A commercial investment partnership involves real estate investors who pool their money for the purchase and typically the rehabilitation of a building. Smaller investors benefit by accessing higher-quality real estate assets with a lower barrier to entry. Many smaller investors and real estate entrepreneurs love these deals because they can invest their IRAs.
However, there are several potential reasons a perfectly performing real estate deal could become distressed. Based on my experience in the real estate investment space, here’s why they go bad and the warning signs to watch out for as a small investor:
At the top of this list are your bad operators, meaning weak and inexperienced operators. The operator is the person raising the money. These folks should know how to add value to the investment. Some operators are good, but in my experience, many are bad.
Here are some of the warning signs: They manage the property themselves, usually under the banner of saving expenses. These first-time operators often don’t know how to value multifamily buildings and are driven to overpay, desperate to get their first deals done. That’s typically why they can’t afford a professionally licensed and insured property management company to oversee the purchase and rehab.
Too Much Time
This is specific to “rehab and flip” value-added deals. These are meant to be started and finished in a short amount of time. However, when the term runs out on the loan or the repairs and expenses have been going on for far too long, the operator will never get out from underneath them. Whether the operator knows it or not, they have passed the point of profitability on the deal.
Following on that point, the third reason is that the costs were underestimated. An increase in costs without an increase in revenue raises the asset’s cost basis and reduces returns.
The operator must have control of all costs. These are:
(1) Acquisition costs: Do not pay too much on day one of the deal. The purchase price is where the money is made on these deals. From my experience, those operators who bought toward the top of the market because a lender was willing to lend them the money almost always have problems later. Markets work in cycles, and the worst time to buy anything is when you feel as though you need to. That false sense of pressure has sunk many operators.