More and more households are looking to support family income with passive investment into commercial real estate. Access to deals via the internet and crowdfunding make a wide range of these assets available to non-institutional investors of all sizes. The longstanding value and stability commercial real estate offers make it an attractive alternative investment.
We often come across the term institutional, but what is the actual definition? I was surprised to find there is no standard definition of institutional in commercial real estate. Yet, the distinction between institutional and non-institutional is very real and recognizable, including in the way the investment is modeled and reported. To understand this distinction, a background in who these investors are and what they are investing in provide additional clarity.
What is an Institutional Investor?
Although definitions of who qualifies as an institutional investor vary, the following organizations are known to be institutional:
- Hedge funds
- Insurance Companies
- Investment banks
- Large Pension Funds
- Real Estate Investment Trusts (REITs)
Also included but less clearly defined are:
- Large national/international investors
- High-net-worth individuals
The SEC (Securities and Exchange Commission) defines a Qualified Institutional Buyer of securities to be “in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity” SEC Modernizes the Accredited Investor Definition
Because such significant sums of money are being invested, there is typically a preference for less risk and a high level of sophistication in financial reporting.
What Real Estate is considered Institutional-grade?
Traditionally, these investors are interested in the four main asset classes Retail, Office, Industrial and Multi-Family. Other specialty classes include mixed use, hospitality, self-storage, and healthcare. A further expansion is seen into portfolios of single-family residences when packaged and operated in a way that lowers risk.
These real estate assets tend to be:
Safe. First and foremost, institutional investors want to minimize risk. This means looking to favorable market conditions in both the asset class and the local economy. For retail, office, and industrial, a majority Credit Tenants or significant historical sales from a local/regional tenant would be required. Tier I/II markets are preferred over Tier III and tertiary markets.
Large. Assets tend to be valued at $50MM and above. Smaller assets are pooled together to create portfolios that are valued at this higher dollar amount. For example, a single-family home would never be of interest to an institutional investor. However, that same home bundled with 200 others being rented in the proximity of a major university, could be considered institutional.
Quality. These properties are in very good condition with minimal risk of deterioration or obsolescence during the hold. The quality of the sponsor is also taken into consideration as the management of a property can contribute both positively and negatively to the value and likelihood that the investment will meet or exceed its projected returns.
Because trends and markets are always changing, so are the habits of institutional investors. Consultants to these investors have a keen awareness for the direction of inevitable change we see in consumer trends. You can stay updated with current institutional investing trends by following publications like the Institutional Real Estate Inc Real Assets Adviser.
Is there a difference in the way these institutional investments are reported?
There exists a significant gap in the ways institutional vs. non-institutional interpret projected returns on an investment. Institutional investors of commercial real estate are concerned with: Internal Rate of Return (IRR), Cash on Cash Return (CoC or CCR) also referred to as “yield”, and Multiple on Invested Capital (MOIC) / Equity Multiple (EM).
Most non-institutional investors focus on Return on Investment (ROI) and Return on Equity (ROE) using these terms interchangeably with Cash on Cash, Yield, and even IRR. With multiple accepted ways to calculate and apply ROI and ROE, clarifying the method used is a critical and often overlooked component when working with non-institutional investors.
When all three metrics preferred by institutional investors are packaged together, this provides the most accurate snapshot available to compare and select real estate investments.
IRR, Internal Rate of Return
Known by many to be the best overall indicator of a real estate investment’s performance because it utilizes all cash flows and takes the aspect of time into consideration. It’s important to point out this metric is a discount rate, revealing the percentage return to break even, not a time adjusted Equity Multiple (which is how it is often misinterpreted). A very good IRR is generally considered 15% and acceptable IRR would be 8% and above. Investments with 8-12% IRR would need to be coupled with other attractive and safe components to be of interest to an institutional investor.
The easiest way to calculate IRR is in excel. If you are interested in learning more about the actual complex mathematical formula, a helpful description and video can be found at Corporate Finance Institute: An Analyst’s Guide to IRR
CoC, CCR, Yield or Cash-on-Cash: total sum of distributions* over one year / invested capital to date
This number will be expressed as a percentage with 8.0% and above considered favorable by all investors. Because this metric is analyzed on an annual basis, it can go up or down over the life of the hold. As such, the Average Yield or Average Annual Cash-on-Cash return reflects the average of these.
