What is Your Investment Criteria?
For investors active and passive, this is the “meat and potatoes” question. How much return on my invested capital am I seeking? That basically boils down to a percentage per year (that may or may not include IRR) and that number may be higher or lower depending on the varying amount of risk associated with the investment.
I always tell people invest what you are willing to lose. Real estate investment measured against other investing methods is more conservative but there are no guarantees and it is still a risk. Having knowledge in real estate investing and understanding not just the numbers but the whole picture can hedge your bets so to speak.
To keep it simple below the “return” I will be referring to is a cash on cash return which is different and easier to calculate than an Internal Rate of Return.
Quick definitions of each:
Cash on Cash (COC) return: is the percentage of return you make on the dollar amount of invested capital.
Internal Rate of Return (IRR): IRR is removes external factors, such as the cost of capital or inflation, from the calculation. There are multiple formulas used to calculate IRR but most commonly it calculates net cash flow, investment cost, discount rate and time period.
Risk it for the Biscuit
Obviously everyone wants the highest return on their investment possible, but when answering the question of What return am I seeking?, you must also ask yourself how much risk am I willing to assume. Risk is relative to each individual's situation and life circumstance, but generally speaking a higher return is usually accompanied by a higher overall risk.
If you say I want a 12% or greater annual return you are likely looking at a higher risk investment, such as a new development or repurposing opportunity. I consider ground up development a riskier investment because of the unknown factors. When you pro-forma a project out, time can be your greatest enemy, the exit landscape may be totally different from the time you entered the project. Discovering unforseen costs in development, bad weather, crooked contractors and a multitude of other risks are make a development deal often riskier than the proposal. The reason the proposed returns are so high is because the sponsor group knows those investments carry greater risk in addition to an accrued payout that you won’t realize until the deal is completed and exited.
In contrast, perhaps you are experienced in developments and you diversify your investment across multiple development projects and except the fact that doing multiple deals is going to yield varying results over time and markets. Am I to argue that is less or more risky than entering one stabilized deal? No! But if you don’t have the capital, experience or wherewithal to invest in multiple development deals at once, should your first venture into real estate investment be a single development deal? I’d also lean toward no.
On the other side of the spectrum, the opposite of an aggressive, high risk, high return investment is a safer more conservative, lower return, steady mailbox money. A more conservative investment (4-5%) comes with more security but much less upside, an example may be a single corporate tenant with a long term triple net lease and corporate guarantee (Ex. Starbucks, Walgreens etc…). With that type of investment you are putting your faith into: a) the corporate tenant, that they have stable financials for longevity and b) the appreciation play, most of those investment are located in growing or stable markets with stronger demographics, incase the tenant did leave you hope that the property value would have appreciated where selling, redeveloping or releasing wouldn’t be a problem. There are many REITS that specialize in triple Net, corporate guaranteed leased property that buy them in large portfolios and are very happy with lower return because they value security and predictability over a higher payout and upside.
Somewhere in the Middle
Most new investors and syndicators start somewhere in the middle of those two examples. Seeking a moderate return (6-8%) with a moderate level of risk, in this market, is not only possible but also the most common or frequently available investment.
Once you decide on your investment niche and can accept the risk vs reward components you will have a baseline of where to start looking and can eliminate deals that fall outside your investment criteria.
Questions to ask yourself:
What return am I seeking? Lower safer returns, higher riskier returns, somewhere in the middle?
What is my money secured by? What happens in a worst case scenario?
What does the exit plan look like?
Is there financing involved, what type and who are the guarantors?
Do the operators have proven experience?