Trait Debate: Let’s Talk About Avoiding the Pitfalls of the Numbers…
Recently, I had a conversation with another real estate investor about a purchase he made in the middle of the pandemic. He was extremely optimistic because of its high return potential but started to notice that the property’s vacancy started to go up as soon as conditions in the pandemic started to improve.
Why?
Tenants in that Class C apartments generally chose to live there because their relative incomes forced them to a lower rent apartment complex, and as employment prospects improved, their new income allowed for a large flight outwards. This was accelerated by vacancies in other available, higher-class apartments.
As he was walking through his case, explaining the numbers, and trying to figure out what went wrong, a light bulb went off in my head. So I said to him, “It sounds like you had a lot of numbers that made the case compelling, but what qualities made it a great opportunity at the time?”
He paused and thought about it. Then it hit him – he really did think too much about the qualities of the property. He spent too much time focusing on the numbers. (see our post about following the numbers)
Blinded by the Numbers
Usually it comes down to being overly distracted by the compelling return numbers, so much so that the desire to get a “piece of it” overtakes the warning signs from other parts of the picture.
Either one chooses to completely ignore all other characteristics, or you choose to shrug off the potential red flags.
Being hyper-focused on the numbers and forgetting about the core drivers (or driving qualities) often leads to real estate investment failure. Getting to know the asset and the drivers of the community always impact the viability of the investment. At CF Capital, we look at multifamily communities as living, breathing entities. What’s it’s health and longevity? Is it plagued by something inherently that might cause adverse conditions relative to our projections?
The Downfalls of the Numbers Saga Continued…
The numbers are great at providing insight on the direction of the beginning of the investment story, by giving a sense of where the property has historically “been,” but will not always be accurate when it comes to anticipating about the “speed bumps” (big and small). This is where nuance insight comes into play as investors.
In other words, historical performance serves as an aid to short-term investment decisions, but those decisions may be detrimental for the long-term if investors are not careful to understand how the nuances of micro and macro economics are at play.
In fact, focusing on the numbers alone, often breeds short-term thinking and puts metaphorical blinders on many investors. It’s certainly paradoxical, because we often say “do the math and let the numbers tell you what to do,” and while that’s certainly true in many ways, as investors we must understand the probability of certain events playing out in the future of a particular real estate investment.
For example, let’s say an investor’s model and financial plan doesn’t account for enough short-term repairs and maintenance. When a pipe bursts and a replacement is required, the high expenses associated with the repair could deter the investor from making the right decision to buy a replacement, and instead put a proverbial bandaid on a problem that really needs surgery. So instead the investor chooses the short-term solution and tries to cheaply fix the pipe. This causes more and more maintenance requests over time, ending up costing the investor significantly more capital than it would have to replace the pipe the first time. These compounded decisions can have cascading effects on any property and ultimately severely negatively impact investment returns.
Specifically, this behavior puts a damper on cash-on-cash returns. To say it another way, this is likely the same short-term-minded approach with many other expenses, and because of that, we already know what to expect when it comes to property performance.
Avoiding the Downfalls
This advice is really simple, and it is something that we have discussed before.
(see our posts on due diligence, underwriting, and asset management)
First, dive into the qualities of the submarket.
Is this where you and enough other people would want to live long-term? Is this a good location for a family? Are there enough quality schools nearby? Is this submarket in the path of progress of future development and growth?
And finally, some questions that would have saved our friend, the real estate investor from earlier… what are the reasons and conditions that cause people to choose to live in the neighborhood? How might future conditions, in various directions, impact that type of resident behavior?
Second, dive into the qualities of the property, including the physical characteristics and the renters.
What are the current attractive property characteristics? What tenants are attracted to the property now, and what tenants could be attracted in the future? Will our target tenants be attracted to this property? What potential property cost-effective characteristics could be added to attract and retain tenants?
The list goes on and on. At CF Capital, we ask these questions and more on a daily basis when considering various prospective investments. We invite you to incorporate these considerations in your own investing, whether passively with our group or actively with your own team.
Until next time, happy investing!
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