Real Estate Lessons So Far

One of my favorite classes this quarter is real estate investment. It's taught by a professor who runs real estate investment funds and is quite active in the industry. His enthusiasm and real-world anecdotes make the class really interesting and insightful.

I've tried to capture the biggest lessons I've learned in the class so far below.

1. The 5 P's of real estate analysis: This is a great framework through which any deal can be analyzed.
   
   People: Who is involved in the deal and what are their motivations? This obviously includes the buyer, seller, brokers, syndicate participants, mortgage financiers, developers, managers, and many other parties. Often, the people involved and their motivations are more important and influential than the project and its economics.
   
   Process: How was the property found, built, developed, negotiated, analyzed, researched, etc.? The class taught me that, due to many factors including the gross inefficiencies in the real estate market, primary research is what drives competitive advantage in real estate investing. Primary research includes thorough property visits, mystery shopping the comps (or comparable properties nearby), speaking to tenants and managers directly, pulling public records at city hall, and not relying on secondary materials (especially from brokers) for anything important. With brokers specifically, there could be many conflicts of interest in dual agency relationships in states that permit them (like CA), where the broker represents both sides and is unlikely to do all the due diligence you really need to make a wise decision.
   
   Project: What is the property involved (location, size, asset class, etc.)? This is a micro-market view of the investment.
   
   Panorama: What is the overall broader market doing where this property is located (demographics, unemployment, interest rates, credit availability, etc.)? This is a macro-market view of the investment.
   
   Projections: Here is where the numbers play in, and the class was very focused on making adequate, thorough projections of an investment's economic performance (specifically, NOI, or net operating income, equivalent to cash from operations). Useful analyses included sources and uses of capital, return on investment, and most importantly, sensitivity analysis of the projections to the largest drivers of value (rental rates, occupancy, cap rate, discount rate, etc.).
   
   
2. Real estate is all about negotiation: Very little in a real estate deal is efficient or governed by some pre-defined marketplace or law. It's all about what you can negotiate from the various parties involved and how you play the game. I was shocked to hear about the prevalence of re-trading, or renegotiating deals after they were somewhat agreed upon, and the importance of calling people's bluffs (like brokers') when they try to take advantage of you. The professor explained how the identity of the first drafter of a contract often determines who has the bargaining power (sort of like the concept of psychological anchoring), and this is something I'll keep in mind when analyzing future negotiations situations.
   
   
3. Taxes are critical to any real estate deal: There are many levels of taxes that operate on an investment (property taxes, ordinary income taxes, capital gains taxes, depreciation recapture, etc.). Deductions for mortgage interest and depreciation are some of the most important drivers of value in a deal. In many investment contexts outside of real estate, taxes can be a second level of analysis, but in real estate, they need to be in the model from the start.
   
   
4. Unsexy property segments can be good deals: Many people overlook deals in industrial properties and certain hotels and commercial properties because they aren't in the best areas or aren't nice looking buildings or operations. Sometimes those unmaintained and mis-operated properties are the best opportunities for turnarounds, capital improvements, and rent increases that can create large value which many might not look to do. One thing to check on though for such properties (and all in general) are environmental issues (through specialized studies and inspections) that could create large costs down the line if unattended to.
   
   
5. Deals with hair require more intricate modeling and more acceptance of risk: Few deals are straightforward and with minimal quirk; more often are deals with lots of "hair," or complications, like market dislocations, leasing issues, strange vacancy situations, and generally unstabilized cash flows. Having one large tenant as opposed to many tenants is an example of a non-standard situation that creates additional risk. Each of these quirks needs to be understood and analyzed and stabilized in some way to be able to value a property with hair.
   
   
6. Syndications offer the opportunity for average investors to enter the real estate market: By pooling together several participants' money, a real estate syndicate can make a larger overall investment and purchase a property that may not be available to any one investor. If this is done carefully and with a clear plan, it can often create a lot of value and provide a positive educational opportunity for people looking to learn about real estate investing firsthand.
   
   
7. Cost segregation is an important tool for tax efficiency: When buying a property, the buyer has some flexibility in allocating the purchase price between personal property, building, and land. There are clear definitions for each category, but many times people do not optimize this allocation. Personal property has the best tax treatment for depreciation, so increasing its allocation to the maximum extent reasonable can save a lot of taxes. There are specialized consultants who help real estate investors do just that.
   
   
8. When pensions invest, they are following a herd mentality: Usually, pensions are late to the game in most investment opportunities (based on research we looked at), so when they invest, it might actually be a good contrarian indicator (time to get out). In terms of what pensions could invest in, they are tax-free investors and would prefer investments that match the duration of their pension obligations and are generally diversified and conservative with a focus on cash flows over capital appreciation. Land and hotels are the most risky asset classes and probably least suitable for pensions.
   
   
9. Constant improvement is essential to maintaining and enhancing a property's position in the market: When owning a building, many managers or owners think their job is just collecting rents; a lot more value can be obtained by working to constantly improve the amenities and looks of the property, finding new ways to meet tenants' needs and ways to attract more demand to the property from prospective lessees. We went over a lot of neat, non-intuitive little services that a building can offer which don't cost a lot but can make a big difference in people's perceptions. A guest speaker taught us to never rent the same apartment twice; always find ways to make capital improvements in between tenants so that the building is constantly getting better.
   
   
10. Management company relations need to be handled with care: It's best to manage a property yourself or have people you really trust doing it. As with any principal-agent situation, management is often not incentivized to care about the bottom line and may even hurt the bottom line just to maximize gross revenues or whatever base it is compensated on. Generally, management companies aim to minimize their own work as much as possible and only by doing surprise visits and careful tracking can an owner know how they're really performing. Since management companies are also in charge of leasing often, they rarely realize how much of that leasing function is actually marketing and basic sales techniques; in most places, leasing practices are extremely suboptimal, which presents opportunities for those who want to do it right.
    
    
11. Utilities are not a fixed cost: This came as a surprise to me and a lot of the class, and it was very interesting to learn about several techniques that can cut utilities costs, whether through technological improvements or through legal inefficiencies and local programs where costs can be renegotiated or restructured with the city. Utilities can be a large line item which is normally taken as a given but which actually can be in your control.
    
    
12. Real estate deals are structured to create value and maximize other people's money: Often, employing clever structures with multiple classes of investors can allocate profit splits differently and allow access to alternative sources of capital that have different risk/reward requirements. By having several classes of debt and equity, different participants can get slightly different risk/reward profiles that match what they're looking for. In this way, the investment sponsor can maximize the use of other people's money and positively leverage the returns of the deal. In doing so, though, it's important that key members of the sponsor and of each important property stakeholder have sufficient skin in the game (or money at risk) so they care about the outcome of the venture.
    
    
13. Building up equity is a myth: Investing in real estate is not a guaranteed ticket to growing your savings and making money in the long run (especially as evidenced by the last few years). The key with this myth is that it ignores the opportunity cost of money (that one can't earn the same return elsewhere). With mortgage rates so low now, we should be able to earn more than this low interest rate through other investments (such as in our own businesses or professions). Yes, mortgage interest deductions (as long as they last in the future) do help make owning real estate more attractive, but just building equity in a property is not sufficient reason to make the investment.
    
    

Though my personal experience with real estate investing is extremely limited, I look forward to learning more about the asset class in the future and maybe even making my own investments sometime down the line.