*Cash-on-cash looks only at the distributions resulting from the cash flow generated by the property, not by debt-financed distributions (aka loan proceeds from refinancing) or by the partial or final sale of the property. You may come across an article or website that defines Cash-on-Cash as NOI/total cash investment. Avoid falling into the trap of including other proceeds and/or leaving out debt payments and other owner expenses when calculating this projection so that you do overstate anticipated returns.
MOIC, Multiple on Invested Capital & EM, Equity Multiple
Both essentially the same, only MOIC can be used at any point in time, whereas EM reflects the snapshot of a completed investment.
MOIC: (distributions to date + unrealized value) / total invested capital
EM: total sum of distributions / total invested capital
Both are expressed as a decimal, often followed by an x to indicate times. There is no standard for favorable multiples, only that it must be greater than 1.0x which indicates break even. A 2.0x multiplier implies a doubling of the investment, 3.0x tripling and so on. This means higher the multiple, the better the return.
In the United States, institutional accounting and financial reporting adhere to GAAP, the Generally Accepted Accounting Principles, which is the standard set by the SEC. These standards allow us to compare investments and ensure transparency. International investments will likely adhere to IFRS Principles (International Financial Reporting Standards).
Should non-institutional participants be concerned with reporting standards?
If your own money is being invested and you understand the methods, there may be no downside to calculating returns and reporting in a way that is comfortable and intuitive to you. However, once third-parties are introduced, there becomes a need for a clear line of communication and reporting standards to keep all on the same page.
Reporting standards exist to serve decision-makers. The common language allows sponsors, investors, lenders, lawyers, accountants, managers and others to come together from various backgrounds and disciplines to support a successful investment. Institutional investors are highly concerned with protecting their money and maximizing investments, which is a mindset worth adopting! Implementing institutional standards and practices arm you and your business with the best information. The result minimizes error, reveals unforeseen events and highlights maximum potential.
What are some ways I can implement institutional-level standards into my reporting?
Here are some key reporting practices to look out for and implement into your non-institutional real estate business. Pass these recommendations on to your accountants and analysts while offering continued training (such as excel and GAAP) to support your financial staff.
- DYNAMIC EXCEL SHEETS. Look for and use blue text for direct numbers, known as “hard inputs” that can be adjusted as needed, and use black text for formulas that will not be adjusted. Have all or as many hard inputs as possible moved to one “Summary” tab where they can be easily located.
- MONTHLY CASH FLOW TO STABILIZATION. If your asset is not cash flowing when you buy it, a monthly detail of applicable construction/marketing costs and absorption are necessary to show until the property is stabilized (defined as 80% or higher occupancy).
- BELOW THE LINE EXPENSES. After Net Operating Income (NOI), there are many hidden additional costs including: debt payments, legal and accounting fees, asset management, leasing commissions/marketing and capital expenses.
- WATERFALL. Showing the capital stack (who owns the equity) and how the cash is to be distributed should be easy to spot. The waterfall should mirror the actual distribution schedule as monthly, quarterly, or annually with key terms such as number of days in the year (not always 365!), hurdle rates, etc. clearly defined.
- DEBT. A separate tab detailing the loan schedule will serve to support dept payments and payoff when you sell.
- REVENUE AND EXPENSE DETAIL. Line item your revenue and expenses to match the same Chart of Accounts you use for bookkeeping. Make sure you include:
- Vacancy / credit loss: Even if the assumption is zero, don’t leave it out.
- Revenue / Expense Increase Assumptions: Clearly present what increases are contractual vs. market estimations
- Comparable Data/ Assumption Notes: Include comps and other market data to support your rent assumptions. Even if you are using a software like ARGUS, accompany the cash flow with an assumptions summary because third parties with an interest know the projected returns are only as strong as the assumptions made.
Accurate projections turn into successful exits and successful exits build investor confidence and portfolio size. Whether you are just breaking into commercial real estate investment or are a seasoned professional, embracing the institutional values of accuracy and transparency in your reporting will serve everyone involved.