Sunday, January 10, 2016

Two Questions to Ask Yourself Before Buying a Property

(Alcatraz)

Whenever I'm presented an opportunity, before I run any numbers, before I look at the area demographics, rent roll, etc... I ask myself two questions:


  1. Why is this opportunity available and why is it being presented to me?
  2. What does my expertise bring to the table? Where am I adding value?

Why is the Opportunity Available and Why is it Being Presented to Me?


Real estate transactions are inherently inefficient. Think about it. If an owner decides to sell a property, they must pay a broker a commission on the sale, the buyer might have to pay a broker, there are an assortment of fees that are paid to lenders, the government, appraisers, and worst of all, property taxes will be assessed higher after a sale which increases the operating cost of a property. All of these factors make it inefficient to sell a property and make it more inefficient to operate for the buyer, so why would anyone buy or sell a property? Well, that's a good question and one that you should ask yourself every time you look at a deal. More to the point, for a transaction to be beneficial to both the seller and the buyer, the buyer must add enough value that it overcomes the numerous transaction costs associated with real estate transactions.

Part of analyzing how much value you can add and whether or not it's enough to overcome the inefficiencies created by a transaction, is understanding why the opportunity is available. For example, if a REIT owns a property and is trying to sell it, you should probably be very concerned. First, a REIT is going to be a very good, sophisticated operator. What do you bring to the table that a REIT doesn't? How could you possibly make it more efficient? Second, REITs tend to hold onto their real estate for a very long time. If the property is good real estate, why would a REIT want to sell it at all? These are the types of questions you should ask yourself when presented with an opportunity. If you don't have good answers, then you should consider passing on the deal.

Of course, if you have the exact opposite situation then you can push hard for the deal. If the seller is an unsophisticated kid that inherited some property from his Dad, has been trying to run it himself / herself without the help of a professional property manager, isn't investing money into the property to keep it competitive in the market, and is now trying to sell because he / she needs money to sail the the Caribbean, then the questions sort of answer themselves and it's clearly a deal you should pursue.

The "why is it being presented to me" question is a bit more nuanced and applies more so to properties that a broker specifically brings to you vs. ones you find yourself. If a broker brings you a deal, are they bringing it to you because they think you're flush with cash and will overpay for the property? Do they think you're a sure closer and just want to get someone solid to take the deal down? Does the property fall within a narrow niche your company is particularly adept in?

Ideally, you would be presented a deal because it falls right within your investment preferences, you have a great relationship with the broker, your reputation makes you desirable to work with, and you can pay a good price for the building because you have a particular expertise that allows you to add a lot of value. Again, these are a few more questions you should ask yourself and be able to answer to determine whether or not it's a good deal for you.

Where am I Adding Value?


Understanding where you add value to a deal is imperative, but even more important is understanding the previous owners' shortcomings and why you are going to do better. Going back to the REIT example, figuring out how you add value that a REIT couldn't is a tricky proposition. Can you operate the property more efficiently than a REIT? Most likely not. Do you have a more efficient capital strategy? Almost definitely not given REITs have access to public markets that will provide a very efficient capital structure. Do you have expertise in the market that REITs don't? Probably not. REITs are very sophisticated, have an unbelievable amount of data, and are usually the industry experts in a given real estate industry niche. Given the answers to the preceding questions, the answer to whether you can add more value than the seller is probably no. In fact, the real reason they are trying to sell it is because the property is just a lemon and they want to transfer money out of it and into something better.

An ideal property is one that you can add value to in a number of ways. Perhaps you can operate it more efficiently. Maybe there is a unique exterior improvement that you think would completely reposition the asset. There could be a tenant that you have a great relationship with that you think would be willing to eat up some of the vacant space. You might also believe the property is under-leveraged and can put a more efficient capital structure on the property. Whatever the reason, it's important to understand specific ways you bring value to the property that the previous owner didn't. In fact, as part of your analysis process you should have a several page investment thesis that lays out these specific points.

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