What do sardines have to do with real estate investing?

The following is an excerpt from the 10/31 edition of our Multifamily Mondays newsletter - to become a recipient, please sign up at alignedrep.com/invest .

Are you investing in trading sardines?

Seth Klarman used a funny analogy in his book?Margin of Safety ?to describe this mistake. He tells the story of special sardines:

"There is an old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared.

One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, "You don’t understand. These are not eating sardines, they are trading sardines."

This story is typically used as an analogy to speculative investment in the stock market-- "like?sardine traders, many financial market participants are attracted to speculation, never bothering to taste the sardines they are trading."

Of course, disciplined investors try their best to avoid this. That said, real estate investors/operators have fallen victim to buying "trading sardines" over the last few years... and may have done so accidentally. Now when describing an acquisition as a "trading sardine", I don't solely mean speculative real estate investments, including "higher-risk" projects such as ground-up development, heavy value-add deals, etc...

Think of all the properties investors have bought in the last few years which they didn't intend to operate long term, but to quickly add value and sell to the next buyer. Examples include buildings located on the fringe of a "good" neighborhood, older year built, containing units with odd floor plans, dated plumbing/electrical, some major CapEx coming due, etc. The investor thinks, "yeah, the roof is dated and the property could use some more parking but the price per unit is too competitive to pass up."

Investors may have assumed an increase in NOI due to a simple cosmetic value-add, followed by an exit to "the next guy". With interest rates increasing (making refinances more expensive) and a significant percentage of buyers exiting the playing field, numerous investors are being left to operate these buildings for a longer period than they intended.

Long story short - don't be an investor who is forced to eat their trading sardines.