* Available for Chapter 1 only.
This chapter discusses topics which a real estate investor must consider when analyzing an investment. While building a financial pro forma is a necessary step, many of the underlying assumptions built into it will be wrong. Many factors beyond financial modeling, such as personal risk tolerance, competitive landscape, the capital market environment, among others play into the decision-making process.
Operating costs can easily be incorrectly forecasted. An increase in expenses will reduce net operating income. Unexpected changes in vacancy can have a large effect on the accuracy of a financial model as well. In a weak or over-supplied market, buildings may have occupancy well below expectations for long periods of time. Liquidity is another underlying risk as it takes a long time to sell a property, and sometimes an investor needs cash quickly. However, real estate also offers unexpected opportunities for investors. Just as operating costs can increase, they can also fall, rents can rise, and property values can appreciate. This chapter lays out some of the risks and opportunities an investor must consider when underwriting an asset.
Conducting market research can help to clarify the supply and demand balance within the market and is the backbone for assumptions made in the pro forma. In this chapter, the importance of conducting such research is reviewed, and examples of sources for information, and what to look for when researching a market are provided.
Finally, this chapter reviews how personal decisions play a role in choosing investments. Investment decisions ultimately depend on who the investor is, how risk-averse they are, and what expertise they bring to the table.
PETER LINNEMAN: So as I look at chapter 1, which really says it all– it’s about risk and opportunities– what would be the three things that you think are the most important things to take away for a young professional or a young professional to be?
BRUCE KIRSCH: Yeah. So just as a general comment on chapter 1, if you are looking to get into the real estate business, and you read this chapter, and it doesn’t blow your hair back and just get you so psyched for what is to come in the book, then it’s probably not the right path for you. I think you did an amazing job of setting the stage, setting the table for just a general macro understanding of opportunities and risks. And so I’d say that the three main things are number one, when we think about overlaying a framework of risk and opportunity, that is the right thrust.
But there is no place to verify that whatever conclusion you come to is correct, right? For instance we, can’t go to discountrate.com and put in our particulars. And yes, lo and behold, my discount rate is 7.2% for year one.
PETER LINNEMAN: That’s exactly right.
BRUCE KIRSCH: And for year two, it’s 7.38%. Nobody is going to send you a letter saying you made the right assumptions.
PETER LINNEMAN: And even more so, the discount rate for any analysis, not just real estate, is reflective of the risks that you’re taking. The risk you may be taking in buying a hotel might be very different than the risk I’m taking in buying the same hotel. It might be my first hotel. I may have never done one before.
I may be a foreigner coming in, and I don’t know the market. It may be my first deal. You may be the 37th hotel you’ve done. Your risk might be very different than my risk. Therefore your discount rate should be different than mine. There’s no metaphysically correct. It’s reflective of.
BRUCE KIRSCH: Right. And it’s all case specific. So if you’re going to look at an apartment building, OK, I’m going to do development of an apartment building. You may have a connection with a university that wants to master lease it because they have a major housing shortage. And I know nothing about that.
So I’m going to go, and I’m going to lease it up at 10 units a month for the next 20 months. And you’re going to sign one master lease. And your risk is gone, effectively.
PETER LINNEMAN: Yeah, two points you make in that, one is that, quote, “old fashioned” real estate was I buy or build an empty building, quote, “knowing” I’ve got a tenant in my pocket. And big part of the value add I got as a real estate person was I knew something the market didn’t know. I knew I had a tenant.
The people I was bidding against thought they could get tenants. Big difference, right, from the risk point of view. Not to mention the cash flow may start sooner. Second thing is your comment about I might have connections with the university. It underscores why the commercial part of real estate, in particular, relationships matter a lot. That if I know that president at the university, and you don’t, I get a hearing, and you don’t.
If I know the head of Walmart’s real estate or the CEO of Walmart, I get a hearing for why I should be the developer for them. You’re still scrambling around trying to figure out how to get a hearing. And people say, well, why are relationships so important?
It’s not like Walmart’s going to do something just because they know the person. But the opposite may be true, that if they don’t know them, they’re definitely not going to do, or you’re up against the– and that one little example drives home why it is a relationship business. Multifamily, a little less so, right, because your example is one where it matters, if you’re doing a master lease.
But if all I’m doing is running into a bunch of 23-year-olds, I don’t have a necessarily a better connection with a bunch of 23-year-olds than you do. You may understand them better. But the relationship is a little less on the residential side than it is on the commercial side, I think. So that was one comment. What other?
BRUCE KIRSCH: You don’t know what you don’t know. And that is very dangerous.
PETER LINNEMAN: It’s hard to know the future.
BRUCE KIRSCH: Right.
PETER LINNEMAN: It’s easy to speculate about the future. You try to study so you have better speculation. But I always like to point out to people that if you sit here today, literally, as you sit here today, Barack Obama, 10 years ago, was just taking office. And you think of all the things at that level that happened in the country, in the world, many of which you would have never dreamed, good and bad.
Yet in our little pro forma, our nice rows and columns that we make up today, it all looks real obvious.
Discounted Cash Flow (DCF) – analysis framework that postulates that the value of a property is equal to its expected future cash flows discounted to present dollars; premised upon two basic concepts: 1) the only source of value for a property is its ability to generate future cash flows, 2) a dollar received today is more valuable than a dollar received tomorrow.