What Real Estate Private Equity Firms Look For in Deals

There are over 5 million commercial buildings and over 6 million multifamily properties in the United States, and if you’re an investor who hasn’t narrowed down your search criteria yet, you’ll have a lot of options to sift through.

Real estate investment firms know this very well, and to narrow down their search to the opportunities that have the highest probability of making money (and the lowest chances of losing investor capital), there are a few core things I’ve seen first-hand that experienced investors look for when pursuing opportunities.

So to help you tap into the wisdom of companies that have been around for decades (through multiple market cycles), this article walks through three things that real estate private equity firms look for in commercial real estate deals, and how to spot opportunities in the real estate market.

If video is more your thing, you can watch the video version of this article here:

High Barriers To Entry

Commercial real estate investment firms often focus most on geographic markets that are supply-constrained, or cities where new construction is either prohibitively costly, difficult to get approved, or difficult to actually execute on due to a lack of available raw land.

This is why large private equity firms and institutions tend to be so attracted to gateway markets like New York and San Francisco, since these cities are almost completely surrounded by water, have extremely high population densities, and also have extremely little raw land available to develop.

Since rents and values in commercial real estate also rely directly on the supply and demand dynamics in a market, investors tend to view supply constraints as a significant value driver over the long-term, since demand is very likely to outpace supply when it’s difficult (or impossible) to build new product.

High barriers to entry can also refer to the depth of the buyer pool, and the amount of investors that would be able or willing to acquire a property. In most cases, the higher the property value and the more complex the property’s operations, the smaller the buyer pool is likely going to be.

A $10 million property with very straightforward operations will usually see very strong buyer interest, since there’s no shortage of companies (or even individuals) that can raise money to buy a deal of this size and run a property with relatively run-of-the-mill operations. This tends to create a competitive bidding process for these deals, that can often lead to inflated market pricing.

However, a $100 million property with more complex operations, whether that’s affordable housing restrictions, intricate commercial lease structures, or a ground lease encumbering the deal, will see a significantly smaller buyer pool in most cases. In CRE, there are very few individuals (and even investment firms) that can raise equity to buy a $100 million dollar deal, while also having the infrastructure and experience necessary to handle a property with unique operations.

Generally, the harder it is to buy and operate a deal, the more potential upside there tends to be in both income and value, which is why many experienced investment firms will gravitate towards larger assets and more complex deal structures that are difficult to understand.

Look For “Low-Hanging Fruit”

The best way to describe this in a real estate context is the process of looking for deals with significant potential to increase the property’s income and value over time, but with very little execution risk on behalf of the investor.

“Value-add” investing has become an extremely popular term in CRE, especially in the residential sector, with the vast majority of business plans on multifamily acquisitions involving heavy renovations of the property’s common areas and unit interiors.

And while this strategy can work well, there are also a lot of things that could go wrong during this process, especially in cases when an economic downturn hits and people aren’t willing to pay an extra $100 per month for stainless steel appliances, or investors see inflation levels that increase construction costs significantly over pro forma projections.

However, unlike focusing on acquiring properties with a major construction component required to raise rents, there are many ways investors can increase a property’s net operating income with significantly lower execution risk.

On a multifamily deal, this might be something as simple as adding washer and dryer appliances to units that already have washer and dryer hookups, which might cost something like $1,000 per unit, but will also often allow an investor to raise rents by $50 per month or more in many markets.

This could also involve things like curing deferred maintenance and reducing ongoing repair costs, renegotiating major contracts with vendors, reducing payroll costs by more efficiently allocating the time of on-site staff, or even utilizing existing unused space at a property to add storage or other fee-based amenities.

The goal is to look for deals where the cost to implement a value creation strategy is relatively low, and the chances of that strategy being successful are comparatively high. When you find opportunities to mix those two things together, this significantly de-risks an investment and increases the potential upside on a commercial real estate deal.

Protect Your Downside

Real estate private equity firms and institutions often look for deals where there’s opportunity to create value in all market conditions, even if things don’t go exactly as planned.

One of the most common examples of this for commercial real estate investors is the process of looking for properties that have in-place leases with significantly below-market rents and very little lease term remaining, and seller discounts related to the uncertainty around whether these tenants will vacate at the end of their lease terms.

Seasoned investors who have built strong relationships with leasing brokers and active tenants in the market know that, even if they acquire a property and have to take on short-term losses associated with downtime and the lease-up of a vacant suite, there’s also an extremely high likelihood they’ll be able to re-lease that space quickly at current market rates.

And for properties that already have in-place leases at current market rental rates, downside protection also often comes in the form of assurance of payment over a sustained period of time, by finding properties that are occupied by tenants with very strong credit and significant lease term remaining.

This is why office buildings occupied by companies like Google or Apple tend to trade at such a premium in the market, with these deals often being able to offer bond-like cash flows to investors with very little perceived risk.

Real estate investors can also find downside protection without brand-name corporate tenants on the rent roll through strategies like investing in properties on long-term government-backed leases, or even investing in affordable housing properties where the owner receives guaranteed rent payments directly from the city.

Ultimately, the more assurance an investor has that they’ll continue to generate revenue as expected, or they can re-lease vacant space quickly at current market rental rates, the more downside protection tends to exist and the higher the likelihood of a profitable exit.

How To Learn More About Real Estate Investment Analysis

This isn’t an all-inclusive list of what makes a great deal, but these are three of the most common patterns I’ve seen over the last decade of working for institutional real estate investment firms, and also investing alongside these companies.

And if you’re looking to break into the commercial real estate industry and learn more about how top CRE firms in the business analyze deals, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam. This exam covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.

As always, thanks so much for reading, and make sure to check out the Break Into CRE YouTube channel for more content that can help you take the next step in your real estate career.