprised of three buildings with nearly 300,000 rentable square feet.
As a disclosure here, the numbers I have are from the most recent public filings from the SEC website for the company so make sure you check Streitwise for updated info.
Laumeier is leased to 25 tenants, most with solid credit profiles and across sectors including insurance, technology, retail and healthcare. Forty percent of the space is leased to Panera Bread Company for its headquarters with New Balance athletic wear leasing another 14% of the buildings.
The property has a tenancy of 99.4% which is very high and tenants have a weighted average lease term of 5.4 years remaining. I’ve seen good commercial properties that were only 90% leased so to be nearly fully occupied is excellent. Core tenants Panera and New Balance both have until 2024 on lease terms so that’s more than half the property leased up for the next six years.
The property was acquired for the Streitwise online REIT for approximately $44.4 million or about $153 per square foot. 2017 net operating income was around $3.95 million so that’s a cap rate of 8.9% on the price. Just over half the purchase was financed with a $24.6 million loan on 10-year terms at a 4.4% fixed rate. Based on this, management has been able to pay a 10% annualized yield since inception in September 2017.
I like the tenant mix spread across 25 companies and diversified in different industries. The two core tenants occupy more than half the space but both are financially healthy and have more than five years left on their lease.
The St. Louis market is huge, the city is the 18th largest metropolitan area with a population of nearly three million. It serves as the headquarters for 17 Fortune 1000 companies and unemployment of 3.4% is lower than the national average. According to Gershman Commercial, office rates for class A buildings ended 2017 at $27.04 per square foot which is well above the rent paid by Laumeier core tenants. Panera is paying $24.04 in base rent and New Balance is paying $22.34 per square foot.
Vacancy in South County, the submarket within St. Louis, was 9% at the end of last year and only the central business district and North County had sizeable vacancy so there isn’t a lot of empty office space weighing on rents. Rents across the area rose 2% from the prior year and have been rising generally while vacancy rates have been falling since 2016, so some very good market dynamics.
The cap rate of 8.9% is very good; I think a combination of solid rents, low expenses and a low purchase price on the property. From base rents paid by anchor tenants, rents look like they can be raised significantly as leases expire so that should help to support cash flow.
Why Include REIT Crowdfunding in Your Portfolio
Investing in online REITs makes managing your portfolio easier because you can analyze each of the properties in the fund. You can track new acquisitions and developments to make sure it fits with your portfolio and is the kind of quality that is going to support those solid cash flows and return.
It’s one of the things I like about online REITs versus exchange traded REITs.
With an exchange traded REIT, you might have hundreds of properties in a fund and more added every month. That makes it impossible to track for the individual investor so you’re made to completely rely on the fund manager.
That’s not to say I don’t invest in listed REITs. They have their benefits as well including the ability to buy and sell quickly but just know that you need to balance your portfolio with both online REITs and listed REITs.
There is no other asset like real estate. Stocks come and go. General Electric, the last original member of the Dow was dropped this year. Bonds are safer but offer very little chance for growth. I’ve been an active real estate investor for decades and have watched the opportunities evolve from direct ownership to listed REITs and now online REITs.
Check out Streitwise for that online REIT part of your portfolio and make sure you watch the other videos in the series to learn more about the new revolution in property investing. Building your wealth while avoiding the risks in each real estate strategies means combining them for a portfolio that grows.