16 Jun BIGGEST Risk – CREPN #200
Merriam Webster defines risk this way:
possibility of loss or injury
In Real Estate, Risk is everywhere. It’s what you don’t know can hurt you.
That can be a problem when you are talking about millions of dollars.
This is why so many wise, experienced investors place a premium on knowledge and so much effort is spent in due diligence.
Most investors agree that you can never know everything, but you can dig in and ask questions and get answers that make sense for you to go forward.
By day, I am an insurance broker. My focus is working with Real Estate investors to assess their exposure to loss and help them manage the risk.
Risk Management Process
Risk Management is a continuous process. There are four basic steps to risk management:
Risk Management Strategies
In insurance, we utilize three specific Risk Management strategies:
- If the situation is too risky, Avoid the risk
- If there are things we can do to Minimize the Risk
- What can you do to Transfer the Risk?
Risk in Real Estate
Where is the risk in real estate? This is the question you have to look for when you buy a property. It’s your job to find where the risk is hidden, because the seller will not tell you. The due diligence period is your opportunity to go through the property from top to bottom looking for the hidden risk. You also need to comb through the numbers to find out what is missing, and where you can make things better.
Depending on what unexpected information you find during due diligence, the purchase process provides you an opportunity to present your findings to the seller. The seller can offer to correct the problem, or provide you a discount on the price. If you fail to find these hidden issues, and address with the seller, they are yours. Once you close, the property and the problems you did not find are yours.
Metropolitan Statistical Area
What do you know about the Metropolitan Statistical Area you are investing in?
- What is the median income?
- Who are the largest employers?
- What are the market rents?
- What is the population of the market?
- What is the forecast for jobs in the market?
- Who is the competition in the market?
- What is the local government attitude towards landlords and tenants?
Beyond, the MSA, you want to understand the neighborhood you are investing in. In many markets, a mile can make a big difference. These are all numbers you want to know and understand to see if they will be able to support your investment model.
Physical Condition of the Property
The physical condition is where you look for deferred maintenance and assess the major building systems, Roof, Electrical, Plumbing and Heating & Cooling. How much life is left in each? What is the cost to replace? These questions need to be answered so you can properly budget for replacement. If you fail to budget for these, the unexpected cost will negatively affect your cash flow and make for some potentially difficult conversations with your investors.
Financial Condition of the Property
What is the Financials condition, what do the books look like? Are the Seller’s records in order? What is missing? What is out of the ordinary? This is where you dive deep into looking for things that are missing and or out of the norm.
A high water bill is a tip off for leaks, and something you can fix and reduce your cost. How do the rents compare to the market rents? Is there room to increase rents? Is there any record of laundry income? Some small property owners put the cash in their pocket without recording. This can be a hidden source of value not expressed on the sellers financials.
Regardless of what you find from the seller, you must contact each service provider and find out what your actual cost will be. If the seller has owned the property for a long time, or owns multiple properties, their cost will be less than yours. Anything you can do to improve the net operating income should be part of your value add strategy.
Management is one of the greatest ways to lose money in real estate. Is management pushing rents? Are they marketing the property to attract quality tenants and turn vacancies quickly? This is an easy area to improve upon, especially if the property has not been professionally managed.
If you are investing with others, what is the experience of your partners or deal sponsor. Are they experienced in this asset class of real estate investing? What makes you certain you will be able to achieve the returns you are projecting?
Your purchase price needs to accurately reflect the value for the property as is. An experienced investor will not pay more than what the property supports. The seller and the seller’s broker job is to get as much as possible. Your job as a buyer is to stay disciplined and not over pay. You cannot get in a bidding war driven by your emotions.
Too often, sellers agree to a sale price with a higher offer only to learn that the buyer cannot perform. If the seller really wants to sell, and no offers meet their ask, they will be forced to deal with the reality of the market.
Due to the significant price of large commercial real estate deals financing is required unless you have an endless supply of money. Fortunately, commercial real estate financing looks at the performance of the property. The bank will not lend more than the property can support.
The bank will require at least 125% debt cover ratio. If you don’t understand this before you make your offer, you may lose earnest money or the deal. Neither is a good option. If either happens, you will not be recognized as a performer amongst the local commercial real estate professionals.
Insurance is easy for new buildings with desirable tenants. There is an unlimited supply of insurance companies ready to provide coverage for this type of risk. As your building gets older and has more deferred maintenance, you will have challenges finding insurance.
To avoid any problems with insurance, pay attention to the age and type of building system in place for: roof, electrical, plumbing and HVAC. Most insurance companies require updates if these are older than 30 years. During your due diligence, ask and find out age and type of building system in place.
Where are we in the market cycle? Are there reasons to be concerned, or is there momentum and demand for you to take advantage of. Do not assume that the most recent past will continue. Markets ebb and flow, and for every top, there is a bottom. If you are buying at the top and selling at the bottom, you are doing it wrong.
What is your exit strategy? Every property will eventually sell, so what is your exit strategy? Your strategy will be very different if you have partners compared to if you are investing solo. How quickly can you return capital to your investors? What rate of return are you projecting? What happens when you get there and the market does not support selling?
Any experienced investor knows there are additional lessons, the unknown, waiting for you. To prepare for these, you have to do your homework up front and make certain our capital reserves are sufficient to take care of these when they happen.
As an investor, you have to understand these lines, and create your own lines you will not cross. In an effort to learn more about investors, their risk models and the lines they will not cross, I began asking the guest on my weekly podcast CREPN Radio the question,
What is the BIGGEST RISK?
To my delight, the guest have shared what concerns them and what they do to manage their risk. Theri answers have covered the spectrum of real estate investing.
Following is an example of the answers guest on CREPN Radio have provided.
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