Buying a CRE asset above its value or at a low cap rate is rarely a route to a successful transaction.
Most of you have heard about the Seven Deadly Sins that include; pride, envy, gluttony, lust, anger, greed and sloth. There are also Seven Deadly Sins of commercial real estate (CRE) investment, and these are not so-called psychological sins but errors or mis-judgments in the art of investing in commercial real estate assets.
The CRE investment process is a multifaceted procedure to analyze, acquire, finance, manage, lease and sell a commercial property. There are many steps in the process from evaluating a broker sales package, to analyzing the market in which the property is located, touring the property, raising the appropriate amount of debt and equity capital, closing the acquisition and managing and leasing the property. Each of these steps is critical to a successful CRE property investment. However, there are many sins or errors committed along the way and our list of seven of these are listed below.
Buying at Low Cap Rates
Acquiring CRE at low cap rates is one of the biggest sins that an investor can commit. This is typically done when interest rates are at artificially low levels, investors don’t understand the various risks in CRE investment and investors have uninvested capital that needs to be used. In acquiring commercial real estate assets, it is more important to buy a good asset at a great value than a great asset at a good value. The most important criteria in a successful real estate acquisition are to buy the asset below its intrinsic value. Buying a CRE asset above its value or at a low cap rate, is rarely, in the long term, a route to a successful transaction.
Poor Due Diligence
The due diligence process conducted before the closing of a real estate acquisition includes all the procedures to make sure the property, financial and market data provided by the seller and broker are accurate and form the basis upon which the purchase price is based. During the booming CRE market of the last few years, the due diligence process has been condensed and, in some cases, not even performed. Sellers have compressed the time to close a transaction, which leaves the buyer with less time to complete a thorough due diligence program. This is especially true of large portfolio transactions with dozens of properties. Shoddy due diligence can result in poor financial proformas, missed negative lease provisions and critical issues with the property’s physical condition. Poor due diligence can lead to lower investment returns and reduced cash flow for the property.
No Market Analysis
One of the key procedures in the due diligence process per above is a detailed analysis of the market the property is situated. This involves looking at property data such as supply and demand for space, rents, vacancy, new construction, cap rates, competition and a highest and best use review. As many of us know, technology is changing consumer behavior, which is affecting the CRE industry, both positively and negatively. Many class A properties that were once tops in their local market and in great locations are finding that the local real estate market has changed and demand for the property has waned or changed substantially. A proper market analysis should uncover these key market issues and reduce the risk of market changes on the value of the property.
This Time It’s Different
These are the most dangerous four words in the investment world and are associated with every market bubble and financial crash. CRE investors that overpay for a property by buying at low cap rates will often utter these four words to justify their investment. They will comment that the real estate market is changing and if we don’t buy this asset at a low cap rate, somebody else will and our investors will redeem their funds. Or we think we can raise the rents substantially during the next few years and that justifies the high price and low cap rate or the cost of debt is so low even borrowing at floating rates, we will be able to flip the property for a nice profit before interest rates rise. This sin is occurring right now in the booming industrial market, where space demand is very strong and cap rates on industrial properties have declined 1.5% to 2.0% in the last few years.
Using Excessive Leverage
Acquiring CRE assets with high leverage is one of the most common investment sins. This was particularly common during the early 2000s and up to the middle of the Great Recession in 2010. Many properties bought during this period had a securitized first mortgage, several levels of mezzanine debt, preferred equity and finally the owner equity. After the financial crisis, the amount of leverage on CRE assets in general has decreased, however, it is still a sin to overleverage a property. Develop your own “stress test” which would be similar in concept to what the federal government pushed on to the banks. The bottom line is that you want to make sure even under stressful conditions locally and economically, if your portfolio can weather through that and you can service the debt through the worst-case scenario (depending on where you sit in terms of risk tolerance). Then you’ve essentially stress-tested your portfolio and you will know if you are over-leveraged or not.
Poor Management and Ownership of a Property
As is any industry or business, there are good owners or managers and bad owners or managers. This is very apparent in the CRE industry, especially with apartments. Apartments are the most management intensive of all real estate assets due to the large number of tenants and leases, high levels of employee turnover and poor management policies. There are a large number of bad apartment managers whose shoddy policies and procedures lead to low occupancy and subpar net operating income and cash flow. There are also bad owners in the CRE industry even some of the largest and most prestigious real estate investment managers. As real estate private equity firms grow to immense size with tens or hundreds of billions of CRE assets under management, they become marketing machines and asset gatherers instead of real estate managers. The unwritten goals of a lot of these firms are to just raise more and more capital, increase the 1.5% to 2.0% asset management fee and acquire more and more assets regardless of the price and performance.
Need to Invest Idle Fund Cash
In today’s frothy CRE market, there is an abundance of unused powder or cash that needs to be invested. Per consulting firm Preqin, there are over 200 real estate private equity funds investing in North America with more than $200 billion in capital looking for deals. The pressure on the sponsors of these deals from their investors to use the funds and justify the 1.5%-2.0% annual asset management fee on these funds and generate the projected internal rate of return is immense. Many of these sponsors will break one or more of the other sins above and begin making bad investment decisions, just to place the capital to work. Sometimes the best deal in CRE is the one you don’t do.
By Joseph J. Ori is executive managing director of Paramount Capital Corp.