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Every market cycle is a little bit different, and there are pitfalls investors, syndicators and operators need to be aware of whenever they get involved in real estate.
There are five common pitfalls I've been seeing consistently when investing in multifamily real estate today and I wanted to share some of my observations.
I'm not a registered investment advisor, so you should always consult with your attorney or investment advisor before investing. This is just my perspective about the market and the current situation that we're in.
#1: Investing with a sponsor that promises returns.
This might sound a bit obvious, but I really encourage you to never, ever invest with anyone that is promising returns. You cannot promise returns. Things change all the time and there are a lot of things that are unpredictable. If someone is guaranteeing any type of returns, that's a big red flag.
We can only share projections and run numbers based on the data that we have, based on past experience and how we think assets will perform.
We say, in good faith, “this is what we believe that this fund or this deal is going to yield”, but nobody can promise you returns. I would very much caution you against investing in any of those type of investments that seem to be promising, but if someone is promising you any type of returns, I would stay away.
#2: Overestimating Projections
The second pitfall in today's market that I see is around overestimating projections. As someone who’s always running, I'm working with a couple of acquisitions teams and, looking at the numbers, I understand how easy it is to make a deal that is actually a terrible deal look like a great deal.
We’re looking at the exit pricing, looking at the premiums that we can charge tenants (meaning the delta between the current rents and the new rents), if we’re going to renovate the units or just bring the units up to market up to market rents, etc. If you overestimate across those projections it can really yield a high return in the spreadsheet.
I do believe that sponsors should be very careful about that. What we do to mitigate that type of risk is use hard data. We have been using AI backed data from a third party that analyzes the market, the submarket and the property, and it projects what concessions, occupancy and rent increases are going to be. So we let the data help us make decisions when it comes to projections. If we see, let's say 9% rent increases, we might use 5% or 7%, but at least we know that there is some path there.
There's always a combination between hard data and making an informed decisions about those projections. But at least the baseline is very hard data, AI back data, when it comes to underwriting which helps us avoid overestimating our projections, which is especially critical in today’s market.
#3. Buying Deals With Short Term Loans
A third pitfall in today's market is to buy a deal with a short term loan without buying a cap or adjusting for unattractive debt in a few years.
For instance, if there's a certain deal that looks good on paper but the debt expires in two years and the team that is buying the deal is projecting new debt in at the beginning of year three after the current debt is expiring, they can miss projections by estimating that they will be able to place new debt at unrealistic interest rate. They may not be able to do that. And that can really impact the deal, the returns and the exit.
Adjusting for unattractive debt in a few years, that's crucial if the debt is expiring before the end of the business plan. What I've seen around me a lot is sponsors that bought an asset without buying a cap or their cap expired and they don't have enough cash in reserves to buy another cap.
The way that the debt works for the cap is that if there's a floating rate being placed, then there's a cap which is acting like an insurance company.
Let's say you've bought a deal at a for cap. Right now it's floating and you're buying a cap that is going to cap your payments at, let's say 6%. Once the senior debt has hit 6%, even if it goes up you're still going to only that 6%. And then that insurance company, the cap company, is going to pay you or the lender the delta.
One of the major pitfalls that I see around me is that the cap has expired after a year and it's a five year hold. The sponsor runs out of money and they can't buy a cap in today's market, caps are very expensive. So when you're investing in real estate today, just make sure that if it's a floating rate that you have a cap in place, it’s extremely important.
#4. Letting Fear Control You
The fourth pitfall is actually letting fear control you and you stop investing.
I know that all things that I've said so far are negative about overestimating projections and not buying caps, but there are still good deals out there if you are staying active.
When you stop investing or let fear control you, you’ll miss those good deals. Now, I never advise anyone to invest if they feel uncomfortable or if they feel confused. But what I would say is educate yourself.
Make sure you have all the information. Read about it. This is your money. Sometimes the feeling it, it feels pretty safe, quote unquote, to not invest. If you’renot investing, at least put your money into something that will earn interest, it might be very conservative, but don’t stop investing altogether.
I've been hearing it from some investors that have stopped many years ago, and I think that they regret it today because if they had been investing they’d have been able to join some very successful investments.
#5. Ignoring Your Gut.
The fifth pitfall is to ignore your gut whenever you're investing.
Whether you're buying a house or investment, whether you're buying a small multi-family on your own, or you're investing with a sponsor with a syndicator. Always listen to your gut regardless of what the numbers say.
If you look at a deal and it doesn’t look overly promising, but you think that this is a strong, hardworking sponsor that will deliver more than the numbers show, then invest with them.
If you look at a deal that has great numbers, but you don't feel a hundred percent comfortable with the sponsor, do not invest. Listen to your gut.
You often know what's good for you. And it's just inside in there. You just have to listen to that inner voice and let it guide you.
Key Takeaways:
- Never invest with a sponsor that promises returns.
- Avoid overestimating projections, use hard data.
- If you buy a deal with a short term loan without planning for buying a cap or adjusting for unattractive debt, that can be painful.
- Don’t stop investing or give into fear.
- Listing to your gut.
These are interesting times and there are always deals out there, both good deals and bad deals. Just choose wisely.
As always, Be Bold, Be great, and Keep Pushing Forward!
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About Ellie Perlman Ellie Perlman is the founder of Blue Lake Capital, a commercial real estate investment firm specializing in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to. A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology. Ellie is the founding host of REady2Scale, a podcast that highlights the assets, processes, and strategies for the multiple approaches to successful real estate investing. She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management. You can read more about Blue Lake Capital and Ellie Perlman at www.bluelake-capital.com.