5 Costly Mistakes Your Real Estate Manager May Make

This article was originally posted on Origin Investments' blog.

It’s possible to invest in private real estate through real estate asset management firms that select, manage and hold or sell properties, often in funds to diversify risk. While these firms may give investors access to high-quality, institutional-quality commercial investment properties, choosing the right one to invest with requires a high level of due diligence.

When acquiring properties, most real estate managers build models based on assumptions they believe can be achieved. Complicating matters, projecting real estate returns is a science and an art that involves thousands of inputs—all determined by the asset manager. That makes the firm’s business plan, team, execution and track record critically important to investors.

Asset management firms say all the right things when courting clients and choosing among them is not easy. Potential investors must assess them analytically, and make sure the firms show their strengths, not just boast about them. Besides listening to what they say, investors should look at the size and training of the team in every area (from acquisitions and asset management to investor relations) to determine its competitive advantages over other managers. Does the firm attract and retain the best people? How long have key team members been at the firm? Ask yourself if they have enough experience and manpower to deliver the service and execution necessary to achieve profitability and the kind of ROI they promise.

In this second article of a two-part series, we break down the five most common mistakes we see real estate asset managers make. Individual investors must watch for these mistakes when evaluating firms to invest with and be sure to ask the right questions to vet potential managers:

Mistake #1: Not vetting locations correctly.

Even experienced real estate management companies choose less-than-ideal sites. They may be favoring global gateway cities or income-generating core properties over high growth targets. Asset management firms may be unfamiliar with a neighborhood, too emotionally invested in it, or they simply may be leading with their gut, giving past practices too much weight in a changing environment.

A data-driven process can narrow down potential locations by analyzing population and industry trends. Residential sales can point commercial real estate companies to affordable submarkets, making tenants easier to attract and retain. “Boots on the ground” observations should confirm due diligence results in real estate, as well as feedback from sellers and suppliers. Popular amenities, short commutes or limited competition all signify a quality commercial property investment.

Mistake #2: Not performing a full underwriting on potential deals.

Banks have the right idea. Proposals go through an underwriting process that probes for weakness in a venture’s cash flow forecast or real estate valuation. In real estate, the same due diligence process helps an acquisition team validate a business plan and its financial assumptions. Over a number of years, even a small change in the rent growth estimate can have a big top-line impact. Asset managers should be able to defend every prediction they make as being achievable.

It’s not enough for a real estate team to research every commercial building on the market. A disciplined real estate management company should be building a database on every investment property in the target submarket, from its physical features and acquisition price to known details about their tenants, owners, and lenders. This should add depth to a competitive market analysis, and inform estimates on vacancies, capitalization rate, and other underwriting factors.

Mistake #3: Not being a patient buyer.

Cash is hard to park on the sidelines. Capital that’s not invested is not being put to its best use, or may lose tax advantages. Asset managers may encourage moving quickly if doing deals helps them meet their payroll. The danger for real estate partners is to pay too much for a commercial building and put investors behind from the start on its ultimate appreciation.

A real estate management company needs patience to build fruitful relationships with commercial property owners, who may become sellers or even partners. Building up a steady deal flow will allow commercial property firms to be more selective. Removing potential conflicts of interest, such as an in-house property management team tied to the asset management firm, eliminates the need to pay staff that may be under-employed after a property sale and align the real estate firm’s goals with those of their investors.

Mistake #4: Taking on too much debt and/or cross-collateralizing assets.

There’s a sound reason to minimize leverage: If rental income ever dips too low to service the debt, there’s a serious risk of losing the property. This risk makes the real estate partners’ equity and cash flow forecast as important as any planned improvements. Commercial property investors who are responsible borrowers insulate their project from a shortfall that triggers a default, or a loan covenant that limits their options.

Few real estate partners can swing an all-cash deal, yet many don’t pay appropriate attention to borrowing costs. Lenders must be paid, and shareholders at the bottom of the capital stack face the greatest risk of loss. A real estate valuation should consider the cost of capital, in terms of interest owed as well as investor returns, to determine whether the project will generate a profit that justifies the project risk.

Additionally, a big debt mistake we witness managers make is when they cross-collateralize assets within the fund. This is when one asset is used to guarantee the debt on another asset, which means that the entire fund is exposed to the full loss of any one investment. This multiplies risk for investors.

RELATED: Part 1 of 2: 5 Mistakes Direct Real Estate Investors Make and How to Avoid Them

Mistake #5: Not evaluating commercial property continuously.

Commercial property investors don’t want their equity tied up longer than necessary, yet they’re often not ready to sell. Instead, they hold on too long for a certain return or sell for whatever price they can get to raise cash. The better course is to take the original purchase price and exit date out of the equation.

A real estate firm should monitor the asset’s valuation and cash flow forecast. From that point, the math is similar to the calculation that was made (or should have been made) at purchase. If future returns are estimated to fall short of the expected returns from selling and reinvesting proceeds, it’s time to sell.