2 Important Truths About Commercial Real Estate Investing

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2 Important Truths About Commercial Real Estate Investing

Truth #1 about commercial real estate investing

A wise man once said, “The season of failure is the best time for sowing the seeds of success.”  So how does this truth relate to commercial real estate investing?  When the real estate market is in its season of failure (think 2008-2009) is when you sow your seeds of success. Those who buy when everyone else is selling usually end up the big winners.  This is true of all types of investing but it’s especially true with commercial real estate.  We all know that those who bought CRE at the bottom of the market during the tough years from 2010-2012 made out like bandits.  As the saying goes, “You make your money when you buy, not when you sell.”

Truth #2 about commercial real estate investing

But the corollary of this truth is unfortunately also true.  It’s during the prosperous times that investors sow their own seeds of failure.  How you ask?  By acting like the good times will last forever they make foolish investment decisions.  They forget the tough times and the hard lessons that were learned.  They say during the bleak times, “Never again will I (fill in the blank)” only to have selective amnesia when the market turns around.

Potential seeds of failure

So as I was saying, it’s during the prosperous times (like now) that investors sow their seeds of failure.  Here are a few examples:

  1. Instead of sticking firm with your offer you get caught up in the buying frenzy of competing with multiple offers on the same property.
  2. Not being concerned that the property doesn’t cash flow well with current rents and expenses.
  3. Assuming rents will continue to go up like they have in the past.
  4. Assuming that property appreciation in a couple of years will bail you out of buying today’s overpriced property.
  5. Under estimating the amount of capital repairs needed to get the property back to an acceptable physical condition.
  6. Not having sufficient cash reserves on hand to weather a downturn.
  7. Over leveraging your property with debt. Even low interest rate debt, which is plentiful these days, is not prudent if it eats up the property’s cash flow after debt service.

So how do we avoid these pitfalls?  Some answers are obvious, almost trite so I’m hesitant to respond.  But I have one answer that may surprise you so here goes:

1.  Wait for the “fat pitch”

We need to be disciplined and wait for the “fat pitch.”  You know what I mean by a “fat pitch” don’t you?  When a pitcher gets behind in the count, both the pitcher and the batter know that the next pitch has to be over the plate or the pitcher is going to walk the batter.  So the pitcher throws it down the middle of the plate giving the batter his best chance for a base hit.  In the same way, investors need to be patient and disciplined when searching for properties to purchase.  I know it’s difficult for investors to wait for the right property, especially for those who have a limited time to identify a property for a 1031 exchange.  It’s almost impossible to put this into practice when you have 45 days to identify your exchange property.  I get that but I felt compelled to state the obvious.

2.  Do a gut check on your investing assumptions

 With every investment opportunity I consider these days, I ask myself if the investing assumptions I’m making are too aggressive.  Are they based on a rosy pro forma that would have worked in the past when the market was gaining steam, but over the next few years are way over the top because the market is beginning to peak?  You remember the party game Musical Chairs?  I wonder when the music stops, i.e., the market turns, am I going to be the one without a chair to sit on, i.e., the investor who is caught with an over-priced property?

 3. Check your emotions at the door

The old adage, “He who is the most emotionally invested loses” is especially true when purchasing commercial real estate.  Check and re-check your investment assumptions.  Are they realistic?  If you think they are, then confidently walk away when the bidding war gets out of hand.  Recently, we were significantly out bidded on a property that I really wanted to own.  The listing broker suggested we might want to increase our offer.  We reluctantly said no and walked away from buying the property.  I felt awful.  I was a bit depressed for a couple of days.  Sixty days later the winning bidder walked away from the deal.  He couldn’t make the numbers work.  Well duh!!!  We eventually got the property under contract at a lower price than our original offer.

4.  Avoid using sophisticated valuation methods

Sophisticated valuation methods, such as the Internal Rate of Return (IRR) do investors a disservice.  Why?  Because they make too many assumptions that no one knows the answers to.  For example, do you know how much rents are going to increase annually?  Do you know how long you plan to hold the property?  Do you know how much you’re going to sell the property for?  The answer to all these questions, and many more, is a resounding no.

There was an old saying back in the early days of the computer that was known by its acronym GIGO – garbage in, garbage out.  In my opinion, using the IRR valuation method is the modern day version of GIGO (more on this in a future blog post).  IRR masks the most important factor in purchasing an income producing property – cash flow.  You can generate an acceptable IRR with a property that doesn’t cash flow well because the projected IRR return is based on future rent increases and the appreciation of the property both of which are just educated guesses at best.  More emphasis should be on this one simple metric: How well does the property cash flow?

