Categories: Education

Common Mistakes Investors Make that
Lead to a Bad Investment

Introduction

Real estate can be highly lucrative—if investments are made wisely. It’s no different than investing in any asset class, really. The more homework an investor does in advance, the greater likelihood their investment will prove fruitful. In this article, we examine the most common mistakes that investors make that can inadvertently lead to a bad investment.

Of course, not all hope should be lost. Even when an investor makes a sidestep, there are ways to shift gears and improve the situation to result in a better outcome. We’ll look at some of the solutions an investor can explore if they see their real estate deal going sideways.

Mistake #1. Not knowing the local market.

Many investors will either a) put blind faith in a sponsor because they know and trust them, and/or b) jump to the returns a deal promises and base their decision on whether to invest on those key variables. In doing so, they overlook an analysis of the market in which the deal is being proposed. A deal led by an otherwise remarkable sponsor who promises tremendous returns may wind up being a terrible investment if the market does not support the deal in question.

It is always best to invest in an area with a thriving
but diversified employment base.

There are a few things an investor will want to know about the local market.

  • What’s driving the local economy? It’s important to understand why that market is compelling from an investment perspective. For example, are businesses hiring and in turn, are new people moving to the area? If that’s the case, then an investment in multifamily might be worthwhile. Conversely, if an area is overly reliant on one or two large employers, some real estate investments might be riskier. If one of those employers goes out of business, people may leave the area in droves, therefore diluting the demand for an asset like multifamily. We have seen this happen time and time again, whether it’s a result of a military base closing or a major corporation relocating their headquarters. It is always best to invest in an area with a thriving but diversified employment base.
  • What’s the demographic profile of area residents? Demographics are a key consideration, as the people who live and work in the area will be your primary audience when trying to lease a property. A multifamily investor may want to know, for example, average household income, education level, and household size. If there are many young families in an area, for example, this could support an investment in multifamily properties that offer larger units with 3+ bedrooms – a style that is more conducive to families. Conversely, an area with many recent graduates may be more appropriate for studios, one- and two-bedroom units. Demographics are highly important to future pricing and absorption rates.
  • Who’s your competition? When looking at a property, it is important to look at the existing comps to see the size, quality, and occupancy rates at your anticipated competition. Competition is not inherently bad. For example, an area with other multifamily properties, can prove that there is demand for additional housing. Especially if these properties are almost entirely leased. Look not only at the existing competition, but any similar properties that have been permitted or are under construction. Be sure that the deal you’re considering will continue to have sufficient demand in the wake of any new supply coming online.

Mistake #2. Not conducting thorough due diligence on the sponsor.

The experience of a sponsor can, quite literally, make or break a deal. Before investing, be sure to do your homework about a sponsor. What other projects have they done? Where? Do they have experience with this product type and/or in this geography? How long has the sponsor been in business? Have they survived multiple real estate cycles? How have they adjusted during economic downturns? Is the sponsor planning to invest their equity in the deal as well, and if so, how much? It is important to know that a sponsor is equipped to execute their business plan as intended, and those with more experience will have had greater exposure to the unknowns that can arise during any deals—and importantly, will have solutions for working through those challenges.

Mistake #3. Not stress testing the sponsor’s pro forma.

Real estate underwriting can become very complicated. At a bare minimum, an investor will want to carefully analyze a sponsor’s pro forma and spot-check certain items to be sure they are in line with market averages. For instance, you might want to pull the comps from nearby properties to determine if the rents that the sponsor is projecting are realistic. Then, discount those rents. What’s the worst-case scenario where the deal would still be viable? What if you increase the vacancy rate? Do the numbers still work? Are the returns still acceptable to you? Fiddling with the numbers will help you determine whether something is a worthwhile investment, even if the sponsor fails to meet original expectations.

Mistake #4. Not understanding a project’s risks.

No real estate deal is foolproof. There are many things that can go wrong, from cost-overruns to leasing challenges, unexpected environmental issues and more. A qualified sponsor will be able to outline the project risks for prospective investors and then describe how they plan to mitigate those risks. An investor can then decide whether to move forward based upon their individual risk toleranceQuestion Mark.

Mistake #5. Not reading the offering documents carefully.

Whether someone purchases a property outright and individually, or through a real estate syndication, there will be a lot of paperwork associated with the transaction. Most passive investors opt to invest through a syndication, and those who do, will likely be provided with a private placement memorandum (or PPM). A PPM outlines the deal terms, the sponsor’s experience and proposed business plan, potential risks, and any other material information that could sway an investor to proceed one way or another. Documents like the PPM provide critical information that is intended to protect both the sponsor and investors. Many investors naively gloss through the PPM and are surprised, down the road, to learn of a complication that was previously identified as a risk in the original offering. Surprises like these can be avoided by carefully reading all offering materials.

