Over the past 10 years, we’ve executed nearly $75M worth of renovation work across 20+ value-add multifamily projects. Over that period, we’ve experienced many of the unexpected things that can go wrong when executing these deals; hidden physical issues, larger than expected tax reassessments, tenant lawsuits, crime, resident delinquency issues, and submarket challenges like unanticipated new supply or poor policy decisions, to name a few. It’s like Farmers Insurance, “we know a thing or two because we’ve seen a thing or two”.
While being educated on all the potential risks of a deal can be viewed as a positive, it can also work against you. When you’ve been burned in the past by unexpected plumbing issues or tenant delinquency challenges, you tend to put more fat in your capex budget, underwrite higher bad debt during the renovation process, and beef up your recurring replacement costs. This conservative underwriting will bring down your projected returns and likely cause you to lose what may otherwise be a great deal. In today’s investment environment, where asset values are at all-time highs, a level of optimism and unique insight is required to outbid the competition to win deals.
Instead of assuming everything that can go wrong, will, experienced operators must recognize the range of outcomes and assign a probability to each. Legendary investor Howard Marks has a great way of describing a superior investor using an analogy of 100 black and white balls in a jar.
If you don’t know anything about the jar, betting would just be a matter of guessing. You would only be right if you got lucky, and luck isn’t something you can count on.
But if you had special insight and knew 70 of the balls were black and 30 of the balls were white, that would allow you to win more often than you lose. So in order to win more often than you lose, you must have a knowledge advantage. That’s what a superior investor has, he knows more than others about future tendencies.
As an operator, we look for jars that contain 70% black balls, but where we’re given even odds. During the underwriting and due diligence process, we have subcontractors bid out all major work. We review maintenance logs to tease potential physical issues and we do detailed lease file audits to determine the creditworthiness of the existing tenancy. A deep understanding of the submarket and local relationships allow us to know about planned capital projects and initiatives before they’re announced. And unique market research gives us insights on the future growth of an area.
Yet it’s important to remember that even if you do have superior insight, you don’t know what’s going to happen. When there are random and exogenous forces at work, there is no certainty regarding the outcome. All that said, there doesn’t have to be a certainty for the game to be worth playing. A knowledge advantage is enough to create success over the long-term. And in the case of real estate investing, the more you know about the risks of multifamily real estate investing, the more you’ll be able to hedge them and make superior decisions.
Don’t let your knowledge of what can go wrong prevent you from making smart investment decisions.