3 Key Mistakes Passive Investors Make When Investing In Real Estate
As an investor, it is important to be mindful of the potential mistakes that can hinder investment success. Limited Partners (LPs) play a vital role in private equity real estate investments, but they can make mistakes that can impede their ability to achieve their investment goals. Here are some common mistakes that LPs can make and how to avoid them:
Return Chasing & Ignoring Risks
Investors who chase the highest return without accurately factoring in the risks can often find themselves with underperforming investments. Investments with higher risk and higher reward have a much wider range of investment return outcomes due to so many risks involved.
Consider a real estate development vs acquiring an existing property. The most important assumptions in any real estate investment are purchase price/cost, long-term interest rate on the financing, rental rates, and the stabilized property tax bill.
On a development deal, none of these key factors are known at the time of investment. You are investing based on the best estimates of the developer/sponsor. Compare that with acquiring an existing property with a permanent loan on it upon acquisition – all of these key assumptions are known except for potentially the sale-price adjusted property tax bill in some markets. The risk profile is very different of these investments and the range out investment outcomes is much wider on the development and much narrower on the acquisition.
While it's natural to seek out the highest possible return on an investment, failing to consider the potential risks can result in underperformance or even loses. Some investors become so focused on the potential gains that they overlook the possibility of losing their initial investment or considering the likelihood of this investment underperforming.
Experienced investors, on the other hand, know that high returns often come with high risks, and they carefully weigh the potential risks against the potential rewards before making any investment decisions. Ultimately, it's important for investors to strike a balance between potential rewards and potential risks when making investment decisions to achieve long-term success. It is better to hit more singles and doubles over the course of one’s investment career than swing for the fences every time out and have a larger deviation of possible returns.
Assuming All Product Types Are The Same
Product types in real estate investment are not all the same, and they each carry with them their own levels of risk. The major product types in Real Estate are Multifamily, Industrial, Office, Retail, and Hospitality, in addition to many other variations and subtypes. There are various factors that differentiate one product type from another, including lease terms, financing options, and potential risks and rewards.
For example, making an investment in a vacant office deal will carry more risk than investing in a vacant industrial deal due to tenant demand one property type being more in favor than the other with the current headwinds facing the office space. While this is generally the case in today’s market, the script may flipped if the office building is in an extremely desirable location in a core market or includes some other positive attributes while the industrial building is in the outer ring of third tier market and the building is functionally obsolete.
Similarly, an investor looking to invest in a commercial office building will likely encounter different lease terms and financing options than an investor looking to invest in a multifamily residential property. Office & other commercial leases typically have longer terms than residential leases – and tenant quality becomes a very important topic when evaluating these types of deals. Residential and hospitality properties will be able to adjust their leases quickly to keep pace with a booming economy, while commercial properties will have more difficult time doing so due to the nature of the longer-term leases (the inverse can be true given negative economic conditions as well).
Financing for commercial properties may require a higher down payment or offer different terms than financing for residential (multifamily) properties as well, since there are traditionally more options available when financing multifamily investments (government backed agency programs dedicated solely to multifamily investments).
Likewise, an investor looking to invest in a hotel or hospitality property will face different risks and rewards than an investor looking to invest in a retail property. Hotels and hospitality properties are more susceptible to economic downturns and fluctuations in the travel industry because you have to lease the space every day, while retail properties may be impacted by changes in consumer behavior and online shopping trends.
It's important for real estate investors to carefully evaluate each product type and consider the unique risks and rewards associated with each one. This includes evaluating lease terms, financing options, potential revenue streams, and other key factors. By taking a comprehensive approach to real estate investing and considering the unique characteristics of each product type, investors can make informed decisions that align with their individual investment goals and deliver long-term success.
Not Factoring in Business Plan Execution Risk
How many moving pieces does this investment have? The more unproven variables, the wider the range of investment outcomes.
It is essential to understand the risks involved in executing a business plan. One key factor to consider is the number of moving pieces involved in the investment. The more variables that are in play, the wider the range of potential investment outcomes. A successful real estate investment requires careful consideration of all the factors involved, including construction risk, how quickly units can be turned and re-rented post construction, re tenanting of commercial spaces, property condition, market trends, financing, and management.
One of the most important pieces of this is to differentiate between construction risk and a stabilized deal. A stabilized deal refers to a property that has been completed and is generating steady cash flow, typically through long-term leases or other forms of occupancy. In contrast, a construction project is a property that is either in the process of being built or undergoing major renovations.
Construction risk refers to the potential for cost overruns, delays, and other unexpected issues that can arise during the construction process. For example, a developer may encounter unforeseen issues with the site, delays in obtaining permits or materials, or unexpected changes in the local real estate market that affect demand for the property. All of these factors can impact the ultimate profitability of the project.
In contrast, a stabilized deal offers more predictable cash flow, lower operating costs, and a more stable overall investment. However, there are still risks associated with stabilized deals, such as changes in market demand or tenant turnover. These risks can be mitigated through a sponsor that conducts careful due diligence, strong management practices, and a deep understanding of the local real estate market.
When considering real estate investments, it's important to carefully evaluate the potential risks and rewards of both construction projects and stabilized deals, in addition to the risks associated with different product types. While construction projects, or an old office building repositioning may offer the potential for higher returns, they also come with higher levels of risk and uncertainty. Stabilized deals, on the other hand, offer more predictable returns but may not offer the same level of growth potential. Ultimately, the decision to invest in a construction project or a stabilized deal should be based on a thorough analysis of the specific property, the local real estate market, and the overall investment strategy.
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