3 Lessons We Learned from Our Worst Real Estate Deal

Topic:  • By David Scherer • June 28, 2018 1,660 Views

3 Lessons We Learned from Our Worst Real Estate Deal

People often say that you learn more from your worst real estate deals than your winning ones. I am not sure this is true, but I do know that you remember your worst real estate deal very clearly. Origin Investments was originally formed in 2007 to build and protect the wealth my partner and I built during our previous careers. The company has grown exponentially from our first investment and we now have over a decade’s experience closing real estate deals.

Looking back, our worst real estate deal is very clear. It was an asset we purchased in 2012 and the investment represents our lowest gains, both in terms of IRR (9%) and equity multiple (1.12x). We purchased the asset through a short-sale — a sale in which the purchase price does not repay the debt from the bank. In a short sale, the bank has to approve the sale because they take a loss on the loan. The bank has a lien or mortgage on the asset that can only be removed through full repayment of the loan, or a release of the lien at the agreed upon lower price of the sale. The bank will agree to a short sale if it is decided that they could lose more money by owning the asset or if they do not have the time, expertise and team to own the actual real estate.

The asset was a student housing complex with 288 bedrooms and a structured parking garage with 900 spaces, located adjacent to Florida State University. The parking garage alone cost over $15 million to build and we purchased both the garage and student housing complex for $14.4 million. We liked the price of the asset so much that we overlooked a risk that was much larger — partnership risk.

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The deal included a 10% equity partnership with a local real estate operator that owned other Florida State University student housing complexes. The operator had partnered with other companies like Origin and we called past references who spoke highly of working with him. After running the customary due diligence process, we thought that we had sufficiently underwritten our partner as a fit both in terms of operational competence and ethics.

We were wrong.

The partner was expected to execute daily property management and leasing activities at the asset but, unfortunately, never properly fulfilled his duties. In student housing, 90% of the leasing is completed from April through August, when students and their parents make the decision where to lease for the upcoming fall semester. During these important months, our partner did not proactively monitor how our leasing numbers compared to previous years. When we finally received the data from our partner, we learned we were 20% behind the prior year’s occupancy for the fall. Further, we learned our partner had hired companies that he owned for work at the property, without our knowledge of a conflict of interest, which was troubling. We questioned his ethics and transparency, and these are most vital to Origin.

We went into overdrive to lift the fallen leasing numbers by helping with marketing, branding and capital improvements to the apartment complex during the summer months. To improve our numbers, we also signed a lease with a neighboring property that needed parking, as our garage had hundreds of vacant spaces that we did not need. We also exercised our legal right to replace the partner from his operational responsibilities with a third-party management and leasing company. This greatly strained the relationship with our partner, who then became a hindrance to all of our efforts to increase value at the student housing complex.

Ultimately, we sold the asset after owning it for just over a year — not because we felt the asset would not appreciate in value, but rather because we wanted to end a partnership that we viewed as unproductive. We made a small amount of money on the deal, but we had spent way too much time and energy for the return received.

With all this in mind, we learned three things from our worst real estate deal that we now revisit before every joint venture:

1. Be cautious when considering to partner with others in a joint venture.

At Origin, we acquire most deals directly, but we will partner in the event that an off-market deal is brought to us that represents a large discount to where we feel it would transact on the open market. When this occurs, we now spend considerable time and money on the legal document — the LLC’s operating agreement. This defines each partner’s rights and responsibilities and we make sure that this agreement protects our rights. We also ensure that our partner has significant “skin in the game,” such that all partners are incentivized to participate and perform.

2. Don’t get excited about the deal until you get excited about the partner.

In our example, we fell in love with the deal because it was an amazing short-sale buy, and this clearly clouded our judgement. We became too focused on the asset and not enough on the partner. Our biggest mistake was that we didn’t underwrite the partner himself enough. Besides just interviewing a couple of past references, we should have visited his office to see his infrastructure. We should have asked for the past leasing data up-front and for what his plan was to beat those numbers in the coming years. We could have reached out to past employees on LinkedIn who no longer worked for him. We should have asked more questions to get to the bottom of his character and integrity. We now have a process to vet potential partners every time that has helped us avoid making this same mistake.

3. Manage a new partner as if they are a new employee.

We took our partner’s word that he would do his job and gave him too much independence after the deal closed. By the time we recognized our partner was struggling, it was too late. We should have clearly written and defined our expectations and responsibilities for his role, as if we were hiring him as a new employee. And we should have held regular meetings to go over operational performance verses the business plan, until we were sure we could trust his work ethic and ability to deliver. It’s in this clarity of expectations and collaboration that forms a true partnership with mutual trust and respect.

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David Scherer

David Scherer formed Origin Investments in 2007, along with co-founder Michael Episcope. He has over 20 years of experience in real estate investing, finance, development and asset management.