All CRE investment opportunities filtered through four criteria
Like you, I get many opportunities to invest my hard-earned money in commercial real estate. Most of these opportunities I say no to rather quickly, but occasionally one comes across my desk that interests me. Lately I’ve had several people ask me, “How do you go about choosing a rental property to invest in out of the many that are presented?” Good question. To answer that question I’ve written a three part series explaining my selection process.
Let me begin by saying that I strongly believe investing in commercial real estate is more of an “art” than a “science.” That is why I titled my recently published book, Mastering the Art of Commercial Real Estate Investing. Everyone has their own method of analyzing the merits of buying a property. I rely heavily on my investing criteria I’ve developed over the years, as well as my intuition and finally on my own approach to analyzing the numbers. So let’s get started.
The first step in the process is identifying which investment opportunities fit in my “box.” By that I mean, which real estate opportunities fit my narrowly defined criteria for consideration. This is a relatively simple first step. For a rental property to be considered it must meet four criteria. If it doesn’t, it doesn’t make the cut. It’s as simple as that. What are my four investing criteria you ask?
1. Acceptable sponsor
As a passive investor I let someone else make all the investing decisions. My responsibility is to provide some of the equity needed to purchase the property. So, the very first decision I have to make is, “Who do I want to trust with my money?” This decision is very important, maybe the most critical of all the decisions I have to make about investing in CRE.
But for me it’s an easy choice. I do all my investing with one real estate sponsor that I’ve known personally for about 25 years. I know his excellent CRE investing track record. I know that he is a man of integrity and because of that I trust him. At this point he is the only person I invest with. Not to say I couldn’t invest with another sponsor. I could, but until something drastically wrong happens with my current sponsor, it’s highly unlikely.
2. Acceptable property type
I believe you should only invest in rental properties where you thoroughly understand their unique qualities. For me, my property type of choice is apartments as most of my real estate lending experience over the past 35 years has been financing apartments. I know apartments well but I could be convinced to buy multi-tenanted office, retail or industrial properties and mobile home parks.
Of the ten rental properties I’ve invested in so far, eight have been apartments, one was student housing and one was a multi-tenanted office building. For an example of the winnowing process in action, I was recently asked by my sponsor if I would like to invest in a Class A vacation rental property. It isn’t a property type that I understand so I easily passed on this investment opportunity.
3. Acceptable geographic market
I only invest in real estate markets that I’m familiar with. For me that means I only invest in the states of Oregon and Washington. Investing in other parts of the U.S. doesn’t make sense to me because I don’t know the strengths and weaknesses of other cities. Yes I could do a thorough investigation of these other markets and maybe get comfortable with investing in a particular city. That’s possible. But that only solves the first problem.
In my business as a mortgage broker, I’ve seen way too many properties in poor condition only to find out that the owner lives out of state and rarely visits the property. That in my opinion, is a recipe for disaster. The adage, “You get what you inspect, not what you expect” is particularly true in CRE. If I’m not willing to regularly visit my rental properties I won’t invest there. Most of my rental properties I could drive to in less than an hour.
For example, I’ve had opportunities to invest in apartments in Arizona and Idaho, and because I’m not willing to fly to these states to regularly inspect them, I’ve passed on these investment opportunities.
4. Acceptable market size
Not only do I want to purchase properties in markets that I’m familiar with, I also want to invest in larger metropolitan areas. There is a reason why cap rates are higher on properties located in small towns. It’s much riskier than investing in large MSAs. Rents and occupancy rates in small towns lag what’s happening in the large cities. My experience is that small towns are much slower in rebounding from a recession than larger markets. Is the lower purchase price of a property in a small town worth it? Nope. Not for me it isn’t. So I’m willing to invest in Seattle, Tacoma, Olympia, Portland, Salem and Eugene. Under the right circumstances I might invest in Corvallis, Bend and Spokane.
The filtering process is a big time saver
When a for-sale listing comes across my desk, I filter it through these four investing criteria. Imagine for a moment my decision making process. How long do you think it takes for me to say “no” or for a few properties to say “maybe?” In very little time at all, a couple of minutes at most, I’ve filtered out 95% of the deals that come across my desk. By using these four investing criteria have I possibly missed some great properties to invest in? You bet I have. But I’ve also substantially reduced my risk of ending up buying a property that I will later regret.
Set your own CRE investing criteria
So if you are following my example, the first step in the rental property selection process is to establish a set of investing criteria that you deem inviolable. I have my four benchmarks, but yours may be completely different. How do you develop your investing criteria? I’ve discovered that my selection standards have been highly influenced by past investment failures. In other words, I’ve learned from my past mistakes. You may want to start there too. But whatever yardsticks you come up with, be very cautious of not following them when a potential opportunity doesn’t quite fit your “box.” It’s far better to pass on what looks like a good deal than to regret it later because you invested in the wrong rental property.
Those are my thoughts. I welcome yours. What are your non-negotiable investment criteria?