The Top 5 Mistakes to Avoid When Investing in Real Estate Today
There’s no doubt that this is a volatile time for passive investors and sponsors who are considering purchasing multifamily real estate. The COVID-19 pandemic has impacted just about every facet of our lives, including jobs, businesses, and of course real estate investments – and that includes multifamily properties.
Despite all of the dire predictions from the media, the multifamily real estate market has not collapsed, tenants are still paying their monthly rents in a timely manner and property owners aren’t lining up to file for bankruptcy protection. The truth is that while occupancy rates did decline over the past several months, the amount was minor, going from 96% to 92% or 93%. It’s really a negligible drop, and vacancy rates have been holding steady through June.
As founder and CEO of Blue Lake Capital, I currently have over $100M in assets under management. Due to the pandemic, we’ve had to make some changes in how we operate and fortunately we’re doing well. From my point of view as a sponsor I see investors making mistakes that could jeopardize their investments, so I wanted to point out the top 5 mistakes and discuss how to avoid them.
Mistake #1: Stopping Renovation
When the pandemic hit, every investor and sponsor was worried about whether or not their tenants would still be able to pay their rent. It’s understandable, because many people suddenly became unemployed. So, sponsors stopped renovation, and shifted the focus to keeping the units full. Logic dictated that trying to increase rent through renovation at that time didn’t make sense. Like many others, we put our renovation on pause as well.
Instead of simply stopping renovation in the long term, we looked at our business plan and decided to adjust to “Renovation on Demand.” When a new tenant came in to lease an apartment, we would offer them the option of choosing our “classic units” at the current rent, or the option of choosing a renovated unit at a higher rent. The difference between the current rent for a “classic unit” and a renovated unit is called the “premium,” which could add 10% to 30% to the current rent. Surprisingly, 70% of new tenants opted to go with the renovated units. These were at a 10% - 29% premium over regular rents.
Instead of simply stopping renovation and giving up the chance to increase overall monthly income, sponsors may consider adjusting to a different business model as we did. By avoiding the mistake of stopping renovation, the sponsor remains open to making more money.
Mistake #2: Lowering Rents
The logic behind lowering rents makes sense – property owners want to keep their rents low in order to attract and retain tenants, and they accomplish this by lowering rents. It was a strategy to avoid high vacancy rates during the beginning of the pandemic, which I totally understand. However, it might have been a good decision early on, back in April or May, but not in June when collections were stable.
Every market and every property are different, yet based on my experience operating in the markets where I have units, which includes Texas, Georgia and Florida, there is no real need to lower the rents at this point. What makes sense in one market doesn’t necessarily make sense in another market. The key is to maintain high rent collections.
Currently, occupancy rates are stable, at 95% on average, and with some very few exceptions. tenants continue to pay rents on time. Lowering rents means giving up income, and if it isn’t necessary then it doesn’t make any sense to do that. If occupancy rates fall or collections are a problem, then it may be worth reconsidering. Otherwise, it’s a mistake you can avoid.
Mistake #3: Letting Emotions Dictate Decisions
The pandemic has exposed the fact that many investors and sponsors are letting their emotions dictate the decisions they’re making. There are two types of emotions faced by investors. One is the absolute fear that paralyzes passive investors or sponsors and prevents them from buying additional properties or entering the real estate market. They just don’t know what to do, given the volatility in the market and the uncertainty in the country due to the pandemic.
There’s also a small group of people who believe there are exceptional opportunities available to buy properties – which are motivating them to buy properties at the wrong time or in the wrong market. This emotion is enabling them to take unnecessary risks, which is why I try to keep emotions out of the equation completely.
Remember, real estate investments are simply transactions. You have to look at the numbers and see if they justify making a purchase. If not, walk away, as there will be other properties to buy. Do the numbers make sense? There’s no real fear involved – if the numbers do make sense, move forward. Fear can cause you to miss opportunities or push you into making the wrong decisions. Conversely, when you’re over-excited about a deal, it can help to cloud your judgement and purchase a property that the numbers simply don’t justify.
