The world of real estate investing would be a lot easier if a crystal ball could predict which properties might deliver the best long-term potential gains. Of course, that’s not possible, so you might be wondering how investment managers and underwriters select properties to be part of a commercial real estate fund.
Understanding the vetting process can help you make informed decisions before adding commercial real estate to your investment portfolio, so here’s what you should know.
General real estate underwriting criteria
When you buy a home as an investment, say a townhome, a condo or even a duplex you intend to rent out, you are mainly interested in its long-term potential for income and appreciation. You will likely consider all the factors that make it appealing for tenants: its location, school district, nightlife, shopping, transportation, access to outdoor recreation, proximity to metropolitan or vacation areas, and overall demographics trends. You’ll need to consider rental comparables of similar properties and the overall expenses of the investment, such as taxes and utilities.
These same basic criteria apply when investment managers pick properties to be part of a real estate fund; but this is only the beginning stages of a more complex and thorough review period. With commercial real estate properties, there’s added due diligence that requires a specific skill set and expertise.
For example, when real estate investment professionals consider an office building or retail property to add to a portfolio, they will also evaluate the following key components among many attributes of the asset:
- Credit-related attributes, such as the financial strength and trends of potential tenants’ credit, and for multi-tenant properties, what percentage is leased to investment-grade tenants.
- Competition and unit performance include the competitive position of the tenant against its peers, profitability of the unit or strategic importance of the property to the tenant.
- The lease, which typically includes the economics, a base lease term, option periods, contractual rent increases and which party (landlord or tenant) is responsible for expenses. These expense “pass-throughs” can be very complicated and often run to multiple pages in some leases.)
- Market fundamentals, such as lease and price rates per square foot of comparable assets as well as replacement cost, land value, and the cap rate compared to other assets in the market.
- Real estate attributes, such as visibility, ingress/egress, age of property, zoning nearby development, traffic patterns, access to transportation network, synergies of other nearby businesses, replacement value, future capital expenses, density, population and job growth.
Ultimately, each real estate fund has their own standards, criteria and process for vetting properties.
In the case of Modiv, our seasoned team applies the above criteria and more to ensure that our investors are confident about which properties comprise our portfolio of income-producing assets.
Additional due diligence factors for commercial property
At Modiv, we acquire single-tenant net lease (STNL) properties leased to credit-worthy tenants via long-term agreements as the foundation of our portfolio. We invest in a diversified portfolio of commercial real estate classes, including retail, industrial, and office properties.
When we consider new property acquisitions, our initial due diligence focuses on commercial properties that we believe have the best opportunities to generate consistent rental income with the potential for long-term appreciation.
“We leverage the resources and tools at our disposal, industry and market knowledge, and our team’s experience to evaluate how each potential investment opportunity could beneficially fit within our portfolio,” says Bill Broms, Modiv’s Chief Investment Officer. “We also work with third-party consultants for additional checks and balances to ensure we’re making factual, tactical decisions.”
How Modiv vets commercial real estate properties
In addition to applying the basic underwriting standards outlined above, Modiv uses the following due diligence measures to ensure that assets:
- “Fit” our fund’s overall goals Every piece of real estate is unique, and Modiv evaluates how it will integrate into the overall fund ecosystem. That said, each property should also aid in diversifying our fund in terms of industry, tenant and geography, as well as economically.
- Debt Flexibility The properties Modiv considers must embody characteristics that are eligible for attractive financing and, if we choose to sell the property, a loan that allows for a clean and clear exit option.
- Have long-term potential for 100% occupancy, aka “sticky properties” For single tenant assets, one of the biggest risks is the tenant leaving a property. To mitigate this risk, Modiv thoroughly investigates why tenants may want to stay over the long term. As Broms explains, “Our immediate thought for any property is its long-term potential, which is why we conduct tenant interviews. This helps us glean a tenant’s ‘stickiness’ to a property — how long they’ll likely stick around. We want to know how their current property fits into their long-term strategy of real estate planning. “Depending on the type of company and how it’s set up, we survey the tenant’s C-suite to determine what investments have been made into the property. This includes whether any machinery and equipment or other upgrades have been added.”
All of this insight helps dictate how likely a tenant will continue to occupy the property and advises the length of the lease, renewal options and rental increases. This is why upfront due diligence is absolutely necessary — so we can also assess whether we are buying it “right” with the right rents associated with it on the front-end.
- Meet our investment committee’s approval Following Modiv’s due diligence work, we must also have 100% approval from our Investment Committee before issuing LOIs (letters of intent) to buy properties.
For any type of property investment, we try to avoid surprises that could lead to the acquisition falling through or not achieving its maximum performance over the life of the lease. We spend a great deal of time underwriting on the front-end, boosting our confidence that the transaction will likely proceed, leading to a higher probability of closing, and being a successful contributor within the portfolio. Of course, risk can’t be completely eliminated and the unexpected can always happen (who could have predicted COVID-19 and the impact it had on the commercial real estate market?) despite the best efforts of the underwriting and due diligence process.
Remember that not all real estate funds are created equal, so it’s crucial that a seasoned team of professionals has the best interests of investors in mind when building a strong portfolio.
You can learn more about the properties within Modiv’s portfolio and the key components that factored into the decision-making process by visiting modiv.com/portfolio.
Due Diligence Checklist
Modiv conducts an exhaustive due diligence process to ensure that a potential transaction meets the appropriate underwriting criteria before adding a new net-lease property to our REIT portfolio.
1. Next steps predicated on transaction meeting criteria and moving forward. The transaction may be terminated prior to closing and taking ownership. Until an acquisition closes, there is no guarantee that a transaction will be consummated.
The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.