If you read through enough private real estate fund prospectuses, you will likely come across an investment strategy that reads something like: “the fund seeks to generate positive, risk-adjusted returns by making opportunistic investments in commercial real estate”
Sounds exciting, but what in the world actually qualifies as an “opportunistic investment in commercial real estate”?
*This page's content was provided by a sponsor of our real estate education series, Sovereign Properties. Sovereign Properties offers investment opportunities for development deals for multifamily apartment buildings via private syndication. You can view replays of their previous educational webinars on our free Real Estate educational series.
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The What of an Opportunistic Investment
Put simply, any investment that is described as opportunistic will seek to profit from a significant gap between an asset’s purchase price (i.e. what the investor is willing to pay for it) and its perceived intrinsic value (i.e. what the investor believes it can sell it for). It follows the old-fashioned investment approach of, “buy low, sell high”, but will often involve significant active management and may take a number of years to realize substantial capital appreciation.
These characteristics point to the specific risk-return profile of opportunistic investments. Because they are more speculative in nature, there is more associated risk, but if executed well and assumptions hold, a potential for higher associated return on investment.
The Why of an Opportunistic Investment
Opportunistic investments may arise because of microeconomic, asset-specific conditions – such as a bias or lack of information that the seller lacks but the buyer has. One of the ways you can participate in an opportunistic real estate investment is through a ground-up development project. If you can develop a property for less than the value of an existing, comparable property, you can create value.
To better understand this type of opportunistic investment, it’s useful to review an example:
Let’s imagine that a family in the DFW metropolitan area has owned a property for several years. The piece of land was acquired by the current owner’s ancestors. The land is zoned for office use, and the current owner is worried about the viability of the office market given the prevalence of remote work post-pandemic. She believes she is better off investing that money in the stock market, so she decides to list the property for sale. The seller hires a real estate broker to market the property and together they conclude that the list price should be $5,000,000, believing that they would not find a buyer willing to pay more for an office site in that market today.
The potential buyer is a group like Sovereign Properties. Sovereign has conducted extensive market research and also concludes that constructing an office on this property does not make sense. However, Sovereign knows from its meetings with the municipality staff that the county would be amenable to building apartments on the property. Sovereign knows that they can re-zone the property to develop a multifamily community and believes they can develop about 300 apartments. At a $5,000,000 purchase price, that equates to $16,667 per unit. Sovereign knows that a piece of property zoned for apartments just 5 miles from this site sold for $23,000 per unit, or 27.5% higher than the site’s list price. Sovereign’s underwriting informs the company that it can meet its investment goals, provided they can re-zone the land for less than about $3,000/unit, which is reasonable. Sovereign decides to purchase the property.
In this example, Sovereign was able to purchase the property at a discount to market given the information bias. Both the seller and buyer are satisfied with the outcome.
Alternatively, opportunistic investments can arise because of market volatility and macroeconomic tumult. During these periods of uncertainty, many lenders and institutional capital providers tend to pull back on investments, which results in lower transaction volumes. With less comparable sales data to evaluate, it can become challenging for buyers and sellers to agree on property values. Those sellers who need to sell, due to maturing loan balances or generally liquidity matters, will have fewer buyers competing for their properties. Those buyers still “in the game” may be able to acquire properties at a discount to full value – resulting in capital appreciation when the macroeconomic environment improves.
Let’s review the current macroeconomic backdrop to better understand:
Following the Great Financial Crisis of 2008 and the ensuing recession, U.S. monetary policy followed a prolonged period of “quantitative easing” – enacting a 0% risk-free rate for much of the last decade. With borrowing rates so low, many commercial real estate deals made sense – a buyer could profit from acquiring a property with a substantial amount of leverage, making a few upgrades to the property, sell it for an increased value a few years later, pay off the loan, and pocket the upside.
Beginning in March 2022, the Federal Reserve began to increase its benchmark interest rate in an effort to curb inflation, thereby ending the period of “easy money” that characterized the post-GFC period. Inevitably, the rapid increase interest rates caused strain for those borrowers who capitalized their projects with floating rate debt – as floating rate interest expense will fluctuate with commensurate changes in the benchmark interest rate.
At the same time, debt originations (loans made to borrowers) have fallen among all primary debt sources, including banks, commercial mortgage lenders, and life insurance companies. As a result of waning credit availability and increased borrowing costs, we have seen sales transactions decline meaningfully across the commercial real estate sector.
So, we have borrowers facing an unforeseen rise in interest rates, and fewer buyers willing to purchase properties/sites due to tightened credit conditions. The fundamental merits of the property may not have changed, but this unfortunate combination will lead many borrowers/owners of properties to list their properties for sale at a significant discount to comparable properties. The lower-than-anticipated acquisition basis for the ultimate buyers could similarly generate an opportunistic return profile to a new Sponsor/investor.
The How of an Opportunistic Investment
The financial headwinds challenging the commercial real estate sector today will actually create opportunities to acquire high-quality assets with sound fundamentals and growth prospects. The important thing to remember is that an opportunistic CRE investment requires the right level of expertise. In order to succeed with an opportunistic real estate investment, the sponsor must be realistic in their assumptions and proficient in the type of development, renovation or repositioning necessary.
Key Questions to Ask Before Making Opportunistic Investments
Does the Sponsor have a proven track record of success?
Management intensive – sponsor needs to be able to execute the business plan.
Does the investment timeline align with your individual goals/needs?
Investments may take years to make distributions. Often times, the majority of the investment return is realized upon sale of the property.
Does the business plan rely on debt? Is that debt appropriately sized?
Remember, the interest rates on floating rate debt may increase or decrease throughout the hold period. Make sure the sponsor is holding sufficient reserves to fund the anticipated interest expense over the life of the loan.
Under what instances might I be required to invest additional capital?
Given the higher risk-return profile of opportunistic investments, there can be additional capital calls required throughout the hold period. Make sure you understand how likely that is and if/how that may affect your investment.
What is the Internal Rate of Return (“IRR”) and equity multiple?
The IRR measures the return on each dollar invested, for each period of time its invested.
If you invested $50,000 and made $20,000 in year 3 and another $80,000 in year 5, your investment IRR is a 16.462%.
The equity multiple is a calculation of the dollar-for-dollar return on your investment, irrespective of the hold period.
If you invested $50,000 and made $20,000 in year 3 and another $80,000 in year 5, the investment equity multiple is a 2.0 ($100,000 total distribution(s) /$50,000 total contribution).
You want to make sure you understand not just how much gross profit the investment is expected to yield (equity multiple), but how long it will take to achieve that profit (IRR).
Bottom Line
Opportunistic investments have the potential for a high upside, but are not without risk. You really want to understand the assumptions that are being made for this potential to be realized, know that you or a sponsor of a syndication have the appropriate expertise and networks to navigate the opportunity and realize the profits if unexpected challenges arise, and be comfortable with the risk-reward profile.