How to Become an Empowered Investor: Use Your Judgement

The Empowered Investor Methodology is a revolutionary way of helping people obtain financial security and transform their lives through alternative real estate investments. This methodology consists of a five-step process: Ethos, Educate, Evaluate, Execute, and Empower.

This article is the third of a five-part series on this original methodology.

Step 3 — Evaluate

“The underlying steps of sound investment should not alter from decade to decade, but the application of these steps must be adapted to significant changes in the financial mechanisms and climate.”

― Benjamin Graham

To quickly recap, Step 1 of The Empowered Investor Methodology discusses the importance of changing one’s ethos and how this puts investors on the right track to succeed. Step 2 covers why and how investors should broaden their financial education, especially their understanding of alternative real estate and specifically of syndicated commercial real estate investments.

That brings us to Step 3, which requires empowered investors to evaluate the merit of a syndicated commercial real estate investment by weighing the variables. The primary variables include the following:

- Investment strategy

- Sponsor and management team

- Investment projections and assumptions

- Alignment of interest

- Investment risks

There are four main real estate investment strategies that are differentiated by their risk-to-return characteristics. These strategies are core, core-plus, value-add, and opportunistic. The risk profile of each strategy is based on the amount of leverage used to acquire the asset and the characteristics of the asset, such as tenant credit worthiness, length of the lease, location, and physical condition of the asset.

In any syndicated real estate opportunity, the sponsor and management team are the most critical element. The sponsor creates the opportunity, obtains financing, and attracts investor capital. Additionally, the sponsor will work with a third-party management company to onboard tenants at market value and gradually raise rents of the existing tenants. Investors receive distributions (cash flow) as appropriate from these cumulative operations. The property will be stabilized and held in accordance with the exit strategy outlined in the business plan.

Innovative sponsors will find ways of increasing efficiency and making constant improvements to the asset. Because the value of commercial real estate is based on the amount of income generated, the asset becomes more valuable with income growth. Each asset should be thought of as a functioning business, and the goal is to make each asset into a better business that will be highly valued by investors.

If the sponsor and management team are the building blocks, underwriting is the foundation every potential real estate transaction is built upon. It is the methodical process of collecting property-related financial data and building a financial model. This model produces a financial statement known as a pro forma, which is based on the sponsor’s assumptions and projections. Investors should determine if the sponsor’s pro forma is reasonable and that the underlying assumptions align with the investor’s risk appetite. Assumptions should be based on factors such as past market performance, existing market characteristics, and future trends. The conservative or aggressive nature of these assumptions should be examined by investors to determine the credibility of the projected performance metrics.

There are four performance metrics that are most commonly used in commercial real estate investments and referenced in business plans and investor pitch decks: equity multiple, return on investment, cash-on-cash return, and internal rate of return. The time value of money is an important concept when evaluating investment opportunities. The idea is that the money you have now is worth more than that same amount in the future. It is important to note that some of the commonly used investment return metrics do not account for the time value of money.

Investors should consider that not all projected returns are created equally, as a “higher” quality return is primarily based on income with associated tax benefits, like depreciation, to reduce tax liability. A “lower” quality return is primarily based on appreciation and principal pay down. The income is generally very consistent with a stabilized income-generating asset, whereas appreciation and principal pay down can be realized only upon a liquidity event. Appreciation generally bears the bulk of investor returns but is the least predictable.

In a syndicated real estate deal, the sponsors are compensated in only two ways: fees and split of distributions. The sponsor can gain a disproportionate amount of distributions relative to their co-invest (initial investment) from “overdelivering” as a result of the sponsor’s sweat equity and their ability to exceed return expectations. There is no universal compensation structure, but the sponsor’s overall compensation should be primarily based on delivering performance (i.e., making money for investors). Investors should determine whether the opportunity has proper incentive alignment between the sponsor and the investors or if excessive risk is being borne by the latter.

Investments carry one or more risks, including inflation risk, market risk, political risk, business risk, currency risk, liquidity risk, and concentration risk. Investment risks cannot be eliminated, therefore, all investments carry some degree of unpredictability. Investors should understand the risks involved in any investment and evaluate whether the investment helps position them to meet their financial goals and needs. In the case of evaluating a commercial real estate opportunity, investors should take their risk appetite and weigh this against an investment’s performance metrics (equity multiple, return on investment, cash-on-cash return, and internal rate of return) and the underlying assumptions behind them. Investors should use this to determine the quality and suitability of the investment.

When looking into any syndicated real estate deal, there will come a time when investors have to decide if they should take it or leave it by evaluating several variables. The process may seem overwhelming, but it is no more time- or energy-intensive than evaluating which stocks or mutual funds to buy.

Stay tuned for the next article in this series: Step 4 of The Empowered Investor Methodology.

For more information on passive investing in commercial real estate, please check out our free eBook — More Doors, More Profits — by .

Mo Bina
Managing Principal
High-Rise Capital
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