4 Submarket-Level Risks That New Investors Often Miss
As a principal in a private multifamily real estate acquisition and asset management firm (we buy apartments), I speak to real estate investors every day. The vast majority of them are hyper-focused on "the deal" (the property itself) and any discount to market they can get on the buy.
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They want a good deal, they need a good deal, and they must have a good deal.
In many ways, I don’t disagree; I like a good deal as much as anyone else.
However, the really good deals (i.e., assets discounted to market) are that way for a reason. Typically, they are more distressed—with deferred maintenance, tenant issues, or a number of other factors that compel the owner to offer the property at a discount. These deals can have greater potential opportunity, but they also come with greater risk.
The following are four MSA/submarket-level risks that could make even the best deal a nightmare.
1. Declining Population
For a variety of reasons, city populations expand and contract. Long-term population contraction is bad news for apartment investors. Like most businesses, it comes down to supply and demand. Declining population equals declining demand.
There are many cities in the United States that are shrinking, and some have been doing so for a very long time. Therefore, it should come as no surprise that cap rates for apartments in many of these markets are significantly higher than in markets where population growth is booming.
On first blush, those higher cap rates may seem to represent a better deal. However, when you factor in rent growth and occupancy rates over the long haul, what you’ll uncover is that those higher cap rates are, in fact, nothing more than risk premiums.
In essence, it is a form of compensation for tolerating the extra risk inherent in contracting markets. More often than not, fair deals in safer markets outperform good deals in riskier markets. This may seem obvious, but it’s surprising how many people fail to make the connection.
2. Environmental Risk
Some years ago, we stumbled onto what appeared to be a financially good deal in a growing, stable market. Not only did the investment look good on paper, it also looked good upon physical inspection. It was during our due diligence that we discovered that this property was located near a Superfund site with contaminated groundwater issues. Of course the seller disclosed none of this.
Had we not had a thorough due-diligence process in place to catch the various land mines that could wreak havoc on an investment, we would have paid the price for owning that “good deal.” The resale market is very limited for properties that contain environmental hazards.
Remediation of such hazards isn’t always possible and when it is, the costs can be enormous. That is why it is not uncommon to find highly discounted properties that contain environmental hazards.
3. Singularity of Jobs Risk
When we look at markets, we like to see diversity of job centers. We like a mix of government, private-sector, and higher-education jobs. By having job diversity, one avoids the risk of catastrophic loss when an industry goes belly up.
In the extreme, cities created by single job centers become ghost towns when massive unemployment occurs. Military towns and the destruction that was created by base realignment and closure (BRAC) back in the 1990’s is a good example of this.
Today, all over this country, there are cities that derive significant portions of their economy from military spending. Cities like these can derive as much as half of their GDP from the military. No matter how good their present economic situation may be, they are always one BRAC away from complete disaster. In my mind, that creates unacceptable levels of risk for the long-term investor, regardless of how good a deal looks on paper.
4. Legal Risk
When evaluating markets to invest in, population growth and employment rates are important. There are several markets that have exceptional numbers in both of these areas that I still wouldn't consider investing in. Local and state landlord-tenant laws can make a big difference when it comes to success or failure in a given market.
Pro-tenant states can have things like rent control, extensive eviction requirements, and other obstacles that make it harder for owners to succeed. While those challenges are not necessarily unique, some areas take their pro-tenant stance to another level.
For example, one major metro passed landlord-mandatory renter-relocation assistance. This law will require landlords to be financially responsible to fund their tenant’s relocation under certain circumstances.
In 2017, just one state away, another major metro passed laws barring criminal background checks.
Criminal background checks have long been the norm in our industry. Good landlords strive to provide a clean, safe environment for the residents who live at their properties. Background checks are a tool that assists them in meeting that obligation.
How they use those checks depends on their management style. Some take a hard-line approach and reject all tenants with a criminal history. Others are more moderate.
Working under the theory of disparate impact, many look to HUD for guidance on this topic. Striking a balance by being as inclusionary as possible while still safeguarding existing residents and property can be challenging.
Banning the use of all criminal background checks is extreme. It handcuffs owner’s rights and obligations to maintain a safe environment. I would think long and hard before investing in properties with laws like that, no matter how good the deal is.
Not All “Good Deals” Are Good Deals
As important as it is to pour through the financials and to know the numbers of every potential property that you are considering investing in, the fact remains that this business is more than just numbers on a computer screen. In fact, good deals in real estate often represent nothing more than a risk-premium. Perhaps you are particularly good at mediating that risk and creating profit. If so, then more power to you. If not, passing on that “good deal” may just be the best move you’ll ever make.
Are there any risks I failed to mention?
Share your thoughts with me below!