Monday, November 14, 2016

The Myth of the Charitable Property Owner

To make money on a real estate deal, the deal must typically have at least one of the following characteristics:
  1. Below market rent - Some properties might have leases that were signed during a downturn, or might might have been signed prior to a rapid improvement / change in the market. When these old leases roll and renewals or new leases are negotiated, there should be a bump in property revenue, resulting in a higher NOI and higher property value.
  2. Above market vacancy - Another way for entrepreneurial landlords to increase NOI is by improving the occupancy level of a property. If a property is 50% occupied, increasing the occupancy to 90% will have a dramatic impact on NOI.
When brokers pitch my company deals, they almost always claim the property has one of the above characteristics. Most of the time it's actually true. A lot of properties do have below market rents. A lot of properties do have above market vacancy. Unfortunately, most of the time properties have one of these characteristics for a reason!

Think Like a Sophisticated Investor

Whenever you start analyzing a property with below market rent or significant vacancy, the very first question to the broker should be: "Why?" Why would a property not be performing well, especially in a booming market like the one we're experiencing right now (in most cities, anyway)? Almost universally, brokers will tell you the property is under-performing for one of the following reasons:
  1. The owner / landlord isn't willing to invest in capex / tenant improvement allowances, which is driving tenants away.
  2. The owner / landlord wants to "drive occupancy" and isn't "pushing rents" because they're afraid of losing tenants.
Talk to enough brokers about potential deals and you hear the above answers so much, you'd believe the real estate world is just full of owners / landlords that just don't care all that much about making money! I call this phenomenon, the curious case of the "mythical charitable real estate owner."

Charitable Real Estate Owners

Brokers would have us sophisticated investors believe there are just oodles and oodles of landlords out there that just don't like making money very much. In fact, they dislike making money so much that they're willing to put almost no effort and resources into increasing NOI, even when it's really easy (increasing a property's NOI is always easy according to brokers)!

Now, you might be thinking to yourself, "But wait, commercial real estate landlords are the greediest bunch of bastards I've ever met. In fact, they're just about the greediest people I've ever met! How come my apartment landlord isn't one of the charitable ones?????"

Some Properties are Just Inferior

The fact is, most landlords are smart and money-hungry. In my experience, most are pretty darn good at maximizing their property's NOI and, subsequently, market value. The vast majority of properties suffering from below market rent or above market vacancy do so for a reason. In a given market, there are a subset of properties that are just inferior, or below average. I mean, almost by definition roughly half of all properties in a submarket must be below average and will under-perform the properties that are above average.

Identifying Those Rare Properties that Can Be Improved

Most properties under-perform because they're inferior, but rare gems do exist that just need a bit of polishing from the right landlord to really shine. If you think you've found a property with under market rents or above market vacancy that can be improved via capital investment or "sophisticated management," just make sure you can answer the following questions:
  1. Why does this opportunity exist?
  2. Why am I the right person / company to capitalize on this opportunity? What unique expertise do I bring to the table that would allow me to add more value than my competitor?
  3. What is the catalyst for this change at the property? Is it simply renovating the exterior and interior? Has the submarket gone through a dramatic change that other investors are yet to identify?
These questions might seem simple, but they shouldn't be if you're being as thorough of an investor as you should be. Just to provide some context, my company recently decided to invest in an asset. In order to get approval for the investment, the investment team had to prepare a 200 +/- page investment thesis to sufficiently answer the above 3 questions...

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