Real estate operators, investors, and owners often believe a deal’s outcome falls exclusively on the shoulders of the operator on the ground. Conversely, we often see the attitude of “If the deal does well, the operator claims responsibility” and if the deal does poorly, the operator blames the [market, the GC, the debt, the property manager, or something else].
Although a competent operator is a requirement for any chance of success in a real estate deal, there are controllable and non-controllable aspects of any deal. This article is going to break out the main controllable and non-controllable variables of a real estate deal.
Not in any order, but all important to varying degrees.
It is much easier to catch a mouse with a trap than grabbing at it with your bare hands. An operator could spend decades researching for the perfect market and asset class. Hours of research could go into this exercise to maybe realize all the opportunities passed while in the extended research phase. A more concise approach is to develop criteria for market and asset class and then filter opportunities as the deals come to you.
Buyers must be selective when bidding on property, because after the acquisition, the new owner will eventually be on the other side of the table and looking for a person willing to transfer their liquid cash for their unique piece of real estate.
After a transaction closes, the new owner cannot ask for credits, a warranty, or price reduction, so it is imperative to price in the current and future risks of the property, but also weigh the purchase price against potential future alternative investments elsewhere in the market.
Said another way: Is this the best use of $X million of equity given everything else available to us now and potentially in the future?
The capital stack must be aligned with the business plan. This includes senior debt, preferred equity, GP equity and LP equity.
Most investors overlook the largest capital provider in the deal—the lender. Not all debt is created equal and understanding the terms of the debt, beyond basic term, rate, and amortization, can adjust the risk profile of an otherwise strong investment and turn it into a poor one. There are many debt options in the market, and many can be customized to fit a specific business plan. Choosing debt that matches the business plan materially improves the chances of a successful outcome.
Preferred equity often behaves more like a contractual return obligation than common equity. Being in the second (read: riskier) position in the capital stack, the terms are often more costly to the deal than the senior lender charges. Current-pay and accrued-return structures can enhance returns in a well-executed deal, but can put significant pressure on common equity if performance falls short.
How much skin does the GP have in the deal? Meaningful GP capital can improve alignment, although the amount and structure matter. A deal with limited GP capital, while the GP retains significant control, can leave the LP with limited recourse if the investment underperforms.
LP capital can be syndicated from smaller investors or a single check writer. The LP investors are your partners. If the deal is going well, no one asks about the partners in the deal. If a deal starts going sideways, or is truly broken, LP partners learn who they are invested with quickly. Ask who the other LPs are before you sign the commitment, because they will be the ones you need to work with if the deal does not go as planned.
Property-level returns depend heavily on the people executing the business plan. Strong underwriting means little if the operator cannot execute it.
Due diligence on the operator is critical to understanding the investment. What is their track record? Do they have an existing team of contractors, property managers, and back office? Can they provide a list of investor references? Have they executed a similar business plan in the same market? Are they signing on the debt or relying on a third-party guarantor?
Generally, the more construction involved, the higher the risk. Unentitled land in need of rezoning, permitting, construction, and lease-up is often riskier than a core, stabilized opportunity. Typically, the more complex the business plan, the higher the risk.
When taking on riskier projects, the potential upside of the project should more than offset the additional risk compared to the return/risk ratio of a more conservative project. When comparing projects, the risk and return profiles of each deal should be viewed in tandem with each other and against the other project. The end goal being to achieve outsize returns relative to the risks undertaken.
There are no risk-free deals. A stabilized deal could be subject to increasing cap rates, declining rent growth, unexpected capital expenditures, or other unexpected issues during the hold. As an investor, sizing the measurable risks and weighing them against the potential upside is paramount in assessing any opportunity.
Much like no one can predict where the stock market will be next year, reliably predicting interest rates, market liquidity, and investor appetite is extremely difficult. Even with long-term, fixed rate debt, there will always be risk in the future when it is time to exit the property.
Neighborhoods are dynamic. New firms enter markets looking for employees. Companies shut down or leave markets. New apartment construction enters the market, but other complexes are torn down for the construction of other asset types.
For these reasons and more, it is very difficult to pinpoint rent growth on a monthly or annual basis. Assumptions can be made about rent growth over the long term, but monthly and annual fluctuations can be heavily influenced by seasonality and tenant demand.
Many developers are merchant builders, meaning they build the property, lease it and sell it. Bringing new units to the market, often with rental concessions so the developer can reach stabilization as fast as possible, can put downward pressure on rents in the submarket.
In addition to an existing product needing to compete with a brand new building, the developer will often offer concessions as their priority is often to increase occupancy first and demonstrate strong top-line revenue second. Existing operators, although concerned about occupancy, are often trying to maximize rents on every new lease signed.
These costs and regulatory conditions can be modeled, but actual outcomes may differ materially from assumptions.
Property taxation varies materially by jurisdiction. Although tax attorneys can be consulted prior to acquisition and utilized to challenge assessments, the property remains subject to future changes in taxation.
Insurance, similar to taxes, changes annually. Certain markets are more volatile than others, but insurance costs can also move broadly across markets. Insurance coverage is a requirement of lenders and therefore must be maintained at the property.
Regulation, most commonly associated with rent control, can also include fee restrictions and changes to landlord-tenant laws. These rules can change over the life of an investment and are largely outside the property owner's control.
At the end of the hold period, the property is only worth what a buyer will pay for it. The basic pricing function is Net Operating Income divided by market cap rate. NOI can be supported by trailing three-, six-, or twelve-month operating statements, but exit cap rates are ultimately determined by the market.
For many value-add real estate investments, a significant portion of total return is realized at sale. Cash flow during the hold is valuable to the investor, but the sale is when a majority of the capital and profits are returned to the investor. Modeling a conservative exit cap rate is one of the simplest ways to stress test a project.
Investing in real estate has inherent risks. The goal is not to eliminate them. It is to understand which risks can be controlled, make those decisions deliberately, and build enough margin for the variables that cannot be controlled. Purchase price, debt structure, operator selection and business-plan execution will never eliminate uncertainty, but they can materially improve the odds of a successful outcome.
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.