by
Luan Ha
AUTHOR
Luan Ha
CEO
Luan Ha, MBA, has 15+ years of experience in commercial and mixed use real property development. Formerly serving as the AVP, Development at RioCan Management Inc., Luan oversaw a $3 billion commercial mixed use project pipeline that spanned across all of Canada in a variety of real estate asset classes.

How Not To Invest in Real Estate

I’ve gained many crucial insights from more than a decade of analyzing and investing in prime real estate opportunities. When I put together the “Modern Playbook for Super Successful Real Estate Investing”, my goal was to arm you with “go-to plays” designed for success. Now, I want to follow up with what NOT to do.

These days, the number one thing people ask me is what NOT to do. For every investing “do,” there’s also a “don’t.” My professional football metaphor works here as well: There are certain things that lead teams to success, and certain things they must avoid if they want to win. Every winning team has a strategy for success – it takes discipline, dedication, and discomfort to reap the rewards of a winning strategy. In addition to knowing what works, it is also important to know what doesn’t work.

As the Fundscraper investor community is interested in learning more about what not to do, I decided to compile Volume 3 to the Playbook delving into the don’ts of investing in real estate. If Volume 1 of the playbook explains how to invest in real estate, Volume 3 tackles how NOT to invest in real estate.

These are 5+1 rules that set broad parameters and help investors insulate their portfolios from the bad apples. At Fundscraper, we follow these rules and that’s how we have helped our investors achieve an average return in excess of 7-10.0% over the last three years.

1. Don’t rely on only one metric. Define your baseline

Don’t rely on only one metric. Define your baseline and look for correlating data variables to reduce your own or others’ biases on that single metric

Sometimes investors are too attracted to one metric, often the rate of return. Risk and return go hand and hand so when looking for corresponding data points that provide more context for a rate of return, assess the additional risk metrics that drive why the return is higher.  Risk in this context is the potential for principal erosion or losses to occur.

For example, if you see a mortgage paying a high interest rate of 16%, look at the: 

(i) Loan-to-value (LTV) ratio

(ii) Local employment trends, employment drivers (industrial sectors), 

(iii) Population growth, income growth

The loan to value ratio (include link to reference the LTV definition in our dictionary guide) is a measure of indebtedness against the total value of the asset.  The higher the ratio, the higher the indebtedness and thus, the higher the risks! The higher return metric should provide the investor with a premium sufficient to compensate for this higher risk.  

Another example:

If a rent roll shows very high rental rates, over and above market rates;

Look for the components of what determines a typical rental rate in a lease:

(i) Lease Term

(ii) Tenant inducements or cash incentives

(iii) Gross, base, percent rent, and net rents as well as common area maintenance (CAM) or other allocated costs such as Taxes, Maintenance and Insurance (TMI).

A very high rental rate but a very short lease term doesn’t really provide the stability of rental income one would expect from an investment property. Similarly, understand the components of the rental rate and whether or not that rate includes CAM, TMI or other components that might not be predictable, such as percentage rents.  

Tenant inducements are inducements typically found in commercial leases where landlords provide a lump-sum cash incentive to assist the retailer with the costs of locating to the retail unit.  As you can imagine, the larger the inducement, the easier it is for the tenant to pay a higher rental rate, but this doesn’t always serve to provide a higher return to the landlord.  The tenant inducement expense can be amortized over the life of the lease, but if the tenant can no longer pay a high rent for the entire duration of the lease, then that tenant inducement expense may never be recoverable.  High churning tenants should not receive high tenant inducements.

Have alternative baseline metrics for relative comparisons:

  • LTC vs LTV
  • Public REIT yields vs Private REIT yield
    • Payout ratios and leverage ratios

2. Don’t use leverage if you don’t have corresponding income.

  • From the lender’s perspective this is called the debt service coverage ratio (DSCR)
  • Tool calculator

You have to assume the worst case scenario and assess whether or not you can continue holding your investment or the asset can sustain itself with its own cash flow.  If too much leverage is utilized, and too little income is available to support it, then the asset is at risk of being lost to its lenders. 

Lenders assess the ability for borrowers to pay based upon a debt service coverage ratio, meaning, how well the borrower’s income can cover or pay for the periodic debt payments.  So if a borrower’s asset income is $150.00 / month, and the debt payments are $75.00 / month, then the DSCR is $150.00 / $75.00 = 2.0x. Somewhat adequate to cover at least the debt payments.  As an investor, you should look to ensure the residual excess cash can cover the costs of operating the asset as well.

3. Don’t assume the market by itself will drive asset values up

Have a value add strategy 

  • Renovation plan
  • Capital Expenditure (CAPEX) investment plan
  • Income growth plan

An asset that doesn’t provide the opportunity to add value through active management gives you additional avenues to increase asset value and correspondingly, more room to absorb potential value swings driven by the market. 

Buy low, sell high; is now, Buy low, add value, sell higher. 

If you don’t have the opportunity to add value, the risk is buying too high a price point, if the market doesn’t go in the direction you want it to, then you expose yourself to additional risks.

4. Don’t rely on only one exit strategy

Have multiple exit strategies either through a refinancing, buyout, sale, sub-division, etc.

5. Don’t focus on the short term

In fact, ignore the short term. If you have to focus on the short term, don’t get in the game.

  • Focus on the long term as real estate capital values take time to increase.
  • Focus on the income capacity of the assets.
  • Returns from real estate over the course of history, are mainly from the income extraction, not through capital gains. So you should expect to invest that way since that will be how your returns will be achieved.

6. Don’t forget to ask “why” at least 3 times to substantiate the trend or direction

  • Why does this investment make sense?
  • Why will the market continue to go in the trend you are seeing?
  • Why will growth continue?

And don’t be too optimistic.

Look at the sponsor’s / borrower’s various data points:

  • Track record
  • Mgmt. quality
  • Scoring sheet

Don’t forget about the don’ts.

Don’t invest beyond your risk tolerance. As in football, don’t always go for the touchdown pass or throw a Hail Mary pass. Consistent short yardage gains are likely to pay off. 

While my updated Playbook is a great tool, let Fundscraper do the coaching to help you select the winning opportunities best suited for you.

Fundscraper uses leading edge technology to make it easy for most Canadians to invest in private real estate offerings using our online platform. We are breaking down the barriers where only the wealthiest few were able to participate historically.

We continue to revolutionize how people invest into real estate and, along with our investor community and issuer clients, do it based upon data-driven investment decisions. Fundscraper does the heavy lifting for you, but at the same time leaves it to you to decide which investments to choose.

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