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INTRODUCTION TO COMMERCIAL REAL ESTATE INVESTING

Investing in commercial real estate can be a valuable addition to any investor’s portfolio, offering various levels of involvement depending on individual preferences and expertise. For those willing to take on the responsibilities of direct ownership, managing and operating a property requires specific skills and a hands-on approach. Investors seeking liquidity may find publicly traded options like REITs or real estate-focused mutual funds to be the most suitable choice. Meanwhile, private equity real estate investments (such as those offered by Hightower Real Estate Partners (HREP”)) provide a compelling balance of income and growth potential for those who prefer a more direct yet passive approach.

The private equity investment model is a powerful tool for wealth building, offering a risk-adjusted approach to financial security. Investors leverage real estate to save for significant life events such as retirement and education expenses, benefiting from three primary components:

Equity Growth – As debt is repaid, investors build ownership in the asset.
Appreciation – Over time, property values tend to rise.
Cash Flow Distributions – Rental income provides consistent, passive income.
Tax Benefits – Depreciation – Investors can deduct the cost of wear and tear of real estate over time or immediately, with accelerated depreciations techniques.

This muliti-pronged approach often results in higher after-tax returns compared to traditional investments like stocks and bonds.

Inflation Hedge

Unlike annuities, bonds, or other fixed-income products, real estate serves as a natural hedge against inflation. Historically, property values and rental income have outpaced inflation, allowing investors to maintain and increase purchasing power over time.

Low Correlation to Public Markets

Real estate investments are backed by tangible, hard assets, helping to limit downside risk. Unlike stocks and bonds, real estate is largely independent of market volatility, making it an ideal diversification tool in a well-balanced portfolio.

The Investment Life Cycle of Commercial Real Estate

Understanding the investment life cycle is crucial for any CRE investment. The cycle spans from acquisition to exit and can be divided into two key phases:

Initial Acquisition: Underwriting & Closing Phase (UCP)
Value Add Phase: Investment Hold & Exit (IHE)

The Underwriting & Closing Phase covers the identification, evaluation, underwriting, and acquisition of a property. The Investment Hold & Exit Phase represents the time a property is held as an investment and the eventual sale. While UCP follows a standardized process, the IHE phase varies significantly based on the investor’s strategy.

Phase I - Acquisition

Underwriting & Closing (60–120 Days)

Acquiring a CRE property follows a process similar to residential real estate, but with notable differences. Like homebuyers, commercial buyers submit offers, conduct inspections, and secure lender approval. However, the due diligence and closing stages in CRE are far more complex.

Deal Origination and Underwriting

CRE investment opportunities arise from outbound efforts as well as having key relationships with brokers, lenders, and industry peers. When evaluating a potential acquisition, its important to have a thorough underwriting process.

Key questions in the underwriting process include:

How is the property currently performing?
Is it operating at full potential, or losing market share?
Why is the seller looking to exit?
Are there deferred maintenance issues?
How can we add value?

If a buyer’s offer aligns with the seller’s expectations, formal due diligence commences.

Due Diligence

In CRE, buyers rely on legal counsel, consultants, and industry professionals to conduct a thorough review, which includes:

Physical inspections (structural, exterior, and interior evaluations)
Financial due diligence (verifying income and expenses)
Environmental assessments (ensuring regulatory compliance)
Legal due diligence (reviewing zoning, title, and contracts)

The due diligence phase typically lasts 30–60 days, with extensions possible if issues arise.

Funding

For real estate equity investments or syndications, sponsors typically seek investor commitments before finalizing the acquisition, usually near the end of the due diligence period. This commitment is initially documented through a commitment letter, which outlines funding timelines and preferred returns. Investors are generally required to wire funds within 10 to 14 days prior to the property’s closing.

Acquisition Closing

The closing process in CRE differs from residential real estate due to higher equity requirements and fewer federal regulations. Unlike standardized home closings, CRE closings are more customizable, often requiring complex legal structures. This process can take an additional 30 days, extending the total acquisition timeline to 90–120 days.

PHASE II - Investment Hold, Reposition & Exit (Variable Duration)

Once a property is acquired, the Investment Hold period begins. Unlike the acquisition phase, there is no standard timeline for holding a CRE investment. The duration depends on the property type and overall investment strategy.

Long-Term vs. Short-Term Strategies

Value-Add & Opportunistic Assets – Typically held for 1–5 years, allowing investors to reposition and increase property value.
Core & Core+ Assets – Typically held for 10–15 years or more for stable cash flow and/or forecasting out to an event that will allow for value creation.

Asset Management & Value Creation

Effective asset management ensures the property meets its performance targets. This involves:

Overseeing property management teams
Monitoring financial performance
Optimizing revenue and minimizing expenses
Tracking market trends and economic conditions
Preparing financial reports and tax documents
Repositioning the asset to the highest and best use
Evaluating exit strategies

Asset management is the key to maximizing long-term profitability.

FINANCIAL STRUCTURES

Understanding the nuances of how a sponsor intends to distribute proceeds from a real estate investment is crucial for investors seeking to maximize returns and mitigate risk. The distribution structure, including preferred returns, profit splits (also known as the Promote), and waterfall provisions, directly impacts an investor’s share of the earnings. Evaluating estimated returns requires a thorough analysis of key financial metrics such as internal rate of return (IRR), and return on investment (ROI). Additionally, investors should assess the sponsor’s track record, underwriting assumptions, and market conditions to determine the feasibility of projected returns. A clear understanding of these factors enables investors to make informed decisions and align their expectations with the investment’s potential outcomes.

Understanding Preferred Return in Real Estate

A preferred return, or “pref”, is the priority distribution of profits to investors before the Sponsor receives any share of the profits. Preferred returns generally range from 5% to 12% and ensure investors receive a baseline return before profits are split further.

