Real Estate

A Framework for Real Estate Portfolio Construction

Every successful real estate investor starts somewhere. That ‘somewhere’ is typically with a single property or shares in a REIT, but over time an investor's portfolio can grow to encompass multiple asset classes and property types. The goal of this article is to offer practical guidance on how to begin building a real estate portfolio.

It’s important to understand that Commercial Real Estate (CRE) is not a generic term. There are many different CRE investment opportunities—such as multi-family, mixed-use, industrial, and office—and each investment type has a different target return and risk/reward profile. 

As you evaluate different investment opportunities, one of the first questions you should explore is how the asset creates value for investors. Here are some questions to guide your analysis:

  1. Is the investment targeting immediate cash flow?
  2. Is the investment targeting capital gains that will only be realized when the investment is sold?
  3. Is the investment targeting a blend of cash flow distributions and potential gains in the value of the asset?

Real estate investments have varying return profiles based on asset and the stability of its cash flow. When a CRE asset is ‘stabilized’, producing sustainable cash flow from rent collected, the asset can then distribute that cash flow to investors, once expenses and debt payments are covered.

 Investors should resist the temptation to ‘Yield Shop’.  Risk and return move in opposite directions: investing in properties with higher return targets involves significantly more risk. 

We can visualize the investment returns and profiles of various CRE investments within a pyramid:

Note, these are hypothetical return profiles for each category and do not represent an actual portfolio

The base of the pyramid includes investments with return profiles of 5%-9%. These are typically more established buildings with existing tenants and cash flow. These types of assets can be attractive for investors who are looking for steady, stabilized cash flow with some potential upside in the value of the asset. This upside potential can come from growth in the broader market and value add strategies (property improvements, etc) at the asset level. 

The middle of the pyramid is focused on value-add real estate where investors add value by making significant upgrades to the asset. These upgrades often require intensive capital spending, which is why very little cash flow is distributed to investors in the first few years of ownership. The goal is to enhance the value of the property and then secure higher-value leases, so that the property can then be sold to buyers who are looking for stabilized assets. The gain to the investor comes when the building starts producing cash flows and is eventually sold above its acquisition price. The risk is that the cost of the improvements and the time to implement could be greater than expected, and if tenant lease rate increases are not achieved it could hurt the value of the building on resale.

At the top of the pyramid, investors are striving for a much higher return profile and are taking significantly more risk to achieve this return.  Typically, the +15% return profile is for ground-up development projects, such as new construction, where there could be no cash flow for years as the project is built. Investors can achieve gains in their target ranges if the assets are sold to new buyers or refinanced at valuations significantly higher than the development and financing costs of the project.

Building a portfolio of CRE Investments:

A blend of these targeted CRE return profiles is a sensible way for investors to begin building their own CRE investment portfolio. The specific blend will depend on an investor’s risk profile and need for liquidity.  

Investors should evaluate the asset, the team that acquires and manages the property (known in the industry as the sponsor), the location, the risk to cash flow and value, and the exit plan. Investors should consider investing with established sponsors where there is total transparency and the ability for the advisor to gather as much information as possible on the investment options.

The next important factor of the investment process is finding an investment vehicle that will enable the investor to evaluate an asset and then gain access to investing in the asset of choice. The final metric to evaluate is how the investor can exit the investment when they want to sell.

LEX supports investors at every step of the process: from initial research to the eventual exit. Before we bring a property to LEX, our real estate investment banking team conducts extensive due diligence on the property’s underlying financials, tenancy, and management. We share this information on our platform, to empower investors with the tools they need to build a portfolio that meets their own unique goals and risk tolerance. If these goals or tolerance for risk change down the line, investors can use the LEX marketplace to exit their positions or enter new ones, without lockups or holds. While we can't guarantee liquidity, LEX does more to enable it than any other real estate investing platform.

LEX Markets does not provide tax, legal or accounting advice. Potential investors are encouraged to consult with professional tax, legal, and financial advisors before making any investment into a securities offering. This investment may not be suitable for all investors. Distributions and liquidity not guaranteed. Property performance and performance of property tenants not guaranteed. Diversification does not eliminate the risk of experiencing investment loss.

November 15, 2022

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