As you can see, thorough due diligence—about the market, the sponsor and the deal—are all ways to help avoid making a bad real estate investment. While there are no guarantees that a deal will go smoothly, or exactly as originally planned, doing your homework in advance will help mitigate the risk associated with investing in any real estate project.

How to Turn a Bad Investment into a Good One

Someone who invests in several real estate deals over the course of time will inevitably find some deals turn out to be more successful than others. There may be occasions when, for example, an investment starts to go sideways. This does not mean an investor should throw in the towel altogether. Instead, there are many steps an investor can take (or push the sponsor to take) to overcome the problem(s) and turn a bad deal into a good one.

  • Determine the primary cause of the problem.
    Before an investor can take any action, they must first understand the root cause of the problem. Let’s say, for example, that a property is not generating sufficient cash flowQuestion Mark. There could be several reasons for this. Maybe there’s a vacancy issue. Perhaps the rents are too low. Or maybe the property manager is not effective. Maybe there are overdue improvements that need to be made to the property. Or maybe there are operational savingsQuestion Mark that could be realized… There is any number of reasons why cash flow could be lagging expectations. An investor should have an honest conversation with the sponsor to determine what’s causing the problem and then collectively, they can discuss ways to improve the situation.
  • Consider whether short-term solutions can stave off long-term harm.
    Some real estate investors are hesitant to take actions that could have long-term implications. Lowering the rents to increase occupancy could, for example, result in less cash flow, less net operating income, and ultimately, a lower property value. Obviously, that’s problematic. Yet, if vacancy rates are so high that an owner cannot pay the mortgageQuestion Mark, a short-term solution might prevent long-term harm (like defaulting on the loan). In this case, one solution might be to offer a one- or two-months’ rent concession to tenants who sign a 12-month lease. Once leasing volume increases, then the owner can shift their focus to renter retention using more cost-effective solutions.
  • Explore whether recapitalization or modified loan terms could improve the situation.
    Debt can be a very powerful tool to help improve the success of a real estate deal. In the case of a property in need of costly renovations, an owner might approach the bank to pursue a recapitalization. A recapitalization is a strategy that replaces equity with debt, which frees up the investors’ capital to be reinvested into property improvements as needed. These improvements can help increase the value of the property, which will then improve the property’s loan-to-value ratio upon stabilization.

    Debt can also be negotiated for the benefit of a deal in trouble. Most borrowers (especially those in otherwise good standing and with proven track records) can approach their lender to see about working in an interest-only period, which will bring their loan payments down in the short-term while they work to address the issues the property is facing. Other lenders may be open to forbearance, which is when the lender allows the borrower to pause or reduce their payments for a short period of time. Many owners successfully modified their loan terms to weather the COVID-19 crisis, a true “black swan” event that nobody could have predicted.
  • Assess the business plan and determine if an alternative path would be more lucrative.
    Another way to turn a deal around is to assess the business plan and determine whether an alternative approach would result in a better outcome. For example, an owner may have purchased a multifamily property with the idea of leasing the units as short-term rentals on a platform like Airbnb or VRBO. Let’s say that after closing, a municipality implements new rules and regulations around short-term rentals. In turn, the original business plan is no longer feasible. This would be an opportunity to re-visit the business plan and explore other more viable alternatives, from repurposing the building to student and/or senior housing or more traditional multifamily housing. In a more extreme situation, if the property is located in a destination market, the owner might consider repurposing the building as a hotel which would then be subject to the area’s local hospitality taxes and regulations.

When all else fails, sell.

At some point in time, investors need to know when to cut their losses. Despite their best efforts, a deal may not be entirely salvageable. It’s best to recoup as much of your capital as possible if the situation begins to look especially dire.

Most syndications will spell out the terms and conditions by which an investor can cash-out or sell their share of the deal (again—this is why it’s so important to read the offering documents!). Short of cashing out one’s personal shares, investors can have an honest conversation with the sponsor about selling the property at a loss (or better, simply with no gain) before being forced to sell by the bank through foreclosure.

Real estate can be highly lucrative—if investments are made wisely.
The more homework an investor does in advance,
the greater likelihood their investment will prove fruitful.

While not ideal, if an investor does experience a loss, they can use this loss as a write-off on their taxes which will offset other income earned that year.

Not every real estate deal will be successful. But as you can see here, there are steps you can take to improve the likelihood of success, and then measures you can take to improve situations when deals aren’t otherwise going according to plan. Turning a bad real estate investment into a good one isn’t easy, but it can certainly be done.


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