Key considerations include:

1. Compounded vs. Non-Compounded Preferred Returns
  - Compounded: Includes both initial investment and unpaid accrued returns.
  - Non-Compounded: Based only on the initial investment amount.
2. Cumulative vs. Non-Cumulative Preferred Returns
  - Cumulative: Unpaid returns roll forward to the next period.
  - Non-Cumulative: Unpaid returns do not carry forward.

IRR vs. ROI: Understanding Investment Performance

Two key metrics help assess profitability:

Return on Investment (ROI) – Measures total return but does not factor in timing.
Internal Rate of Return (IRR) – Accounts for both return amount and timing, making it a better indicator of investment efficiency.

Return on Investment (ROI)

ROI calculates the total return relative to the initial investment. It is a simple formula:

While easy to use, ROI does not account for the time value of money—meaning it doesn’t show when returns were generated, only the total percentage gained.

Example:

Investor A invests $100,000 and earns a total return of $150,000.
ROI Calculation: ($150,000 – $100,000) ÷ $100,000 = 50% ROI.

While 50% sounds great, the holding period matters. Was this return achieved in one year or ten years? ROI does not differentiate.

Internal Rate of Return (IRR)

IRR is a more sophisticated metric that accounts for both the return amount and the timing of those returns. It measures the annualized rate of return over the investment’s lifespan.

Since real estate investments often generate returns at different intervals (e.g., rental income during ownership and a lump sum at sale), IRR helps investors compare investments with varying cash flow structures.

Example:

- Investor A: Invests $100,000 in a property and holds it for 5 years. They receive 5% annual returns ($5,000 per year) and a large return ($180,000) upon selling.
- Total Return including initial equity: $200,000
- ROI: 100%
- IRR: 16%

Now, let’s examine Investor B, who also invested $100,000 into real estate and held the investment for five years BUT rather than having a large capital event in year 5, the annual distributions are larger with a moderate return in year 5.

- Investor B: Invests $100,000 in a property and holds it for 5 years. They receive 20% annual returns ($20,000 per year) and a moderate return ($120,000) upon selling.
- Total Return including initial equity: $200,000
- ROI: 100%
- IRR: 20%

Even though both investors had the same ROI, Investor B’s Internal Rate of Return (IRR) was 20%, compared to Investor A’s 16% IRR. Why? Because Investor B received more of their returns earlier, leading to a faster return of capital and higher return efficiency over time.

This example highlights an essential distinction: two investments with identical ROI can have very different return profiles based on how and when cash flows are received.

While ROI is useful for simple comparisons, IRR provides a more precise evaluation of an investment’s profitability over its hold period. However, IRR is not the sole metric for assessing an investment—it is simply one tool among many that investors should consider when evaluating opportunities.

Understanding Waterfall Distributions & Promote Structures in Commercial Real Estate

What is a Waterfall Distribution?

A waterfall distribution is a structured method of allocating cash flow and profits between the General Partner (GP)—also called the Sponsor—and the Limited Partners (LPs)—the investors.

It’s called a waterfall because profits are distributed in sequential stages, or “tiers,” with certain return hurdles needing to be met before further distributions occur. This structure is designed to align incentives between the Sponsor and investors, ensuring the Sponsor is rewarded for exceeding expectations. The more investors earn, the greater the Sponsor’s share of the profits.

How Does a Waterfall Structure Work?

A waterfall distribution outlines how profits are allocated between investors and the Sponsor. Let’s break down a simplified waterfall model with the following terms:

X% Preferred Return (First Hurdle)
Return of Invested Capital (Second Hurdle)
Y/Z Profit Split Thereafter (Final Distribution Tier)

Step 1: Preferred Return (First Waterfall Tier)

The Sponsor guarantees investors a preferred return of X on their invested capital. This means investors receive their proportionate share of distributable cash flow equal to an X% annual return before any profits are shared with the Sponsor.

Step 2: Return of Invested Capital

Once the preferred return threshold is met, the next distribution ensures that all investors recoup their initial investment before further profit-sharing occurs.

Step 3: Profit Split (Final Waterfall Tier)

After investors receive their preferred return and invested capital back, any remaining profits are split according to a pre-agreed ratio—in this case, Y% to investors (LPs) and Z% to the Sponsor (GP).

This Z% share to the Sponsor is known as the “promote” or “carried interest”, serving as an incentive for the Sponsor to drive strong returns.

Example Waterfall Distribution in Practice

Let’s say a real estate investment sells for $3 million, with the following financial obligations and distributions:

Lender Debt Obligations – First, the lender is paid off: $1.95M.
Accrued & Unpaid Preferred Returns – Any outstanding investor preferred returns are distributed: $18K.
Return of Capital – Investors are reimbursed their initial investment:
- $636K to the LPs
- $201K to the GP
Profit Distribution (70/30 Split) – The remaining cash is distributed based on ownership percentages:
- 80% of the 70% to LPs = $109.2K
- 20% of the 70% to the GP = $27.3K

Once the investors hit their return hurdle, the Sponsor’s “promote” kicks in, earning 30% of all additional profits thereafter.

Why Does the Waterfall Model Matter?

Waterfall structures are critical in CRE investing because they:

Ensure investors receive priority returns before Sponsors are compensated.

Align incentives by encouraging Sponsors to exceed return expectations.

Create transparency in how profits are shared between investors and Sponsors.

By understanding how waterfall structures work, investors can better evaluate investment opportunities and ensure their interests are aligned with those managing the deal.

Conclusion

Understanding CRE investment benefits, life cycles, and financial structures is key to making informed investment decisions and maximizing returns in commercial real estate.