A Good Deal?

Evaluating a Commercial Real Estate (CRE) investment goes beyond a simple calculation of income versus price. To make a truly informed decision, investors need to understand how the potential returns stack up against other investment opportunities. In this article, we’ll move past basic comparisons (deal cap vs market cap) and explore the more meaningful benchmarks that serious CRE investors utilize to assess the true attractiveness of a deal in today’s market.

Benchmarks for Investors Evaluating CRE Deals:

1. High-Yield Savings Accounts and Money Market Accounts: As mentioned before, these offer a slightly better return than checking accounts (currently around 4-6%), representing a very low-risk, liquid option. However, the return is still significantly lower than what most investors would expect from a real estate investment.
   
2. Certificates of Deposit (CDs): CDs offer a fixed interest rate for a specific period. Depending on the term, rates might be in the 4-6% range, potentially slightly higher for longer terms. This provides a guaranteed return over a set period with low risk.
   
3. Municipal Bonds (Munis): You are spot on with this suggestion! Municipal bonds are debt issued by state and local governments. Their interest income is often exempt from federal (and sometimes state and local) income taxes, making them particularly attractive to investors in higher tax brackets.
   
   • Comparison: Investors would compare the after-tax yield of a muni bond to the pre-tax cap rate of a CRE investment. The attractiveness will depend on the investor’s tax situation, the credit rating and maturity of the bond, and the risk profile of the CRE deal.
     
4. U.S. Treasury Bonds: These are considered very low-risk as they are backed by the full faith and credit of the U.S. government. Their yields serve as a benchmark for other fixed-income investments. Investors might compare CRE cap rates to the yields on Treasury bonds of similar durations, considering the higher risk premium associated with real estate.
   
5. Corporate Bonds: Bonds issued by corporations offer potentially higher yields than government bonds but come with varying levels of risk depending on the creditworthiness of the issuing company. Investors might compare CRE cap rates to corporate bond yields, factoring in the relative risk profiles.
   
6. Dividend-Paying Stocks: For investors seeking income, dividend-paying stocks can be an alternative. The dividend yield (annual dividend per share divided by the stock price) can be compared to a CRE cap rate. However, stocks are generally more volatile than bonds or real estate.
   
7. Other Real Estate Investments: Investors might compare the cap rate of the specific CRE deal they are considering to the returns offered by other types of real estate investments, such as:
   
   • Real Estate Investment Trusts (REITs): These offer liquidity and diversification in the real estate market but might have different risk and return characteristics than direct ownership.
     
   • Real Estate Crowdfunding Platforms: These can offer access to different types of real estate investments with varying risk and return profiles.
     
   • Other Direct Property Investments: Comparing against similar property types in the same or different markets.

Key Considerations for Comparison:

• Risk: Each investment option carries a different level of risk. CRE is generally considered more risky and less liquid than bonds or publicly traded stocks. The higher potential return (cap rate) is intended to compensate for this higher risk.
  
• Liquidity: How easily can the investment be converted to cash? Bank accounts and publicly traded securities are generally very liquid, while real estate is less so.
  
• Management Effort: Direct CRE ownership requires significant management effort (or the cost of hiring a property manager), which is not a factor for most bond or stock investments.
  
• Tax Implications: Different investments have different tax treatments. Munis are tax-exempt, while CRE has its own set of tax advantages and obligations.
  
• Investment Goals: An investor’s specific financial goals (e.g., income generation, capital appreciation, long-term wealth building) will influence which comparisons are most relevant.

In summary, when evaluating a CRE deal, an investor would look beyond the initial analysis and compare the cap rate to the yields of other low-risk to moderate-risk investments like high-yield savings, money market accounts, CDs, municipal bonds, treasury bonds, and corporate bonds, as well as other real estate investment options. The attractiveness of the CRE deal will depend on whether its risk-adjusted return (as indicated by the cap rate) is competitive with these alternatives.