Mistake #4: Not Digging into the Numbers Enough
A lot of passive investors are letting emotions make investment decision for them – and don’t look at the numbers closely enough. They look at the beautiful photos, they look at the way the beautifully packaged presentation is put together. They avoid looking at the 5-top deal components that every passive investor should examine. That’s fine when the economy is strong and real estate investments are solid. But now, during a pandemic, there’s a lot of uncertainty and the numbers are more important than ever.
Numbers to look at include the cap rate (Capitalization Rate), and the exit cap, paying particular attention to the cap rate versus the exit cap. The cap rate shows the relationship between the Net Operating Income (NOI) of the property and the price of the property. For example, if the NOI of the property is $50,000, and the price of the property is $1,000,000, you would divide $50,000 by $1,000,000 and have a cap rate of 5%. The lower the cap rate, the higher the price of the property.
Another important number to look at is the exit cap versus the cap rate. Exit cap – which is a preview for how much the property will sell for. An exit cap is the cap rate you will sell the property at, when it’s time to sell. Higher cap rate means lower profits. For example. if you’re looking at a deal that has a 5% cap rate, and the exit cap is 5%, it means the market is going to be as strong when the property sells as it is today. Usually, it makes more sense to assume higher exit cap when compared to your purchase cap rate. Always know the in-place cap rate, and the exit cap rate. If it’s not in the investment package, ask the sponsor for the numbers.
Another number to look at is the “premium,” which is the difference between the current rent, and the projected rent once the value-add renovation has been completed. If the sponsor is projecting a $300 - $400 premium, it may or not be realistic. Dig into the logic behind the numbers to see if they really make sense. Also, look at the debt structure and make sure that you’re comfortable with it. Is it agency debt – debt that is backed by the government?Or, is it bridge debt from a bridge loan? Are the rates fixed, or do they fluctuate every month? Fixed rate loans are always preferable. Finally, make sure you understand the LTV – the “loan-to-value.” If it’s 70% - that’s a good number, but if it’s 90%, for example, the loan is too highly leveraged.
Mistake #5: Having Unrealistic Expectations on Returns
Sponsors predict returns on their investments, but things have changed since the pandemic hit. You simply can’t expect the same returns now that you saw before COVID-19 hit. Before COVID-19, we projected a yearly 8%-9% cash-on-cash (a calculation of the cash income earned on the cash invested in a property), and a 15% -17% IRR (internal rate of return that provides an estimate of the future rate of return). After COVID-19 hit, we have adjusted our projection to 7%-8% cash-on-cash, and 13%-15% IRR. The lower numbers were more realistic based on the uncertainty due to the pandemic.
We really don’t know what’s going to happen in the market due to the pandemic, but we can assume that rents won’t grow as much as they have, or that we might not execute a value-add plan as we originally planned. Another reason to lower projected returns is that debt terms are not as good as they used to be. Lenders are offering much lower leverage (55%-65% compared to 75%-80% prior to COVID). This, in turn, lower returns. Some investors still have unrealistic expectations, expecting returns that were achievable before COVID-19 hit, or even higher. While there may be some amazing deals out there, watch out for overly aggressive projections.
The COIVID-19 pandemic has altered the way investors and sponsors look at multifamily property investments. While tenants are currently paying rents on time and occupancy levels are relatively stable, nobody knows what the next several months may bring. The key is to avoid common mistakes made when investing in real estate today. Don’t stop renovations, alter the approach you take. We went to a “renovation on demand” approach, and nearly 70% of our tenants chose to go with the more expensive renovated unit. As long as tenants continue to pay rents on time and occupancy rates remain stable, don’t lower rents. You’re giving up income when you do, and if it isn’t necessary, it’s a mistake. Keep emotions out of your decision-making process – it can skew the process and make you take unnecessary risks. Be sure to dig into the numbers when looking at deals, because with the uncertainty in the market due to the pandemic looking at the numbers is more important than ever. Finally, avoid having unrealistic expectations on returns. You simply won’t see the same returns post-COVID-19 as you did pre-COVID-19. And watch out for overly aggressive projections.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the "APS" of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.