Real estate closings aren’t like stock trades. They take weeks or months—not hours—to research, arrange and execute. More significantly, there’s no sell button to undo a bad buy. Property buyers have to live with their investments because they don’t get to unmake them. For these reasons and more, making purchase decisions on investment properties takes a great deal of time and knowledge.
Investors can choose to participate in private real estate investment either directly or indirectly. With direct investments, they buy and manage properties themselves, or directly oversee the professionals they hire to help with property management. With indirect investments, they outsource the selection and management of properties to a REIT or private equity firm. There are pros and cons to both options; the right choice comes down to individual investors’ specific preferences, experience and available time.
As commercial real estate private equity managers, my partner and I see many owners struggle with direct property investments. Sometimes they’re sellers sitting across from us at the closing table. In this first article of a two-part series, we’ll break down the five most common mistakes we see direct real estate investors make. Part two will cover the most common mistakes we see indirect real estate investors make.
When it comes to direct investing, getting into the real estate game means showing up ready to play. A tremendous amount of data-driven research is necessary to support any investment and, in our view, the best way to limit risk is to be an exceedingly selective buyer. The five biggest mistakes we see direct investors make are all failures in preparation—and avoidable. Here they are:
Mistake #1: Picking a weak location. So many demand drivers for rental properties are specific to its city as well as its submarket or neighborhood. Transportation, schools, retail and all its critical amenities should be subject to a competitive market analysis that evaluates how a rental property fills tenant needs compared to the competition—whether nearby or in a comparable area. This is a part of due diligence, and buyers should verify it themselves.
Envision yourself as the renter and visit at various times during the week. Is the lobby appealing? Is the floor plan efficient? Is this somewhere you’d want to live and work? And do the same for the competition; for every property, there are three-to-five contenders that potential tenants can choose instead. Understand that it isn’t about buying the best property—it’s about buying a property that will be economically sustainable and profitable if you have to discount rent to lure renters away from competitors. Ask yourself which one would you rather live in, why and how much will I have to lower rent to keep units filled?
Mistake #2: Getting the deal’s pricing model wrong. A key to building real estate value is to purchase a property at an appropriate price. We use a comprehensive financial modeling process that looks at a property many ways when analyzing its pricing, and so should direct investors. For instance, instead of focusing on market comps (properties with similar rents or sales prices), price per square foot vs. replacement cost, or a building’s capitalization rate at purchase and sale, we use all of them—and more, such as a discounted cash flow (DCF) model to determine a property’s viability.
A DCF model looks an investment’s projected income and/or cash flow, then discounts that cash flow to determine an estimate of the property’s current value (the basic concept is that the value of a dollar is worth more today than in the future). Using this model relates improvement costs, the higher rents they justify and the timeline for an eventual sale back to a property’s purchase price. This gives investors a cash flow forecast that can help them determine if their business plan is reasonable given a property’s asking price.
Mistake #3: Using the wrong inputs for projections. Using financial models before buying a property is half the battle; the other half is testing them. We call it stress testing. For instance, if a DCF model assumes that you can increase rent by 15% if you put in new kitchens, it must also include a depreciation schedule to account for diminishing returns as the kitchen becomes outdated over the next eight-to-ten years—and the costs to renovate those kitchens all over again. Or if it sets rents at a certain price, direct buyers must be able to justify that price based on a range of variables, from competitive rentals in the area to the community’s demographics over time. And when factoring in rising rents, every input must be defensible. For example, 3% instead of 2% will yield very different results.
Over a long period, even a small thing changes a real estate valuation. Understanding the market and using reliable historical data will help make defensible estimates. An objective risk model will account for the fact that forecasts become less certain over time. Shorthand measures like capitalization rates don’t account for that risk. If an investor estimates a 5% cap rate at sale, a commercial building with $1 million in net operating income will be worth $20 million. At a 10% cap rate, the investor will exit with only a $10 million deal. Investors need to understand that they have little control over the exit cap rate. However, they do have control over their ability to drive income. The question investors should ask themselves is “how much net operating income can I create at the lowest spend?”
Mistake #4: Taking cash flow for granted. Bankers are right: They forecast cash flow to make sure they’ll be repaid, and so should investors. The wrong way to look at leverage is to buy a property without enough equity and assume too much debt. It’s a path that leads to a huge risk. Instead of borrowing as much as possible, the right way to capitalize on a rental property is to start with cash flow. “How much cash will this asset produce in years one-through-five? What kind of debt service will that revenue support? What will be its income stream?”
Having an idea of these numbers is critical. What’s certain when you put debt on a commercial or multifamily property is that you’ll have to pay the debt; what’s not certain is how much cash it will generate. Knowing how much a rental property has produced in the past helps investors develop a defensible plan to maintain or grow that income. Buying great properties will be a mistake if they’re wrong about debt service; more debt raises the risk of losing it all.
Mistake #5: Getting the replacement cost analysis wrong. Rents can only go to a certain point in a market before new product comes in to compete with it. That ceiling exists in every market, and it’s not based on how much a renter will pay but whether that higher rent level will justify new product. Since properties in growing markets are often priced at or near their replacement cost, that makes getting this analysis right critical because new construction floods the market with better product and holds down pricing. Yet at the same time, the developer who is looking to build new product is not just looking at replacement cost, but rather a level that allows them to make at least a 20% margin on their money.
Still, the closer a property’s price is to its replacement cost, the more careful to be about buying that property; the price will impact how much can be spent on improvements. A buyer wouldn’t want to put in a lot of money and have rents become the same price as a new high-rise—they won’t get it. The existing property will be renters’ second choice and command less rent.
A cash flow forecast must consider potential new construction projects and show a property’s rents will be affordable even with improvements. Yet construction costs vary by location and design; high rises are more complex to build—and expensive—than garden apartments. So, every improvement project needs a thorough plan budgeting how much to spend on units, the lobby and amenities. Budgeting multifamily housing right down to the cost of countertops and finishes leaves less room for major miscalculations. However, a killer location could make the cost of a property near or at replacement cost defensible.
My partner and I built a rigorous underwriting process to meet our own goals because we invest our personal funds in every deal we organize. Our due diligence approach to real estate has grown far more data-driven over the years. Taking time to buy in a more disciplined manner eliminates the surprises. In hindsight, the bad choices always seem rushed.