Investors are often easily wowed by the financial characteristics of a prospective investment. However, shiny exciting numbers are fraught with risk. Instead, investors should focus on a few basic characteristics to select and make investments in the real estate markets.
Before we jump into what to look at, a discussion of what to avoid deserves attention. Investment plans that rely on the unproven even for a specific project should be avoided by smaller investors. To be clear, I am not saying that all such plans are bad investments. In fact, many are superior investments. However, for smaller investors (though possibly quite sophisticated, this requires resources and a tolerance for potential loss that many aren’t armed to support. So, to continue, avoid the following:
- Investments that are not based on a long standing established revenue and expense profile.
- Investments that project new revenue based on changes that are not in place at this point in time.
- Investments that require heavy capital improvements to maintain the existing base as these often require underlying assumption on post improvement costs and buying that may not prove true.
- Investments that expect a major repositioning in the market place.
With this in mind, what should a proposed investment deliver? Some of the major characteristics include:
- Low leverage. Some consider 70% low leverage. The events of the past few years support placing this at 60% or less.
- If financed, the debt should have a long horizon. This should be 5 or more years.
- The debt should be at a fixed rate unless put in place at the peak of a rate curve. However, estimating whether the rate is at a peak includes assumptions that may not prove true and could create unnecessary risk.
- Revenues should be based on historical results and should be demonstrably consistent in the surrounding market place.
- The demographics should be consistent with the future expectations and demographic trends should prove the assumptions are sustainable.
- The economy should be diverse and offer proven performance even in weak economies.
- Expenses and services should be proven with a diverse base of sources to serve the investor.
- The management contract and principals incentives should be consistent with the investors goals. In consistent goals will inevitably result in disappointing results for the investor.
While these items may narrow the potential investments for smaller investors or perhaps even not so small investors, these considerations will protect against losses, disappointment, and frustration and at the same time assure the continued investment portfolio that is important to your asset and cash flow goals.