In this tumultuous environment, there are several concerns that investors should reevaluate to assure a successful investment.
It appears that the CRE industry is entering a period of high volatility with the Fed promising to raise interest rates beginning in March, soaring inflation, the war in Ukraine, and a possible recession occurring later this year due to this high inflation, especially in food and gas prices.
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. CRE investment is subject to many risks that were ignored during the last six or seven years due to the buoyant market. However, in this tumultuous environment, there are several concerns that investors should reevaluate to assure a successful investment.
- Acquiring Properties at Low Cap Rates
Acquiring CRE at low cap rates is one of the biggest sins that an investor can commit. Today, many apartment and industrial properties are trading at sub 4.0% cap rates. This is due to artificially low interest rates, an abundance of capital looking for CRE investments as an inflation hedge and strong fundamentals. 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 and can lead to lower investment returns and reduced cash flow for the property.
- Inadequate 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 you 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 that will negatively affect 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 in U.S. history. 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 perverse thinking is occurring right now in the booming industrial and apartment markets, where space demand is very strong and cap rates have declined below 4.0% in the last few years.
- Using Excessive Leverage
Acquiring CRE assets with high leverage is one of the most common investment risks. This was particularly common during the early 2000s and up to the middle of the Great Recession in 2010. Many properties bought during that period had a securitized first mortgage, several levels of mezzanine debt, preferred equity and finally the owner equity. Excessive leverage is nirvana when the market is booming, inflation is high and prices are rising, but is persona-non-grata, when the economy and markets tank. Thankfully, the regulated lenders have been very conservative with their real estate underwriting and lending structures, often limiting loan to value ratios of 65% or less.
- Poor Management and Ownership of a Property
As is any industry or business, there are good owners and managers and bad owners and 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. With 27 million apartments in the U.S., 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, whether they are incompetent, lack serious experience and expertise, or are naïve about owning and operating CRE assets. This includes some of the largest and most prestigious real estate investment managers. As real estate private equity firms grow to immense size with 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 industry data, there are over 200 real estate private equity funds in the U.S. with more than $250 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 fees on these funds and generate the projected internal rates of return is immense. Many of these sponsors will overlook the risks above and make bad investment decisions, just to place the capital to work. Sometimes the best deal in CRE is the one that you don’t do.