Commercial real estate transactions and private business transactions are more similar than you would likely expect. The process by which a person would buy a business or buy real estate is quite similar. There are, however, subtle nuances in the transaction process and terminology that differentiate one from the other.
In this article, I will cover some of the differences in terminology and transaction procedures. For the sake of simplicity, when referring to real estate, I am referring specifically to commercial real estate (CRE). When referring to private business transactions, I will use the name private equity (PE), and I am specifically referring to small businesses that would be considered lower middle market or smaller; therefore, in the area of $2-20 Million in annual revenues.
The table below compares and contrasts industry jargon and their respective meanings. This is not a complete list, only those that you will undoubtedly come across in your business / real estate career.
Although commercial real estate and private business transactions are quite similar, there are some subtle differences in both terminology and process as outlined above.
Listed in the table below are commonly used real estate metrics and their business equivalent. One of the most common metrics used in evaluating real estate is the capitalization rate, aka the cap rate. Unlike many business transactions, where the value is difficult to ascertain, the value of the property is directly correlated to the net operating income of the property. Real estate investors are also focused on the cash-on-cash return metric (detailed below). Real estate investors speak in terms of a loan-to-value (LTV) ratio, while business investors use the debt-to-equity ratio to measure financial leverage.
The table below compares widely-cited commercial real estate metrics and the related private equity equivalent.
The metrics in the table above are just a few of many metrics used by real estate and private equity investors. Many of the metrics used to value or assess the performance of a business are used to analyze commercial real estate assets as well. For example, the Internal Rate of Return (IRR), Net Present Value (NPV), and Return on Equity (ROE) are metrics used to evaluate both real estate and stock or business investments.
When I say lower middle market private equity, I’m referring to smaller deals (i.e. businesses making between 5-20 million in revenue each year). We are talking about existing businesses that have a track record of performance.
One of primary reasons real estate is attractive as an asset class is due to the ability to use a lot of leverage. Private equity firms are notorious for slapping a ton of debt on properties. Because we are focused on lower middle market private equity deals, you won’t see the kind of debt levels you hear of in large leveraged buyout deals where they lever the business up, sell off the assets, lay off half of the company, reduce overhead and improve returns through growth. Generally, in lower middle market deals, they generally place 20-40% of debt on these companies. Conversely, in commercial real estate transactions you can get up to 75% debt on the property.
Investing in businesses can be more risky. There is a chance that a business could go to zero. The market can change, or a competitor could come in and make the product obsolete. With real estate there is a much smaller chance that the asset will lose a substantial amount of value.
For comparison, think of all the software companies out there that come and go because a competitor came along a produced a better product at a lower cost to its customers. Conversely, think about an apartment complex. There will always be renters and even if the economy tanks, people still need a place to live (and there are likely going to more renters). Additionally, even if the building became functionally obsolete, at least you are left with the value of the land. Software code doesn’t carry that same residual value.
Generally higher risk equates to the potential for higher returns. Real estate has a lower ceiling and a lower floor. Private equity investors want to see larger returns compared to real estate investors due to the increased risk they are taking on. In private equity you can grow the business much more significantly. It is possible to triple or quadruple the revenue in just a few years. You are not likely to even double the revenue in a real estate investment. Venture capitalists, who invest in startups, are taking on even more risk than their private equity peers, and as expected, they can possibly attain higher returns. However, there are only so many unicorns that generate returns of 50x or 100x. Be sure to focus your investment thesis on risk-adjusted returns.
Both real estate deals and business deals are valued on the money that they make. In general, it is easier to value commercial real estate properties than private companies. Commercial real estate properties are evaluated using three distinct methods: the income approach, the sales comparison approach, and the cost approach. When analyzing the commercial real estate deal, you will look at the net operating income; the profit. Software company valuations are typically determined by applying a multiple to the revenue. Manufacturing companies, however, are typically valued on the profit the business generates – value is based on an EBITDA multiple.
Hopefully, this article will demystify the differences and similarities of investing in commercial real estate and private equity.