Most of you have heard about the Seven Deadly Sins that include;
pride, envy, gluttony, lust, anger, greed and sloth. There are also
Seven Deadly Sins of CRE investment, and these are not so-called
psychological sins but errors or misjudgments in the art of investing in commercial real estate assets.
The CRE investment process is a multifaceted procedure to analyze, acquire, finance, manage, lease and sell a commercial property.
There are many steps in the process from evaluating a broker sales
package, to analyzing the market in which the property is located,
touring the property, raising the appropriate amount of debt and
equity capital, closing the acquisition and managing and leasing the
property. Each of these steps is critical to a successful CRE property
investment. However, there are many sins or errors committed
along the way and our list of seven of these are listed below.
Buying at Low Cap Rates. Acquiring CRE at low cap rates is one
of the biggest sins that an investor can commit. This is typically
done when interest rates are at artificially low levels, investors don’t
understand the various risks in CRE investment and investors have
uninvested capital that needs to be used. In acquiring commercial
real estate assets, it is more important to buy a good asset at a great
value than a great asset at a good value. The most important criteria in a successful real estate acquisition are to buy the asset below
its intrinsic value. Buying a CRE asset above its value or at a low cap
rate, is rarely in the long term, a route to a successful transaction.
Poor Due Diligence. The due diligence process conducted before the closing of a real estate acquisition includes all
the procedures to make sure the property, financial and market data provided
by the seller and broker are accurate and
form the basis upon which the purchase
price is based. During the booming CRE
market of the last few years, the due diligence process has been condensed and, in some cases, not even performed. Sellers have compressed the time to close a transaction, which leaves the buyer with
less time to complete a thorough due diligence program. This is
especially true of large portfolio transactions with dozens of properties. Shoddy due diligence can result in poor financial proformas,
missed negative lease provisions and critical issues with the property’s physical condition. Poor due diligence can lead to lower investment returns and reduced cash flow for the property.
No Market Analysis. One of the key procedures in the due diligence process per above is a detailed analysis of the market the
property is situated. This involves looking at property data such as
supply and demand for space, rents, vacancy, new construction, cap
rates, competition and a highest and best use review. As many of us
know, technology is changing consumer behavior, which is affecting the CRE industry, both positively and negatively. Many class A
properties that were once tops in their local market and in great
locations are finding that the local real estate market has changed
and demand for the property has waned or changed substantially.
A proper market analysis should uncover these key market issues
and reduce the risk of market changes on the value of the property.
This Time It’s Different. These are the most dangerous four
words in the investment world and are associated with every market
bubble and financial crash. CRE investors that overpay for a prop-
erty by buying at low cap rates will often utter these four words to
justify their investment. They will comment that the real estate
market is changing and if we don’t buy this asset at a low cap rate,
somebody else will and our investors will redeem their funds. Or we
think we can raise the rents substantially during the next few years
and that justifies the high price and low cap rate or the cost of debt
is so low even borrowing at floating rates, we will be able to flip the
property for a nice profit before interest rates rise. This sin is occur-
ring right now in the booming industrial market, where space
demand is very strong and cap rates on industrial properties have
declined 1.5% to 2.0% in the last few years.
Using Excessive Leverage. Acquiring CRE assets with high lever-
age is one of the most common investment sins. This was particu-
larly common during the early 2000s and up to the middle of the
Great Recession in 2010. Many properties bought during this
period had a securitized first mortgage, several levels of mezzanine
debt, preferred equity and finally the owner equity. The worst CRE
deal ever completed in 2006 and chronicled in our editors’ first
book, “The 50 Commandments in CRE Investment” had this same
convoluted capital structure. The property was the Peter Cooper/
Stuyvesant Tower Apartments complex and was capitalized with a
securitized first mortgage, 13 different mezzanine loans and 15 dif-
ferent equity investors. The property was acquired in 2006 and
defaulted on its debt in 2010. After the financial crisis, the amount
of leverage on CRE assets in general has decreased, however, it is
still a sin to overleverage a property.
Poor Management and Ownership of a Property. As is any indus-
try or business, there are good owners or managers and bad owners
or managers. This is very apparent in the CRE industry, especially
with apartments. Apartments are the most management intensive
of all real estate assets due to the large number of tenants and
leases, high levels of employee turnover and poor management
policies. There are a large number of bad apartment managers
whose shoddy policies and procedures lead to low occupancy and
subpar net operating income and cash flow. There are also bad own-
ers in the CRE industry—even some of the largest and most presti-
gious real estate investment managers. As real estate private equity
firms grow to immense size with tens or hundreds of billions of CRE
assets under management, they become marketing machines and
asset gatherers instead of real estate managers. The unwritten goals
of a lot of these firms are to just raise more and more capital,
increase the 1.5% to 2.0% asset management fee and acquire more
and more assets regardless of the price and performance.
Need to Invest Idle Fund Cash. In today’s frothy CRE market,
there is an abundance of unused powder or cash that needs to be
invested. Per consulting firm Preqin, there are over 200 real estate
private equity funds in the U.S. with more than $200 billion in
capital looking for deals. The pressure on the sponsors of these
deals from their investors to use the funds and justify the 1.5%-
2.0% annual asset management fee on these funds and generate
the projected internal rate of return is immense. Many of these
sponsors will break one or more of the other sins above and begin
making bad investment decisions, just to place the capital to work.
Sometimes the best deal in CRE is the one you don’t do.
Joseph J. Ori is executive managing director of Paramount Capital Corp.
The Seven Deadly Sins of CRE Investment
By Joseph J. Ori