Returns for Limited Partners: small business investing vs commercial real estate investing?

November 2022

Investing as a limited partner has its benefits. Are they greater in small business investing than commercial real estate?

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CRE vs Small Business: CAP Rates and EBITDA Multiples

The Commercial real estate world orients itself around capitalization rates, one could argue. The capitalization rate is the net operating income divided by the price of the property. The net operating income (NOI) Is the income after all the expenses for running the property are spent, including taxes and insurance. If it is a triple net property where there are no expenses for the landlord to pay, then the gross rental revenue is also the NOI.

In the private equity business world capitalization rates are not used but rather EBITDA multiples. EBITDA is the earnings of a business before deducting interest, taxes, depreciation, and amortization. The multiple referenced above comes from the price of the business divided by its EBITDA, which is often in the range of 3-5x. Naturally, there are many other metrics that are vital to assessing the health of the company as there are for real estate, but for now, the EBITDA multiple is a close comparison to the capitalization rate.

EBITDA Multiples by Industry

For smaller businesses that are not tech related and have established revenue, seeing a purchase price in the range of a 3-5x EBITDA is quite common. What this means is the purchase price of the business divided by the EBITDA from the latest year would equal three, for example, as in a business selling for $3M has an EBITDA of $1M. If a business has seen some variance in their EBITDA over the last three or four years, the buyer/financier may average the last few years' EBITDA figures and then multiply that by the appropriate multiple. EBITDA is also roughly referred to as "Cash Flow" in the world of buying and selling small businesses.

The EBITDA multiple varies across industries, and also depends upon the self sufficiency of the business. Revenue multiples are another common method of valuation, which often arrives at a similar purchase price figure as the EBITDA multiple. Below is a table of common ratios in purchased small businesses.

EBITDA Multiples by Size

The multiple a business can ask for commonly increases with the business size. Case in point, a business with an EBITDA between 100k and 4M might fetch a multiple of 3, but ones with EBITDAs of 5M+ can command a 5x EBITDA price tag. Greater yet, enterprises with EBITDAs in excess of 100M often close with a purchase price 8x EBITDA.

A Comparative Basis

Comparing this back to real estate, multi-family and industrial commercial asset classes currently sell at cap rates range of 5-6%, with office closer to 6.5%. To put this on a similar basis for comparison with small businesses, a small business selling at a 6% cap rate is equivalent to selling at a 16x EBITDA (NOI).

Among the many questions that this comparative basis evokes, one of them is why? Wel, among many reasons, real estate commands a higher price due to its less volatile nature (debatable), relative ease of management compared to running a business, and some tax advantages. However, that lower volatility and easy management comes with opportunity costs.

For example, an industrial building with a $3M purchase price selling at a 6% cap rate would generate an EBITDA (NOI) of 180k (3,000,000×6%) for the new owner. In contrast, a small business with the same $3M purchase price and a market average of 3x EBITDA would generate $1M for the new owner. That’s more than 5x the return.

The reasons why the market has found equilibriums like this, and these different industries are many. One of which is the fact that an industrial building for example, almost always has a triple net lease, so the owner of the building has minimal responsibilities on the property, except for major remodeling. On the other hand, the new owner of the $3 million company might need to work the day-to-day business, grow relationships with major clients, manage troublesome employees, and negotiate new contracts with suppliers.

Still looking at the returns only, purchasing small businesses present a strong case if an investor is looking for the quickest way to grow their money, especially if they are going to be a limited partner in either option.

A Comparison of Limited Partner Returns

A common waterfall structure in real estate for a limited partner/sponsor set-up could come with a 6% initial preferred return, then 70/30 cash split up to 12% return, then 60/40 on cash flow above that. Without going into the nuances of waterfall structures, let’s apply that to see how much each scenario pays out to the limited inverter.

If applied to the above example of an industrial building at $3M with a 6% cap rate and going with a bank loan at 8.5% for 25 years with 35% down (most common terms), that investment would result in a cash return to the limited partner of 0% on year 1. On the other hand, if the same investor was a limited partner in the purchase of the small business scenario above with an SBA loan of 9.5% for 10 years and 20% down (most common terms), he would receive a cash-on-cash return of 45% in year 1.

Even with lowered interest rates of 5.5% and 6.5% for the real estate and small business, respectively, the divergence of returns demands consideration. The real estate investor would have received 4% cash-on-cash return year 1 while the small business investor would have benefitted from a 47% return.

What About the Risk?

While the small business investor’s return might have been capped per the operating agreement before they hit 47%, his outsized returns would remain difficult to disregard. This white paper is not an attempt to explore all the return vs risk variances between small businesses and real estate, however, one point is worth mentioning: industrial commercial real estate as an asset class has a loan default rate nationwide of less than 1% according to Stastita.com while an SBA 7(a) small business loan has a nationwide default rate of approximately 8.9%, according to vettedbiz.com. So the 10x small business return (4% to 47%) comes with close to 10x the risk. The return vs risk parity is hard to escape in any asset class.

The wise limited investor, true to his investment preferences and tolerances, must yet again align with the investment that matches his risk and return appetite. Much like emerging markets in public equities, small business investing brings salivating returns along with a volatility that might make you lose your lunch. On the other side of the coin, CRE, much like income-producing stocks, brings bland returns yet with a higher chance of actually getting fed.

Wrap Up

Small business investing and commercial real estate investing are two different animals of the same investment zoo. One may be more wild while the other, more tame. Yet both have something to offer investors. The owner and operator of a small business investment that proves successful may see not only his initial investment quickly returned but also continued out-sized returns that are hard to match. An owner and operator of a commercial real estate venture that proves successful as well will see moderate returns at best. Though while the small business owner that rents from him is managing inventory, he might instead be taking his kids to see the animals of the local zoo, though with coupons in hand.

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