Investing in commercial real estate (CRE) is a significant financial decision, prompting the crucial question: "How does CRE generate distributions?" This article aims to demystify the revenue generation process in CRE investments, offering insights into the diverse income streams, revenue timing, expense considerations, and how your position in the capital stack can affect your distributions. However, it is important to note that distributions are never guaranteed in any real estate investment.
How Does Commercial Real Estate Generate Distributions?
In real estate, a distribution payment refers to the disbursement of profits or earnings generated by an investment property. If they occur, distributions from private real estate investments predominantly come from property-generated revenue. This revenue primarily stems from tenant rent payments, but there may be additional revenue sources.
For example, a multifamily property charges tenants rent for occupying the apartments, but it may also receive additional fees from tenants, such as those for pets, parking, trash services, or use of amenities. Similarly, a hotel charges a nightly rental rate, but may also generate income from events, charging for use of their conference space or catering services.
When determining how an investment may generate distributions, generally the first consideration is to identify what streams of income may exist for the property.
What Is the Timeline for a CRE Project to Create Revenue?
A second consideration may be determining when the income streams might begin. Considering the risk profile and potential risks of a CRE project is essential for understanding when income streams could materialize. Different project types, such as development deals or core investments, come with distinct timelines for potential revenue generation. With a development deal, there is typically no revenue initially, as the sponsor cannot charge tenants rent until the property is actually built and then occupied. Whereas, a core investment is likely already generating a significant portion of its income from occupying tenants.
How Can Sponsors Enhance Revenue?
A third consideration may be: “How will the sponsor maintain or improve revenue?” Whether through increased occupancy, higher rental rates, or a combination of both, sponsors play a crucial role in driving revenue growth through their business plan.
For example, a value-add strategy may involve a property with high occupancy but in need of renovation to compete better in the market. In its current state the property might have low rent rates, but the sponsor can plan to renovate the building creating a basis for charging higher rents. During the execution of the business plan, occupancy might remain stable or it may dip until the renovations are complete and leasing resumes at higher rates.
How Can Expenses Affect Distributions?
Now, let's talk about the other side of the financial equation – expenses. To operate, the property incurs costs such as employee salaries, marketing efforts, maintenance, insurance, and more. Commercial real estate commonly uses Net Operating Income (NOI) as a key metric, calculated by subtracting operating expenses from property revenue. However, it's crucial to note that NOI only covers property-level costs and doesn't include additional investment-related expenses like debt servicing, capital expenditures (capex), and management fees.
Given these expenses, your fourth consideration may be: “Where do I stand in the capital stack?” The capital stack determines the order in which you receive your share of any available revenue. Even if NOI is positive, after paying debt servicing and interest to senior lenders, mezzanine lenders, or preferred equity investors, there may not be enough revenue left for common equity investors. Factors like loan covenants, upcoming expenses (i.e. insurance, taxes, capital expenditures), or other financial considerations (i.e. rising interest rates or expiring rate caps) can impact the sponsor’s ability to distribute available cash.
What Are Some Things To Consider During Your Due Diligence?
When completing your due diligence, consider the current and projected NOI based on the sponsor’s business plan. Ask yourself the following questions:
- Does the plan to increase revenue seem feasible?
- Has the sponsor properly budgeted for anticipated expenses and included a reserve for unanticipated expenses?
- If I am lower in the capital stack, what impact could the other share classes have on my portion of the revenue?
Once the investment is underway, a reliable sponsor will generally provide a quarterly income statement, which allows investors to see how the revenue and expenses are tracking against the budget. If net cash flow is not positive, a distribution should typically not be expected. Additionally, a communicative sponsor may potentially offer a qualitative update on how they are managing any variances and keep you apprised of any deviations to the business plan.
Navigating the intricacies of commercial real estate distributions involves a careful balance between revenue and expenses, understanding your position in the capital stack, and conducting thorough due diligence. As you embark on your investment journey, remember to carefully evaluate sponsors' business plans and assess the feasibility of the projected revenue growth, while also considering potential challenges and the effects of deviation from the targeted timeline or NOI.
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