So you’re evaluating a syndication for a potential investment? I’ve got some good news for you: Observing these principles may allow you to reject this investment opportunity without a deep dive into the financials or a site visit.
Confused? Let me explain.
If you want to be a great real estate investor—or a great investor of any type—you’ll want to say no a lot. Almost always.
So, our first rule when evaluating a commercial real estate (CRE) syndication is to assume you will pass on the deal. Assume it’s a no, then look for reasons to confirm this conclusion.
Starting with yes, which is far more common, will result in confirmation bias, which will lead you down multiple bad paths, both in investing and life.
With that out of the way, let’s look at the top-down analysis. This term is borrowed from the stock investment world, and it directs us to start with the big picture and then drill down.
Stock investors start by looking at the national economy as a whole. How does it drive markets and pricing? Then they drill down to the performance of various industries and how that performance benefits from big-picture factors.
An investor would be unlikely to buy a stock in an industry that is tanking. But a thriving industry is cause to keep drilling down. You get the picture. And it equally applies to real estate investing.
Applying Top-Down Analysis to Real Estate
We can apply a similar analysis to commercial real estate. To do that, we’ll start with a very broad national view, then drill down level by level.
Starting with the big picture: National economic trends
Real estate, like most businesses, is deeply impacted by the national and even international economic climate. Ask questions like:
- What is the national economic outlook? Is GDP growing at a healthy clip?
- What is going on politically, and how does that impact the economy?
- What important legislative trends may affect real estate?
- Is there a groundswell of public opinion that could negatively impact this asset type?
- What is happening in the lending environment? Where are interest rates?
Think carefully about these questions and many more. Consider passing on this opportunity (no matter how promising the numbers or how glossy the brochure) if the economy is wrong.
Conversely, recognize that many great fortunes are made by contrarians. But don’t use this as an excuse to ignore big-picture factors that could wreck your deal.
I made a lot of money investing in waterfront lots in the early 2000s, conveniently ignoring data (including a reputable magazine cover story) that showed the real estate bubble was about to burst around 2007. And I paid a price for my foolishness!
Narrowing your focus to metropolitan statistical areas (MSAs)
MSAs are a fancy statistician term for metropolitan statistical areas. Questions to ask:
- Which MSAs are growing—and how does this city compare to others?
- Which MSAs are stagnant or declining?
- What trends are impacting this MSA?
- Does this MSA support a broad base of employers? We like to see healthcare, education, and government. This provides a diversified cross-section of employers that are often less impacted by economic downturns.
- What crime and legislative trends could impact this investment?
If you’re looking for a market to invest in, comparing MSAs can be a great start. If you’re analyzing a specific deal, it’s important to ask these hard questions about the subject MSA.
So if your MSA analysis is positive, it’s time to take a related critical step.
Examining submarkets within MSAs
Next, you’ll want to examine submarkets within your MSA. Why? Because even growing cities have areas in decline.
If you’re still looking for a location to invest in, this examination can continue to focus on ever-smaller areas to hone in on the best locations for investment. If you are looking at a deal, it is important to compare the subject submarket to others in the MSA, region, and nation.
While certain asset types require a very tight geographic analysis (think Walgreens or Starbucks that need to precisely pick a corner), many types (think multifamily and mobile home parks) don’t require such extreme rigor.
Here are some steps to take:
- Analyze crime stats in this submarket.
- Is this specific area declining (becoming more of a slum) or gentrifying?
- How are school districts in this submarket ranked?
- How do the “big three” (job, income, and population growth) stack up in this submarket?
There’s nuance and wisdom required here. For example, it’s easy to assume a seedy area a few blocks from a gentrified neighborhood will itself undergo transformation in the coming years. This is a very risky assumption—not one I’d bet my hard-earned investment dollars on.
Or you may note low violent crime and higher property crime. But a mall and retail district dominating certain submarkets may be the source of nonviolent car theft that has little bearing on other asset types.
Watch out for supply-side risks
Healthy submarkets often result in new development. While that’s a great metric for the area, it can also result in oversupply. And this can produce significant stress or even failure for your syndicated commercial real estate investment. Most of us have witnessed this in the self-storage realm these past several years.
Developers often get carried away just before the top of the cycle, and the forthcoming downturn is often devastating for them and other late-cycle entrants.
Ironically, most investors jump in at exactly the wrong time, when risk is highest and likely return is low. Think this through carefully. I recommend you start by reading and internalizing Howard Marks’ classic treatise Mastering the Market Cycle—Getting the Odds on Your Side.
This is not just a subjective analysis. Helpful metrics include:
- Recent construction starts and building permits
- Absorption ratio
- Occupancy (vacancy) rate trends and predictions
- Legislation impacting new development
I mentioned overbuilt self-storage. My firm invested in a ground-up self-storage syndication in the suburb of a growing Northern city. While the MSA’s stats showed oversupply, this suburb had placed a moratorium on building new self-storage in their locale—after approving the project we invested in. It pays to dig into the details.
