Top 15 CRE Investing Mistakes

Avoiding Common Mistakes in Commercial Real Estate Investing

Commercial Real Estate (CRE) operates uniquely as a transaction-driven industry. The industry’s success hinges on sale, financing, and lease transactions, making transaction volume a key indicator of profitability. In 2021, the CRE sector witnessed a record-breaking year in transaction volumes, underscoring its potential for substantial returns.

However, success in CRE isn’t guaranteed. Even the most seasoned investors and companies can fall into common traps that lead to suboptimal performance, equity loss, or even foreclosure. Here are the 15 most frequent and detrimental mistakes made in CRE investment according to an article by GlobeSt.com:

1. Acquiring Properties at Low Cap Rates: Investing in properties with cap rates below 5.0% is risky. It’s comparable to buying a tech stock with an exorbitant price-to-earnings ratio, banking on uncertain future rent increases to justify the low initial return.
2. Lack of Portfolio Diversification: Failing to diversify, whether by property type, location, or industry can be disastrous. For instance, concentrating investments on office properties in Silicon Valley exposes investors to significant risks if the tech sector falters.
3. Insufficient Due Diligence: In large portfolio acquisitions, overlooking thorough property-level due diligence is a common pitfall. Investors often focus on major assets, neglecting the smaller ones, or rely on inexperienced third-party evaluators.
4. Negative Leverage: Acquiring properties where the cap rate is lower than the mortgage constant results in negative leverage. This situation lowers the cash-on-cash return, which is a fundamental mistake in CRE investment.
5. Short-Term Floating Rate Debt: Financing long-term assets with short-term floating rate debt, without hedging strategies like swaps or collars, is risky. Rapid interest rate hikes, such as the recent increase from 0.0% to 5.25%, can catch investors off guard.
6. Unrealistic Terminal Cap Rates: Using terminal (also known as exit) cap rates lower than the initial cap rate to boost the internal rate of return in underwriting is deceptive and can lead to faulty investment decisions.
7. Inexperienced Management: Investing with sponsors who lack seasoned senior management can lead to poor outcomes. Teams with experience in previous CRE downturns will most likely be prepared to navigate market challenges.
8. Overly Optimistic Rent Projections: Inflating rent projections to make deals appear more attractive often backfires. Realistic, conservative projections are crucial for sound investment.
9. Ignoring Retail Sales Metrics: When investing in shopping centers, neglecting to analyze sales data, particularly of anchor tenants, can lead to misjudging the property’s viability and demand.
10. Excessive Leverage: High leverage, particularly over 75%, is dangerous. It was a significant factor in the 2007-2012 Great Recession and remains a high-risk strategy.
11. Lack of Employee Equity: Not offering equity stakes to senior-level employees, known as “golden handcuffs,” can result in losing valuable talent to competitors.
12. Overlooking CRE Risks: Failing to integrate the 15 key CRE risk factors (cash flow, value, tenant, market, economic, interest rate, inflation, leasing, management, ownership, legal and title, construction, entitlement, liquidity, and refinancing) into the investment strategy is a critical error.
13. Misguided Sector Investments: Investing in specialty sectors like hotels and senior housing without relevant experience can be problematic. These sectors primarily operate businesses, requiring specific expertise beyond typical real estate knowledge.
14. Missing Portfolio Discounts: Not negotiating for a “Kmart discount” can lead to overpaying when acquiring large CRE portfolios. On average, buyers should seek at least a 1.0% higher cap rate for the inherent risks.
15. Unchecked Underwriting Formulas: Errors in Excel underwriting workbooks are common. Ensuring all formulas are independently reviewed can prevent costly mistakes.

Our Takeaway

Real estate can be an excellent investment vehicle, however, it’s easy to make mistakes when acquiring properties.  This article includes many tips for private and institutional investors alike, providing an excellent reference to help investors avoid common errors.  As advisors, we value our client relationships and the role we play in assisting with their acquisitions, operations, and dispositions.

Please contact us for thorough and personalized guidance on your next transaction, or to strategize the future of your existing assets. We look forward to working with you to optimize the return on your real estate investments.