I want to let you in on a little secret: Not every commercial real estate property I invest in turns out to be a “home run.” Now that I got that confession off my chest, maybe some of you can relate. In the summer of 2007, which turned out to be the absolute peak of the last real estate cycle, I, along with a like-minded group of investors, purchased a 32 unit apartment located in a small town.
Indicators of a Good Commercial Real Estate Investment
At the time it seemed to be a good investment:
- Large unit sizes
- One story buildings
- Nice, quiet little town
- The potential down the road to convert to condominiums
Hey, what could go wrong, I asked myself? Well it turns out that plenty could go wrong, some of which could not have been predicted by even the most savvy of real estate investors. Because of that I needed to extend mercy to myself instead of beating myself up over investing in this property, which I eventually did. In 2015, with a sigh of relief, we sold this apartment. For several weeks after the sale you could see me doing “back flips” celebrating the sale of this loser property.
A year has passed since we sold this property and from the vantage point of time I now realize that I learned some invaluable lessons:
4 Lessons Learned From Investing in My Loser Property
Market timing is everything.
The old adage, “You make your money on an investment when you purchase it, not when you sell it” is very true. This investment had very little chance to perform well because we simply paid too much for it. We bought this property at the very peak of the real estate cycle. If we had purchased it a year or two earlier at a much less inflated price this property would have likely performed admirably.
There’s a reason why properties in small markets have higher cap rates.
When the economy went bust in 2008 unemployment soared, vacancy rates rose and rents flattened or declined because of concessions. As bad as this was in the large metropolitan areas (think Portland) it was far worse in the small towns which had higher vacancy rates and struggled with more significant rent concessions. When the commercial real estate market finally turned in the large cities it was still another year or two before the small town our property was located in began to see occupancy rates rise and modest rent growth.
Never underestimate the cost of deferred maintenance.
This property was purchased as a value-added play. We realized at the time we bought it that there was a lot of deferred maintenance that needed to be corrected. So when we purchased the property we had what we thought was a sizeable war chest set aside for capital improvements. In reality, we weren’t even close. When we sold the property, I’m sure the buyer was thinking that all he had to do to make this property perform well was to tackle all of the deferred maintenance.
Pay close attention to your on-site manager.
The old adage, “You get what you inspect, not what you expect” is very true. During the eight years we owned the apartment, we had three different on-site managers (we had to fire the first two). Each started out well managing the property but over time their performance was highly correlated to how well we monitored them. Once we began to trust how well they were managing the property, the property’s performance began to slowly go downhill – vacancy rates rose, the grounds didn’t look crisp and clean, and tenant evictions for non-payment of rent lingered longer than they should have. But as soon as we started asking the onsite manager insightful questions about the property’s performance and occasionally visited the property things began to improve.
Take Heed, These Issues Could Happen To You
Why should you care that I learned these four lessons the hard way about investing in my loser property? Simply put, because the same types of issues could happen to you, especially now. I sense that once again we are approaching the peak of the real estate cycle. Investors are sensing this too and as a result they’re doing the following:
- Paying too much for properties assuming that rents will continue to rise like they have in recent years (a.k.a. Lesson #1 above).
- Seeking out more reasonably priced investments in tertiary markets forgetting that there is a reason why cap rates are higher for these properties (a.k.a. Lesson #2 above).
- Buying more value-added properties which may or may not be a good investment decision. If you’ve never purchased a property with a lot of deferred maintenance be very careful (a.k.a. Lesson #3 above).
I don’t have the ability to know when the market peak will happen. But I know this: the lack of product on the market and the bidding wars that for-sale listings are now receiving reminds me of 2007. Doesn’t it you? It gives me pause. Now I could be wrong. Maybe this commercial real estate market will continue well into 2017. That is a real possibility. I’m not a soothsayer. I’m not clairvoyant. But consider yourself forewarned.