Investing in commercial real estate is without a doubt a “high risk” and “high reward” venture. Truly there’s lots of money to be made in commercial real estate. Just talk to those who had the courage and foresight to acquire income producing properties just after the Great Recession. Those properties that were bought at bargain basement prices have more than doubled in value in today’s market.
But talk to those investors who owned overpriced and over leveraged properties prior to the Great Recession. How many of these properties ended up going back to the lender? How many investors filed for bankruptcy when their properties with vacancies rising no longer cash flowed? So it goes both ways: High risk, high reward.
But there are things that you, the investor can do, to significantly reduce the risk of real estate investing. You will never be able to eliminate the risk, but I believe you can reduce it to a manageable level. What follows are my thoughts. They are in no particular order:
- Develop a commercial real estate investment team of advisers. Each of these advisors will bring their unique expertise to the transaction enhancing your chances that all the potential issues will be identified upfront with a proposed course of action taken to mitigate the risk. At the very minimum you should have on your advisory team one of the following:
- Commercial mortgage broker
- Commercial real estate agent
- Property management company
- Real estate attorney
- General contractor/inspector
- Become an expert in one particular property type. Each type of property has its own unique idiosyncrasies. Learning the nuances of a specific property type increases your chances of being a successful commercial real estate investor.
- Don’t be afraid to deviate from the crowd. The “herd mentality” usually results in poor long-term investment results. If you have well thought out investment criteria that run counter to the prevailing view, don’t be afraid to chart a different course than rest of the pack.
- Know intimately your geographic market. Know the macroeconomics of the metropolitan area you’re investing in. More importantly know which neighborhoods are better than others. Understand the long term growth patterns. Know which neighborhoods are going to be the up and coming areas of the city over the next ten years.
- Use objective measurements to determine the worthiness of buying a property.Whether you use a Cash-on Cash analysis, Internal Rate of Return, Net Present Value or some other criteria, live and die by it. Don’t get sucked into someone else’s method of determining the value of an investment. And don’t use a subjective criteria that has no rational basis to it, e.g., buying a “trophy type” property that looks great but is so overpriced it would be better if you invested your money in bonds with a 2 percent rate of return. Use whatever object criteria makes sense to you and then stick to it.
- Never, ever use the seller’s pro forma for evaluating an investment. Assume that all sellers and listing brokers are liars and you won’t be far off. I can’t recall ever receiving the listing broker’s marketing package where either the rents weren’t overstated or the operating expenses weren’t understated, or both. Always ask for the actual operating statements for the past three years and a current rent roll. Base your numbers from the historical operating statements, not from the marketing package.
- Buy properties with a potential to add value. Let’s face it. At this moment in the real estate cycle properties for sale are overvalued. Let me state it very clearly: If you are buying a property today, you are buying a property close to the top of the market. There are only two ways to make money on commercial real estate at today’s prices, either: a) have a long term hold strategy (10 years or longer), or b: find properties that have the potential to add value. Generally these are properties that have some type of “hair” on them. Solve the issue and you’ll be rewarded with a substantial increase in the property’s value.
- Choose a property management company that specializes in your property type, your property’s size, and its geographic location. For example, let’s say you buy an 80 unit apartment. Find a property management company who specializes in apartments, who has several apartments under management in that size range and who manages properties within close proximity to your property.
- Remember, you get what you inspect, not what you expect. Some will tell you that owning commercial real estate is a passive investment. For most property types, that’s a myth. If you want to maximize your chances of getting a good return on your commercial real estate, you must be proactive in overseeing your properties. Even if you hire a quality property management company they are too busy with the day-to-day operations of the property to do much more than “put out fires.” Quite frankly, they don’t get paid enough to do more than that. It is imperative that you regularly inspect your property to make sure something is not being overlooked. And you need to regularly review the property’s operating statements and ask questions when something doesn’t make sense to you.
- Don’t over leverage your properties. Take advantage of all the “blue light specials” that lenders are offering today except for one: don’t over-leverage your properties. Those investors with over leveraged properties at the beginning of the Great Recession can you tell you that if they had to do it over again, they would have been far more conservative on leveraging their properties.
Those are my suggestions for reducing the risk of real estate investing. I am eager to hear your thoughts. What have I missed?