Key Indicators in Real Estate Top-Down Analysis
There are dozens of metrics you’ll want to review in your top-down analysis. There are literally hundreds of sources for these metrics. A world-class, passive CRE investor may dig up data that the syndicator misses (or fails to report!). You won’t always have to do this to succeed, but I can assure you that some of our fund’s savviest investors ask the hardest and highest quantity of questions.
My firm has a 27-point due diligence checklist we employ when considering passive CRE investments. This checklist covers details far beyond the scope of this post. For our purposes, we’ll start with the big metrics of commercial real estate.
Population growth
It’s hard to make money on a commercial real estate asset when the MSA population is shrinking. Conversely, a growing population obviously provides positive fuel for most CRE investments. (Note that growth can be a prime factor leading to oversupply, as discussed.)
We like to see MSAs and submarkets with positive, growing net population migration, i.e., people moving to the area. This is often influenced by the next two metrics.
Job growth
An expanding job market is key to the success of most commercial real estate investments. Jobs created by employers result in more employees (call me Captain Obvious!). Employers typically require commercial real estate to grow their companies. And new employees often bring along families that utilize commercial real estate to survive and thrive.
Income growth
Increased pay leads to higher disposable incomes. Disposable income fuels local economic growth, which can result in better CRE investment outcomes.
This is another instance where wisdom and experience help. While some asset types thrive on higher disposable income, others don’t require this and could even benefit from lower incomes.
Think about how self-storage or high-end retail benefit from higher incomes. But an investment in working-class multifamily or mobile home parks may perform better in a lower-income market.
Household formation
While population growth is important, look deeper to analyze household formation as well. For some CRE asset types, like multifamily and mobile home parks, household formation often trumps population growth. Why? Because households (as statistically defined) rent (or buy) residential units.
Population growth and household formation do not always go hand in hand. For example:
- New births lead to population growth, but babies don’t rent apartments.
- Adult kids move out. Divorces happen. Households are formed and units are rented, but the population doesn’t grow.
- The economy tanks, and adult kids move back home. Single renters double up. Household formation shrinks.
Think about this the next time someone tells you to invest in real estate because “everybody needs a place to live!” That’s a hoax. Commercial multifamily (large apartments) investors from 2008 will verify that their investments often tanked due to negative household formation.
Other metrics
Smart passive CRE investors will analyze quite a few other important metrics before even looking at the financials. These may include:
- Space under construction as a percentage of inventory
- Rent growth
- Market vacancy
- Long-term vacancy average
- Median income
- Rent-to-cost of ownership ratio (compared to regional and national)
- Income-to-housing cost ratio
- Market rankings (compare metrics to MSA, regional, and national stats)
Good news: You’re not on your own! There are more sources than ever before to obtain and analyze these statistics from the comfort of your own home office. Here’s a quick list to get you started:
- BiggerPockets Market Finder
- Milken Institute’s annual Best-Performing Cities Index
- PwC and Urban Land Institute’s annual Emerging Trends in Real Estate report
- Forbes’ annual lists of most desirable cities and most business-friendly states
- Data from research firms like REIS, CoStar, Axiometrics, Yardi Matrix, etc.
- Data published by large commercial brokerage firms
- U.S. Census Bureau
- Texas A&M Real Estate Research Center
- Local CRE brokers and planning and zoning offices
You can even gather insights from searching on U-Haul and Penske truck rental sites. Consider the implications of a rental from L.A. to Dallas that costs six times as much as the charge for the reverse trip!
Final Thoughts
Are you investing your hard-earned capital into someone else’s syndication? If so, you owe it to yourself to do some hard work. Don’t just rely on a broker’s stats or a syndicator’s slick presentation. They have the upper hand in knowledge. Do what you can to even the playing field.
Check their work. Verify their assertions. Dig out more details. Ask hard questions. Follow the money and consider alignment of interests. And like Warren Buffett and most of the world’s greatest investors, please default to no. There are a lot of other opportunities available.
Speaking of Warren Buffett, he encourages investors and operators to stay within the limits of their knowledge and experience. He calls this the “Circle of Competence.” You should hire your syndicator based on this at a minimum.
But there’s a folly my team calls the “Circle of Codependence” that’s equally in play here. It goes something like this: Everyone is standing in a circle, looking at the person to their left who invested with a sponsor. They think, “He or she is happy with their investment and must have done a lot of due diligence.” That person is looking at the person to their left and thinking exactly the same thing—until it goes full circle back to the first person.
No one has actually done any real due diligence. But the deal caught on because a couple of people in a group invested with that sponsor, sometimes only a few months earlier, when there wasn’t yet sufficient time for the investment results to replace the upfront due diligence that wasn’t done.
That’s how many of the “marketers” who are now losing investor capital raised a lot of it in the first place. It’s also known as “word of mouth.” There’s nothing wrong with it if someone you know and trust actually did the due diligence, or if the operator had round trips through a full market cycle and skin in the game to shorten the due diligence timeline. All too often, however, that just isn’t the case.
You can start your own “Circle of Competence” in the due diligence arena. It’s common for the herd to take syndicators at their word and write a check. But you can do better than that.
And it starts with a thorough top-down analysis. Hopefully this will serve as a signpost to get you started.