Microeconomics & How Opportunity Arises Locally

This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.

How Opportunity Arises Locally

Commercial real estate markets are inherently inefficient. The complexity and time-intensive nature of real estate transactions, the varying level of accessible information about assets, and the knowhow necessary to execute real estate transactions, all mean that pricing in the real estate market is imperfect, and in many cases open the door for transactions where assets trade at below market value, transferring value to the buyer. The stock market — conversely, with its uniform pricing mechanisms, nearly-perfect information, and liquidity — operates far more efficiently.

In this inefficiency lies opportunity: savvy real estate sponsors are adept at recognizing inefficient situations and seizing on them — for example, building in an underpriced submarket, an untapped rezoning opportunity, or a seller that is overly eager to unload an asset. EQUITYMULTIPLE allows individual investors to essentially co-invest in these inefficiencies, alongside sponsors and developers who are adept at identifying and exploiting these inefficiencies.

Let’s take a look at a few examples of micro and submarket-level inefficiencies that may create opportunity for yield:

Operational Inefficiencies

This is a major driving factor in projected returns across our projects. An owner of a property, for whatever reason, lapses into suboptimal day-to-day management of their asset. They could be employing lax leasing practices, exhibiting inattentiveness to tenant’s needs, doing a poor job marketing to fill vacancies, or all of the above. These operational shortcomings compromise the NOI of the property, and thus the value of the asset. Sponsors with strong operational and management capabilities can often purchase such an asset, improve operations, and sell the asset at a healthy profit, all while avoiding any major capital improvements.

Underpriced Submarkets

Even someone with no real estate experience would agree that Midtown Manhattan is valuable real estate, and will continue to be valuable real estate, where property values will appreciate predictably. Consequently, real estate investing in such core submarkets tends to be very safe but carries limited upside, as competition for assets drives up prices in the market and squeezes margins. Savvy real estate developers and investors find greater opportunity for upside in sub-core areas where a commercial core and cultural cache are less established. Though information on demographic trends, employment, and zoning are generally public domain, investment dollars tend to be sluggish when it comes to ascending submarkets, creating opportunity for forward-looking investors. A few examples:

• Bushwick, Brooklyn — The historically industrial neighborhood benefitted greatly from the explosion of culture and population in nearby Williamsburg. Rents skyrocketed in Williamsburg, creating demand in the adjacent Bushwick, just a short train ride away. Opportunistic investors bought and developed warehouse space, building chic condos and hip bar and event spaces, often realizing great returns.
• Georgetown, Seattle — While the city and metro area’s growth has been recognized for years, this centrally-located and character-rich neighborhood hadn’t received much interest from real estate investors until recently. The lack of attention owes perhaps to its industrial character in a city known for its sweeping views and greenery. The neighborhood’s gritty vibe and geographic convenience make it attractive to the young professionals making up much of Seattle’s population growth.
• Downtown Detroit — The Motor City became a symbol of post-crash urban blight, eventually filing for the largest public bankruptcy in U.S. history. Meanwhile the downtown core suffered from underinvestment and dwindling population for decades, as people and jobs fled to the suburbs. While Detroit’s reputation scared away investors for years, entrepreneurs, artists, and community organizers began to reclaim downtown in earnest, setting the stage for a renaissance that’s prompted an influx of jobs and apartment rental demand. Forward-looking investors have been acquiring and renovating pre-war buildings and establishing boutique retail, even as unfavorable perceptions of Detroit linger, suppressing competition.

Distressed Assets

In some cases a seller’s situation can cause them to sell a perfectly good property at below value. This could arise from overleverage, overextension (too many properties in an seller’s portfolio), personal bankruptcy, or some combination thereof.

Fortunately, you as an individual investor don’t need to originate and investigate these instances of market inefficiency. If you are able to evaluate the sponsor’s track record, and you believe in the underwriting and thesis as presented by the platform, you can enjoy the benefits of inefficient real estate markets while investing passively. Understanding these factors can help you quickly identify and evaluate the investment thesis, and ask the right questions as you do your own diligence on an investment opportunity.