The CRE industry appears to be entering a period high in volatility, with the Fed promising to increase interest rates starting in March. This will likely lead to soaring inflation and the war in Ukraine. There may also be a recession later in the year due to the high inflation, particularly in food and gas.
The CRE investment process involves many steps to acquire, finance, manage and lease commercial properties. There are many steps involved in the process, from evaluating a broker sale package to touring the property, raising sufficient equity capital and debt, closing the acquisition and managing and leasing it. Each step is crucial to a successful investment in CRE property. CRE investment comes with many risks that were not considered during the boom years. Investors should reconsider their investment strategies in order to ensure a successful investment in this turbulent environment.
- Purchase properties at low cap rates
Investors can commit the greatest sin of buying CRE at low caps rates. Many apartment and industrial properties trade at below 4.0% cap rates today. This is due artificially low interest rates, capital looking for CRE investments as an inflation hedge and strong fundamentals. When buying commercial real estate assets, it is better to buy a quality asset at a high value than a great asset for a low price. In order to make a real estate acquisition a success, it is important to buy the asset below its intrinsic worth. In the long-term, it is rare to buy a CRE asset at a high cap rate or above its intrinsic value.
- Poor Due Diligence
Before closing on a real property acquisition, due diligence must be completed. It includes all procedures necessary to verify that the financial, market, and property data provided by the seller or broker are accurate. These data form the basis of the purchase price. The due diligence process was compressed during the boom in the CRE market. In some cases, it was not even completed. Sellers have reduced the time it takes to close a transaction, leaving the buyer with less time for a thorough due diligence process. This is especially true when there are multiple properties in a portfolio. Poor due diligence can lead you to poor financial proformas and missed negative lease provisions. It can also lead to critical issues with the property’s physical condition. This can cause lower investment returns as well as reduced cash flow.
- Market Analysis: Inadequate
The due diligence process includes a thorough analysis of where the property is located. This includes analyzing property data such as the supply and demand for space and vacancy, cap rates, competition, cap rates, and a highest- and best use review. Technology is changing consumer behavior. This is having a positive and negative impact on the CRE industry. Many class A properties in top locations and in high-demand markets are now finding that the local market has changed and that the demand for these properties has decreased or changed significantly. A thorough market analysis will reveal these key market issues and reduce market volatility that could adversely affect the property’s market value.
- This time it’s different
These four words are the most dangerous in the investment world. They are often associated with every financial crash and market bubble in American history. These are the four words CRE investors will use to justify their investment if they overpay for a property and buy at low cap rates. They will say that the real estate market is changing, and that if they don’t buy this asset at a low rate, someone else will. Investors will then redeem their funds. We think we can increase the rents significantly over the next few years, which justifies the high cap rate and high price. Or, the cost of debt is so low that even floating rates borrowing is possible, so we will be able flip the property for a nice profit and before interest rates rise. This is the perverse thinking that is happening right now in the booming apartment and industrial markets. Cap rates have fallen below 4.0% over the last few years and space demand is strong.
- Using Excessive Leverage
High leverage CRE assets are one of the most dangerous investment risks. This was especially prevalent in the early 2000s, and up until the middle of the Great Recession. Many properties purchased during this period had a securitized mortgage, multiple levels of mezzanine and preferred debt, and finally owner equity. Excessive use of leverage is great when the market’s booming and inflation are high, but it can become a problem when the economy and markets plummet. The regulated lenders have been very conservative in their real estate underwriting and lending structures. They often limit loan to value ratios to 65% or less.
- Poor Management and Ownership
As with any industry or business there are good and bad owners and mangers. This is especially true for apartments in the CRE sector. Apartments are the most complex real estate asset due to the high number of tenants, leases, employee turnover, and poor management policies. There are 27 million apartments across the United States. Bad apartment managers have poor policies and procedures that result in low occupancy, subpar cash flow and net operating income. Incompetent or lacking in experience and expertise in managing CRE assets, there are also bad owners. These include some of the most prominent and prestigious real estate investment professionals. As real estate private equity companies grow to enormous size and manage billions in CRE assets, they become asset gatherers and marketing machines instead of real estate managers. These firms have unwritten goals to raise more capital and increase the 1.5% to 2.0% asset management fee while acquiring more assets, regardless of price or performance.
- Need to Invest Idle Fund Money
In today’s frosty CRE market, there are a lot of uninvested powder or cash. According to industry data, the U.S. has over 200 real-estate private equity funds with more than $250 Billion in capital that are looking for deals. These investors are putting enormous pressure on the fund sponsors to use these funds, justify the 1.5%-2.0% annual management fees and generate the projected internal rate of return. Many of these sponsors will ignore the risks above and make poor investment decisions in order to get the capital to work. Sometimes, the best deal in CRE can be the one you don’t do.
Joseph J. Ori is Executive Managing Director of Paramount Capital Corporation, a Commercial Real Estate Advisory firm