Are we at a tipping point?

I believe we are nearing the tipping point in commercial real estate investing. I believe there is anecdotal evidence to suggest that rents are peaking or at the very least rental increases are beginning to slow down.  Do I have the ability to time the market?  Can I tell you emphatically that 2017 will be the year the market turns?  Heck no.  No one has that ability.  Certainly not me.  How long do commercial real estate market cycles last?  No one knows.  Related Article: Apartment Rental Rates – Are We at a Tipping Point?

This I do know: They don’t die of old age.  No, they die of unexpected economic shocks.  At a day and time unknown to all, some event will occur that will send a tremor through the real estate market.  This event will then trigger a series of cataclysmic shock waves resulting in the market turning over night.  It won’t be a gradual change.  It will turn on a dime.  And when it turns I hope that I am prepared to withstand the downturn.  And I hope that you are too.

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  1. Rennie November 17, 2016 at 10:28 pm - Reply

    Hi Doug. Insightful as usual. I like how you see the IRR as calculation that is not relevant because it is all based on guess work for the future.

    • Doug Marshall
      Doug Marshall November 18, 2016 at 9:14 am - Reply

      Rennie, I have up until this year been a big believer in IRR. But in the past year I’ve realized that IRR can give you a projection that doesn’t reflect reality. It may not be sexy but I believe a much better approach is to calculate the property’s projected Return on Equity in the first year of operation. If you can get a modest return in the first year, let’s say 4 or 5% based on realistic expectations for income and expenses then that should be okay. Appreciation of the property and future improvements in cash flow will likely happen increasing your overall return on your investment but there is no realistic way to measure what that will be from the outset. I do like using IRR once I’ve sold the property. At that point you know all the figures: down payment, annual cash flows and the gain on sale. It’s a good way to definitively say I had a X% Internal Rate of Return on this property. But using it for acquiring a property makes no sense in my opinion.

  2. Carolyn November 18, 2016 at 12:04 pm - Reply

    Hi Doug, I am unfortunately the fortunate person that you described in #1 above: someone who will be entering into a 1031 exchange and will need to make decisions about identifying a property (or properties) within a short 45-day window. This will be my first venture both for doing a 1031 exchange and in buying apartments. What advice do you have for a first time buyer who can’t afford to screw this opportunity up? It’s difficult to trust a commercial broker because it’s difficult to know whether they are working in my best interest or theirs? Is the property they’re pitching a nice prospect, or are they trying to unload a problem building, get it off their books, and making a commission in the process… And then there is the question of whether to leverage, or pay cash. It’s a a short, SHARP learning curve! I’m interested in your thoughts. Thanks in advance.

    • Doug Marshall
      Doug Marshall November 18, 2016 at 2:04 pm - Reply

      Carolyn, there are no easy answers to your situation. Here are some suggestions: 1) On the property you’re selling, add a couple of 30 day options to extend closing. A delayed closing extends your 45 day window; 2) Have a really good real estate broker working for you someone who knows apartments inside and out; 3) Have your CPA calculate your capital gains taxes to determine how much of a tax bite you’re going to take if you don’t do a 1031 exchange. Sometimes it’s better to pay the taxes than to buy an over inflated property. Good luck.

  3. Nathan K Smith January 4, 2017 at 8:33 am - Reply

    Hi Doug, very informative post! Thank you for sharing. So when you say your more focused on the projected return on equity in the first year of operation……..are you essentially focused on the cash on cash return ratio?

    • Doug Marshall
      Doug Marshall January 4, 2017 at 2:50 pm - Reply

      Nathan, thank you for your response. Yes that’s exactly what I mean. A property owner should focus on the before tax cash-on-cash return. But there is a nuance difference between return on equity vs return on investment. It’s important not to fixate on ROI. Your initial investment remains static. Your equity in the property fluctuates over time. Hopefully it grows over time. What many investors don’t consider is their ROE. As the equity in your property grows, your return on equity declines. You need to look on an annual basis what your ROE is. When the ROE falls below an acceptable return, let’s say 4%, you either need to leverage your property with new debt or you need to sell the property. A 4% return on your stock portfolio is unacceptable. Why should a 4% return be okay for your real estate portfolio? It shouldn’t.

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