A dry real estate report conceals a bombshell: One of the most common methods investors choose the “best” investment is often incorrect.
Paul Kaseburg, author of “Investing in Real Estate Private Equity,” has participated in over $1.7 billion of real estate transactions on both sides of the table. According to him, one of the most common errors investors make is falling in love with the “story” of an investment rather than doing enough research.
Green Street Advisors’ investigation demonstrates how perilous it is to depend on some of these reports.
“In perfect pitch.”
Demographic demand is one of the primary ways that sponsors argue for the alleged superiority of their product or service. Moreover, their proposals seem to be really persuasive. For instance:
“Austin, Texas is one of the top five cities for millennials to live, work, and play. Even if it was a little costly to acquire this house, the influx of young people to Austin over the next several years would make it a wonderful investment.”
“The population is rapidly aging. Thus, we acquired this mediocre assisted care facility at a substantial discount. Then, as the demographic tailwinds of the next years take effect, profitability will skyrocket.”
“Renters are growing while homeownership is diminishing. Therefore, even though the acquisition price of this portfolio of single-family homes was greater than we desired, it was well worth it since we will all be quite pleased in the end as the demographic tailwinds continue to strengthen.” (This is a near-exact paraphrasing of an investment I recently rejected.)
Unfortunately, as mentioned above, each of the pitches is probably incorrect.
“Rear wind” or “warm air”?
Green Street evaluated the country’s top 50 real estate markets and all property industries. They discovered that demographic changes that are “simple to predict” seldom increase net operating income and, thus, rarely contribute to the bottom line. Occasionally, they even work against investment and diminish profitability.
In the report’s somewhat dry wording, they explain why:
This tendency does not significantly impact NOI growth since developers often respond rapidly to demand because supply limitations are minimal in the vast majority of industries and markets.”
In other words, these clear favorable demographic trends inspire many others to follow suit. Increased supply decreases rents and prices, hence diminishing profitability. So the anticipated tailwind never materializes.
In Austin, the favorable demographics actually led to a decline in performance. Green Street says:
“Most local apartment purchases were financed during this decade, which was impacted by the phenomenal demand rise. However, developers saw the same patterns and swarmed the city with shovels. In contrast, in the absence of major supply restrictions, Austin’s inventory rose almost three times the national pace, resulting in revenue per available square foot (RevPAF) growth below the national average.”
Therefore, excessive numbers of individuals pursuing the same concept undermine it for everyone. This is a very crucial aspect that many investors utterly disregard.
“Regulate Your Enthusiasm”
The investigation did, however, uncover one significant exception.
When the availability of new real estate was restricted, demographic tailwinds did improve profits.
Age-restricted prefabricated housing, for instance, has favorable demographics but no new supply since nobody wants a trailer park in their backyard. Consequently, this demographic tailwind will boost profitability.
However, it is also vital to be wary of hype in this regard. Many sponsors attempt to market New York City ventures as “supply restricted” because of the high cost of land and construction. Upon examination of the figures, Green Street concluded that they did not, in fact, restrain supply.
They discovered that in regions like California, where municipal and state laws make construction very difficult, supply is restricted and benefits from population growth. However, investing in these regions is challenging. A sponsor with both patience and expertise is required. The ability to navigate local zoning and regulatory systems is crucial.
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