Unlike stock transactions, real estate closings are different. Planning, carrying out and conducting the essential research take weeks or months. The lack of a sell option to cancel a bad purchase is a greater issue. Real estate buyers must accept the effects of their actions since they are unable to change them. Considering all of these aspects and more when making decisions about purchasing investment properties takes a lot of time and knowledge.
Private real estate investments are open to both direct and indirect investor participation. When making direct investments, investors either purchase and manage real estate themselves or directly control the property management contractors they engage. In the case of indirect investments, they delegate property selection and management to a REIT or private equity firm. Both approaches have advantages and disadvantages; the best decision will depend on particular tastes, background, and time constraints of individual investors.
My business partner and I saw numerous landowners struggle with direct property investments as commercial property private equity managers. At the closing table, they are occasional sellers seated across from us. We’ll go through the five most typical errors we observe direct property investors do in this first of a two-part series. The second section will discuss the most typical errors that we observe among indirect real estate investors.
Getting into the game of real estate investment requires being prepared to participate, especially when it comes to direct investing. Any investment must be supported by an overwhelming amount of data-driven research, and in our opinion, the greatest approach to reduce risk is to be a really picky buyer. The top five errors we observe among direct investors all stem from preparation deficiencies that might have been prevented. Here are several examples:
Mistake No. 1: Selecting a vulnerable area.
There are several variables that are specific to a city and to a certain submarket or region, that affect the demand for rental properties. Whether a rental property is situated locally or in a nearby area, comparative market analysis should be carried out to ascertain how effectively it satisfies tenant wants in contrast to the rivalry. Transportation, educational institutions, retail outlets, and any other vital amenities should all be included in this study. Buyers should perform due diligence by independently verifying this information.
Assume you are the tenant and go to different times throughout the week. Is there a nice lobby? Is the floor layout practical? Are you interested in relocating and working here? Likewise, you should do the same for the rival properties, as each one has three to five rivals from which possible renters might select. Recognize that choosing a property to invest in doesn’t have to be about finding the greatest one; rather, you should go for one that will be financially viable and lucrative, even if you have to provide a lower rent than your rivals to attract tenants. Consider which one you would want to live in, why, and how much I will need to reduce the rent to keep the apartments occupied.
Mistake No. 2: Select the incorrect pricing approach for the offer.
A property’s real estate value can only be raised by making the correct investment at the right time. Direct investors should do the same as we do when analyzing a property’s pricing by utilizing a thorough financial modeling process that takes a property into account in a number of different ways. To determine an estate’s viability, we use all of them—and other methods, such as a discounted cash flow (DCF) model—rather than focusing just on market comps (properties with comparable rents or sales prices), pricing per square foot vs. replacement cost, or a property’s capitalization rate at purchasing and selling.
A DCF model is used to analyze the anticipated income and cash flow of investment, discounting that cash flow to determine the asset’s present value (The fundamental idea is that a dollar now is more valuable than it will be tomorrow). With this strategy, the price of upgrades, the higher rents they enable, and the timetable for a prospective sale are all tied to the price of the original property. In this way, investors are given a cash flow forecast that they may use to judge if their business plan is feasible given the property’s asking price.
Mistake No. 3: Using incorrect projection inputs.
Before making a real estate acquisition, the initial phase of the battle entails developing and testing financial models. It is known as stress testing. If a DCF model, for example, predicts that you may increase rent by 15% if you construct new kitchens, a depreciation schedule must be incorporated to account for diminishing returns when the kitchen becomes outdated over the duration of the next 8 to 10 years, as well as the costs to rebuild such kitchens once again. In contrast, if it fixes rents at a specific level, direct purchasers must be capable of defending that value in light of a number of variables, including appropriate rentals in the area and long-term demographic patterns in the neighborhood. Every input also needs to be defendable when taking rising rents into account. The outcomes will be substantially different, for instance, if you use 3% instead of 2%.
Even a minor adjustment over an extended period of time affects the value of the real estate. Making tenable projections will need knowledge of the market and the use of trustworthy historical data. Forecasts lose accuracy with time, which will be taken into account by an objective risk model. These risks are not taken into account by quick measurements like capitalization rates. A commercial facility with $1 million in net operating income would be valued at $20 million according to an investor’s 5% cap rate projection. The investor will only make a $10 million profit at a 10% cap rate. The exit cap rate is not something that investors have much control on, as they should be aware. They do, however, have some influence on their potential to generate income. Investors should ask themselves, “How much net operating income can I generate with the least amount of money?”
Mistake No 4: Overlooking financial flow.
Bankers, like investors, predict cash flow to ensure repayment. The incorrect approach to leverage is to purchase a home with insufficient equity and incur excessive debt. It is a dangerous route to take. The ideal method to leverage on a rental property is, to begin with, cash flow rather than taking out as much debt as you can. How much money will this asset generate over the course of one to five years? With such income, what type of debt service is possible? What will be the source of its income ?
It’s crucial to get a grasp on these figures. When you borrow money against a piece of real estate, whether it be commercial or multifamily, you know you’ll have to pay it back, but you don’t know how much money it will really make. Investors can create a defendable strategy to retain or increase that revenue by understanding how much a rental property has historically earned. If they are incorrect regarding debt servicing, then buying excellent homes will be an error because taking on additional debt increases the danger of losing everything.
Mistake No 5: Making an incorrect replacement cost analysis.
Before new products enter the market to compete with rents, rents can only rise to a particular level in a given market. Every market has a ceiling that applies, and it is determined not by the renter’s ability to pay but rather by whether raising the rent level will enable the development of new goods. Accurate analysis is crucial because assets in developing markets are frequently valued at or close to their replacement cost because the new development market is flooded with higher-quality goods and keeps prices low. However, the developer who wants to create a new product is also searching for a level that would allow them to generate at least a 20% profit margin on their investment rather than only looking at replacement value.
But if a property is being bought for close to its replacement cost, it is best to move cautiously because this will influence how much money will need to be spent on improvements. In order to have rentals equal to the price of a brand-new high-rise, buyers would not want to spend much since they would not be able to do so. The current home won’t attract renters, making it less expensive.
Related Article: 5 Expensive Errors Your Real Estate Manager Might Commit, Part 2 of 2
A cash flow estimate must indicate that rentals on a property will remain reasonable even with renovations and consider future new development projects. However, the cost of building varies based on the area and design; high buildings are more difficult to build, which increases their cost. As a result, every remodeling project requires a detailed plan outlining how much money will be spent on units, the lobby, and amenities. There is less space for costly errors when multifamily housing is budgeted down to the cost of worktops and finishes. A property’s price may be justifiable if it is in a prime location or costs less than its replacement value.
Because we spend our personal capital in every venture we organize, my partner and I developed a stringent underwriting procedure to achieve our own aims. Over the years, our real estate due diligence process has become much more data-driven. The surprises are eliminated by taking extra time to make disciplined purchases. The poor decisions usually appear hurried in retrospect.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.