Believing current trends will hold up forever is an avoidable mistake when investing in commercial real estate
It’s easy to fool yourself into believing the hype surrounding today’s commercial real estate market in South Florida.
After all, values are increasing overall, especially in specific “hot” property classes. So, as an investor, all you have to do is pick the right investment, buy today, and sell in a few years to make a substantial profit, right?
Not so fast. Failing to look at a property’s actual value is a good way to end up holding the bag when the market cools—specifically on a property that doesn’t meet the essential ROI. Doing extensive, commonsense due diligence ensures what you’re investing in isn’t propped up by smoke and mirrors. Rather, it should have solid fundamentals that can create a consistent income stream.
Here’s a look at two types of investing and what they could mean for success as a CRE investor.
A look at “old-school” CRE investing
Far more CRE investors used to look at the big picture. They wouldn’t count on the property’s value increasing substantially to make their money because the investment possessed other intrinsic value.
Old-school investors believe that you make money on CRE properties when you buy them rather than when you sell them. Making money on the purchase means finding something with the right yield number, which is a combination of potential increases in property value and the income stream you can expect from renting it.
For a purchase amount to make sense, you’ll need to factor in whether you can keep the building consistently rented, how much maintenance will cost, and if you can carry the property when it’s vacant. It’s not primarily rooted in what you can sell the building for later, but how you can profit from it while holding it. Separating the cost from the true value when buying is an integral part of the process, too.
You can potentially make big money on its appreciating value over time—but you know that it isn’t a guarantee and have planned accordingly.
Putting a strategy together with solid fundamentals makes it far more likely that an investment will be successful, and you won’t be left holding the bag if the market drops.
How many recent investors are doing things
Unfortunately, smoke and mirrors are becoming common in all forms of investment. For example, many individuals are plowing money into cryptocurrencies like Bitcoin and Ethereum, but they don’t have any real-world, intrinsic value other than what other excited investors are willing to pay for them. Similarly, certain “hot” growth stocks are reaching values and market capitalizations that have little to do with classic benchmarks like price-to-earnings (P/E) ratios.
In these cases, investors are counting on the resale value of their investments continuing to rise rapidly rather than assessing practical value. A reliance on appreciation is routine for stocks, of course, even those that pay dividends. But when it comes to commercial real estate, it can be a much bigger mistaken assumption.
Some of the same smoke and mirrors are becoming more prevalent in CRE investing, as a new breed of investors counts on commercial properties appreciating significantly to turn a profit. They don’t focus on the fundamentals of the investment—or fail to project them realistically—because they believe that the property will be worth far more in a few years than it is today.
The problem is there’s no guarantee that will happen. In contrast, a property with solid fundamentals will make money, even if the resale value isn’t there on a short timeline.
What the riskier method of CRE investment ignores
The main issues with this new school of CRE investment are the aspects it doesn’t take into account. These factors include:
- Who will rent it? Some investors might not sufficiently research the industry or tenant candidates they’ll need to attract to keep a building occupied. Who will pay the rent? What kinds of leases do they prefer? Will there be lengthy enough agreements to justify standard property improvements? Failing to investigate these factors before investing could leave you in a challenging position when the bills are due.
- Location and building characteristics. Not all sites are equal, even in attractive areas of South Florida. When opening a warehouse or fulfillment center, for example, you’ll need a spot close to the highway, suppliers, producers, and/or customers to attract tenants. Likewise, an office building close to downtown or a hotel near tourist areas will bring far greater success than a location missing key elements. Don’t assume tenants will come just because a beautiful building is there.
- The numbers. If the building isn’t ready to lease, there could be significant construction and renovation costs and delays. Other aspects investors can overlook include the terms of the loan, the creditworthiness of possible tenants, realistic occupancy rate projections, average lease periods, and rent price appreciation—all of which could vastly impact the amount of money made on an investment.
Failing to do a deep dive on potential tenants, locations, structural characteristics, and pragmatic financial projections often leaves investors counting on the property’s resale value to turn a profit. But prices don’t go up forever, nor at a consistent rate. And will there even be an attractive buyer if you aren’t making enough money holding the property?
The market is hot right now, but there are no guarantees. And investors who don’t look at the actual value of a property could find themselves in trouble.
Taking a sensible approach
As you consider potential CRE investment properties, remember to dig into the details and place value on deals where the numbers make sense. It’s essential to be realistic with calculations and projections because expecting the market to continue climbing could put you in a challenging position.
Morris Southeast Group can assist as you conduct thorough, “old school” due diligence—accounting for but also regardless of trends. We help ensure the numbers work long-term by using realistic data proven to hold up over time.
We’re available at 954.474.1776 to go over your CRE investment needs. You can also speak to Ken Morris directly at 954.240.4400 or kenmorris@morrissegroup.com.
