Decoding Real Estate Risks: A Guide for Investors
Today I wanted to address an issue that is near and dear to my heart. I’ve been in the real estate world as of the time of this writing for close to 19 years and an owner and developer for nearly 10 years. As a native to Los Angeles, I’ve seen this city change from good, to great, to now a mixed bag of uncertainty. It is my contention that the core of most of society’s problems in our time actually emanate from the increasing risk profile that property owners have to assume on a year over year basis. If these risks were addressed in a logical fashion, I believe over the long term, you would see the quality of housing increase while pricing would fall simultaneously. In any event, I wanted to take some time here to show you some aspects of the thought process that we consider when we’re making an investment in a potential project and the risks that surround them.
Margin of Error
Whenever we look at a prospective deal (especially development opportunities), we’re looking for very thick margins of profitability. Is that because we’re greedy investors who are looking to build a swimming pool and fill it with gold coins like Scrooge McDuck? Not really. Also, diving into a pool of coins sounds really painful by the way and is a plot hole Duck Tales never fully addressed and has bothered me since I was a child, but I digress.
In any event, we look at margin as the degree or magnitude of problems that we can sustain. These can be either our mistakes or externalities forced upon us from the government, economy, people, etc. The margin is more or less our safety net to ensure that we can survive a project and not become bankrupt while having to switch our diets to instant ramen to survive. When you take on a deal with thin margins, you’re telegraphing to the world that your expectation is that you will execute perfectly, which I’ve said time and time again is a very unrealistic expectation.
With that in mind, I wanted to show you some of the specific risks that will eviscerate your margin of error.
Squatters and Vandals
I’ll lump these two together even though they carry different characteristics. These days, especially in major cities, nothing in the world is more vulnerable than a vacant single family home. The news these days report numerous incidents of people being away on vacation for an extended period of time to return home and find someone else is living in their homes. Unfortunately, laws are too far in favor of squatters these days which makes removing these unwanted guests extremely difficult and costly. In a typical development, the property that you tear down will definitely be spotted by these kind of people and they will break into your home to stay the night (or several months). If you don’t catch them quickly, they will make your life hell by claiming tenancy, thus putting a huge brake on your dreams of building.
Vandals on the other hand, along with thieves, typically enter your property at night during the construction period. They do annoying things like rip copper wiring out of the walls or steal fixtures such as cabinetry, faucets, etc. They sell it for pennies on the dollar to buy important things like drugs but it costs you a fortune to replace it since a large component of the cost involves labor to reinstall the same items.
We’ve had maybe one project in the past 10 years that didn’t experience some combination of the above. At this point, we simply budget robust security systems such as actively monitored cameras provided by companies and/or physical checkups by paid security professional to visit the site in the off hours. This unfortunately isn’t cheap but given that crime seems to be on the increase these days, it’s way more cost effective to prevent thefts, vandalism, and illegal tenancy than hope it doesn’t happen and deal with the repercussions afterwards. Always plan for physical security immediately after your acquisition and throughout the length of your development/renovation/business process. Don’t sleep on this one.
Economic Conditions and the Passage of Time
A deal that makes sense today is one that may not make sense tomorrow. Any office building developer who acquired a commercial site on January 2020 and finally received permits to begin construction in 2023 will tell you that with some tears in their eyes. The passage of time is the enemy to almost every real estate project imaginable. As cities continue to add numerous roadblocks to permits and entitlements which require many layers of review of approval, future real estate projects will require even thicker margins to account for this passage of time risk. The market will substantially change in a few years, with demand for your specific product potentially decreasing and more importantly, interest rates rapidly increasing. The combination of the two can make your very profitable project turn into a break even deal overnight, which actually is a great outcome since you at least won’t lose money in such a scenario. I don’t have a specific solution for you on this particular threat other than acquiring a crystal ball, but the above a huge reason to consider margin as a shield against this outcome. Most people in the last decade will disagree with me and say that time has been generally kind to their real estate holdings, but I still disagree. Construction costs in 2015 versus 2023 are from completely different universes. The story of these costs reminds me of those memes you see on the internet where your grandparents bought a home in Beverly Hills for $15,000 and now it’s worth $4,800,000.
Government
These days, I believe the greatest threat to all real estate projects comes directly from government control and regulation. I talked a little bit about why there’s going to be an eternal housing shortage in California. Unfortunately, the lack of predictability from governments regulating land use and laws around tenancy pose the greatest risk to every real estate investor, especially in California. These days, every law being passed by the legislature shifts more risk to property owners, who in turn must respond by de-risking.
A new bill is making its way through California to limit security deposits to 1 month of rent. This sounds like a win for tenants and tenant advocacy groups, but I would contend it’s a major loss. Under current law, deposits are allowed to be collected for up to 2 months of rent for an unfurnished unit and 3 months for a furnished unit. Typically, owners collect 1 month of rent, but 1.5 to 2 months can be warranted in situations where the tenant’s finances are thinner and pose greater risk to the owners. They may feel uncomfortable taking on this tenant without them having some kind of skin in the game and to be invested in the outcome of the property. If deposits are limited to one month, landlords will most likely respond by seeking prospective tenants with higher credit scores and better income and savings, which is a huge blow to lower income tenants with poorer credit, obviously.
Government might then respond to that by stating that landlords can no longer evaluate tenants based on their credit or finances, which would be absurd. Unfortunately, we are in an environment where laws are passed without any studies conducted on their potential outcomes. I suppose at this point, property owners can stop leasing their units, like New York property owners are now doing. But then maybe government can pass a law making it illegal to do that. I’m sure that will go well too.
The way to counter government risk these days is to have great legal counsel on hand who consistently track new legislature coming down the pipeline in the state and city or county you invest in. You can gauge risk based on these laws and take action to either account for these changes or divest (or not invest at all in that area). Joining local trade associations can help as well, such as apartment associations or institutes that focus on public policy. The point is, you can’t bury your head in the sand if you plan to actively grow your portfolio and you will need to be aware of what laws are being introduced at all levels of government as part of your asset management activities.
Next Steps
As always, I don’t write these articles to scare you from investing in real estate. Quite the contrary, I want you to grow your portfolio and become the next mogul. It’s important that you take these factors into consideration so that you aren’t caught by surprise and you have the tools you need to protect your wealth and grow it. I prefer to see the problems ahead of time and build systems to address them, rather than focus on my praying skills to hope that they never come to be. As always, we’re available to chat about your real estate investment strategies.
