Commercial Real Estate Investing Mistakes: The Top 15
Time and time, the same crucial errors are committed.
The CRE sector differs from every other sector in that it uses a transaction-based paradigm. Transactions involving the sale, financing, and leasing of goods and services are the industry’s lifeblood. The industry as a whole, its participants, and the firm all profit more as there are more interactions. The year 2021 saw unprecedented transaction volumes and a tremendous CRE boom.
The most prosperous organizations and people in the sector are typically skilled in marketing, financing, and/or leasing CRE property. However, the same crucial errors are consistently made when pursuing these transactions, which typically leads to subpar performance, the loss of equity in a property, or the loss of the property in foreclosure. The following are the top 15 commercial investing blunders that we’ve identified:
- Purchasing real estate at a low cap rate. Even if the investor thinks that potential rent increases in the future, which may not materialize, will offset the low initial return, cap rates below 5.0% are not warranted. Purchasing CRE at cap rates under 5.0% is comparable to purchasing a tech stock at a 100 price-to-earnings ratio.
- Not varying a nationwide portfolio by region, sector, and type of property. Numerous major funds are diversified by kind and region by national firms, but industry diversity is often overlooked. In Silicon Valley, 70% of apartment tenants and 70% of office tenants, if an investor purchases only flats and offices, are employed by the technology sector. Many apartment residents could lose their jobs and be unable to pay their rent if the IT sector experiences a slump. They could even go back home or share rooms with roommates. The apartment market will suffer as a result of this. The office market will suffer if many of the internet companies fail on their leases or reduce the amount of space they need.
- Not carrying out all of the necessary financial and property due diligence before buying a portfolio of properties. Many institutional investors that purchase huge portfolios made up of dozens or hundreds of properties don’t perform enough due diligence at the individual property level. They either employ unskilled third-party organizations to perform the property-level due diligence or they just examine the larger and more expensive homes in the pool.
- Purchasing real estate using negative leverage. Negative leverage is a “no-no” in commercial real estate because it happens when the cap rate is lower than the mortgage constant, which means the cash-on-cash return will be lower than the cap rate. Many businesses buy real estate using negative leverage in the hope that rising rents will more than offset the low initial return.
- Fund a long-term real estate asset or portfolio with short-term floating-rate financing without the added security of a swap or collar. In the past two years, when the Fed abruptly increased the federal funds rate from 0% to 5.25%, this is what has happened. Due to the sudden surge in interest rates brought on by floating-rate debt and the lack of interest rate protection, many CRE investors are now frantically trying to cut their financing costs and risk.
- Using a terminal cap rate that is lower than the going-in cap rate when underwriting an acquisition. To “juice up” the internal rate of return on the equity in a transaction underwriting, this is frequently done by the acquisition team or another internal division within a large CRE business.
- Institutional investors who provide funding to sponsors with junior management teams with little expertise. The senior management group should be older, with members having seen at least the two most recent secular CRE downturns, from 1987 to 1992 and 2007 to 2012. Having team members with extensive and long-term expertise and understanding of various property kinds, markets, and economic recessions is one of the most crucial factors in CRE investing success.
- Utilizing excessively upbeat rent predictions while underwriting a deal. This frequently happens when an inside group trying to grow or acquire a deal wants to improve the transaction’s appearance.
- Not looking into the retail tenants’ sales per square foot, a crucial indicator when purchasing shopping centers. The sales per square foot of the anchor tenants, after the cap rate, is one of the most crucial indicators when purchasing retail complexes. A center with high sales per square foot is in a prime location, will remain fully leased, and is in high demand among tenants and customers.
- Utilizing a high leverage of above 75%. High leverage is one of the dangers associated with CRE investing and was one of the factors contributing to the Great Recession from 2007 to 2012.
- Not granting top staff members an equity stake in the business, holdings, or fund. The “golden handcuffs” are what are referred to as CRE. Your top personnel will depart if you don’t look after them, joining your competition.
- Not including in a real estate firm the 15 CRE hazards. Risks in the firm’s investment strategy include those related to cash flow, value, tenants, the market, the economy, interest rates, inflation, leasing, management, ownership, legal and title issues, construction, entitlement, liquidity, and refinancing.
- Investing in real estate segments where the investment firm has no prior experience, such as hotels and senior housing, which are more operational businesses than real estate deals. Senior housing is often 80% to 100% operating business and 0% to 20% real estate deal, while hotels are normally 70% operating business and 30% real estate deal.
- When buying a sizable portfolio of CRE assets, not getting the Kmart discount. When a sizable CRE portfolio changes hands, it usually consists of Class A queens, Class B pigs, and average Class B transactions. The buyer needs to receive a discount of at least a 1.0% higher cap rate to account for the risk of the Class C properties.
- Not double-checking the formulas in an XL underwriting spreadsheet because every CRE underwriting worksheet contains at least one mathematical inaccuracy. When creating a challenging Excel underwriting workbook, this is a regular occurrence, thus businesses should ensure that all calculations are double-checked by an impartial third party.
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