CRE can be an intimidating endeavor for new investors. There’s a lot of industry jargon and complicated legal processes to navigate. But, a middle-market CRE investment strategy has several benefits for those who dive in. Learn about the following:
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Low Risk
As a smaller industry segment, middle-market CRE investors have less financing competition. It often translates to lower leverage ratios and more favorable investment terms (e.g., cash flow sweeps that minimize credit risk and minimum multiples). Investors can access opportunities in all positions of the capital stack in middle-market CRE transactions with the aid of an asset management firm. Among online platforms, multifamily tends to dominate, but single-tenant and value add strategies also have strong return potential. Pricing in the middle market sector also tends to be more stable than in premium, high-market properties. It is partly because middle-market properties are generally located in secondary markets rather than major metropolitan areas. These properties typically attract local interest and fewer outside investors who may drive pricing peaks and valleys.
Strong Cash Flow
As interest rates continue to rise, many CRE borrowers will likely face near-term debt maturities, higher borrowing costs and tighter credit standards. In the face of rising borrowing costs, these borrowers will either be forced to contribute more equity, sell properties or face foreclosure – all of which can harm investors’ returns. Middle-market assets tend to have investment-grade tenants with long-term leases, resulting in stable and dependable property cash flow that can withstand the economic cycle. It provides a better alternative to speculative office space, retail malls with less certain occupancy and weaker industrial areas that may need help during recessions.
Strong Equity Position
Despite significant performance dispersion, the $4.4 trillion commercial real estate (CRE) industry provides investors with a broad range of return potential. Investors seeking higher returns can pursue opportunistic strategies, find more off-market deals, or acquire Core assets. Although CRE’s cyclicality and exposure to interest rates create risk, we do not anticipate widespread property distress. Tenant demand may slow, and vacancy rates could rise in some subsectors and markets, but these headwinds are expected to be contained. Most CRE investments have lower correlations with stock market indexes and bonds than public REITs. And with streamlined, tech-powered investment platforms and low prevailing minimums, private CRE investing is more accessible than ever before.
Tax Advantages
The CRE industry continues to intrigue investors. One reason is the relative stability of middle-market properties. It results from reduced financing competition seen in other asset classes and an ongoing need for construction projects in the space. While investor demand for CRE is expected to slow, and vacancy rates may tick up for some subsectors and markets, the sector’s healthy fundamentals should support tenant demand and mitigate downside risk. Elevated interest rates and scheduled near-term debt maturities will likely push cap rate and discount rate increases, putting headwinds on values. The illiquidity of private-market CRE investment strategies and information asymmetry makes the selection of an optimal platform and sponsor key to maximizing return potential. It is especially true for passive LP investments.
Flexibility
CRE transactions involve debt and equity financing instruments, and investors can participate in any part of the capital stack – though positions lower in the capital stack (such as mezzanine debt or preferred equity) tend to offer less risk. Online CRE investing platforms often focus on these junior-middle positions, while more senior classes like common equity can feature higher return potential.
Investors should consider their liquidity needs, risk tolerance, and investment horizon when selecting private CRE portfolio strategies. Investors should also be clear on their goals for participating in private CRE – whether pursuing a steady stream of income, back-ended return potential, or the relative value opportunities offered by mezzanine loan structures. Investors should also understand how illiquidity impacts return potential, as private CRE investments generally carry an illiquidity premium.
Resources:
The Sweet Spot: What Makes Middle Market Deals Attractive?
Benefits of a Middle-Market CRE Investment Strategy
