Baruch Sternlicht wanted to get into real estate investing; he’d inherited some money and figured he’d try to find some deals to grow some wealth. The truth is, he didn’t know anything about real estate, but since everyone he knew seemed to be doing well with it, he figured that somehow, he could too. But first, he needed to understand the underlying research a good operator performs before committing huge sums of cash.
What kind of research do successful real estate investors do?
Significant Homework Required
While the specifics vary based on the asset type and deal size, doing solid real estate due diligence is a real job. I wouldn’t call it the most difficult type of research, but the homework required to invest with intelligence is significant. Even after excellent digging verifies facts on the ground, investors need to make projections about the future of the property, which is quite difficult and often nebulous. Some take lots of shortcuts, especially if they don’t have their own money at stake, but proper hishtadlus demands that real estate investors acquiring property do some serious due diligence in the following categories.
Regional Reviews
An office building in downtown Dallas, Texas, will probably follow a very different trajectory from one in Liberty, New York. Same for a warehouse near a bustling seaport or airport versus one in a dying region, or a house in Ocean County, New Jersey, vs. one in Cleveland County, North Carolina. Regions can change, but the general direction they are taking and the makeup of their economies and political structures have major effects on local real estate.
Local Specifics
Within a general region or even within the same city, select pockets can have vastly different characteristics as far as incomes, population growth, crime, business environments, open space, etc. Consider, for example, that the poorest states in the United States have plenty of super-rich people, while the richest states have plenty of terribly poor people. A well-located shopping center in North Dakota may be a much better investment than a poorly located shopping center in California.
Every Site Differs
Even within the same neighborhood, the specific site beneath a building can make or break its future. Zoning, accessibility, visibility, topography, size, layout, and even proximity to an anchor business driving other tenants and customers to the area can make a huge difference in a property’s prospects. All these details should be considered before projecting the numbers a property can attain over time.
Beyond Building Basics
The bricks and mortar one is purchasing is obviously another crucial aspect to be examined closely. First is verifying the built out facts on the ground. Believe it or not, there’s sometimes confusion among sellers and brokers about exactly how many units or square feet a large property has. Then, what is the quality and condition of the building design and finish? Are there any deferred maintenance or hidden structural or environmental issues? These questions should be answered very early in the process.
Income Information
Real estate income is generally about tenant rents, and the value of commercial real estate is very much connected to the income it generates. It’s vitally important to know what kind of rent can be reasonably expected from the property both currently and in the future. The strength and structure of the leases matters very much in this analysis. And, debt financing, another whole parshah, is very much connected to the quality of tenant leases.
Multi-family leases typically turn over every year, which has pros and cons versus office, retail, or industrial leases, which can be locked in to specific terms for years or even decades. It may seem nice to know your rents are contractually set to arrive for years, but the size and structure of escalations built into a long-term lease can determine the viability of a real estate investment. And that’s assuming that tenants will make good on their commitments for the contractual term. Sometimes they can’t or won’t.
Expect Expenses
Real estate owners have to control expenses too, which can include maintenance and repairs, utilities, taxes, insurance, or other expenses. This is definitely so for multi-family properties where owners have exposure to most of these costs. But expenses usually matter very much even for a property that passes all the expenses to tenants. If a property’s expenses are needlessly elevated, whether due to bad “bones,” outdated utilities, or an unfair tax assessment, tenants will ultimately want to pay lower rents.
Proforma vs. Current Realities
It is a fair amount of work to verify the existing locational facts, property condition, and net income generated by a property. Where things really get challenging is projecting what the future portends. Things change. Regions evolve. Laws and politics shift. Buildings age. Market competition moves. Tenants’ needs and preferences adjust. Projections, or proformas, as they are known, are only part science, and cynics would say they tend to be pure guesswork or even elaborate fiction. But where things are headed often matters more than where they are today.
Management Matters
Often, proformas relate to how a property position in the market may be changed and potential value added through upgrades and improved management. The right manager can make a vast difference in how well a property is run, while a bad manager can really cause damage. Real estate investment and valuation aren’t set in stone; the property may be worth more to one manager versus another.
The Right Price
This brings us to the crucial bottom line: what’s a good price to pay for a specific expected investment outcome. Ultimately, competitive forces drive pricing, but a manager that believes they can squeeze more income out of a property may be willing to pay a much higher price than others. Also, competing buyers may have lower investment expectations and/or have access to better financing. The right price is the one that makes sense for an investor’s desired returns, based on their projected plans for the investment.
Scratching the Surface
But now you’re probably gathered that investing in real estate intelligently requires quite a bit of research, knowledge, and skill. Frankly, though, we’ve just scratched the surface—each of these categories deserves an article or series of articles of its own. Nor have we delved into the financing and taxation of commercial real estate, each a worthy avenue to get familiar with. And not everyone has the temperament or skill set required to undertake real estate investing on their own. (Note that single-family homes are generally much easier to research and manage than other types of real estate.)
Managing the Managers
This complexity is one of the reasons even investors with large sums often choose to send their money to syndicators and asset managers who specialize in real estate investing. But not all these managers know what they’re doing either, and relying primarily on sparse and limited track records is a simplistic approach. Researching and managing investment managers is a science-and-art mixture of its own, one that we hope to discuss in another article.