The Top 3 Mistakes New Real Estate Investors Make (& How To Avoid Them)

When you’re first starting out in commercial real estate, avoiding big mistakes is a lot more important than trying to hit home runs, and the stakes are really high when you get to these price points.

This is true if you’re starting as an analyst and working for a bigger company, but this is especially important if you’re investing your own money or raising capital from investors to buy commercial properties.

So this post, we’ll walk through three things that new real estate investors tend to miss, and why each of these things should be on every investor’s radar.

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#1: Property Tax Changes Over Time

Property taxes are one of the biggest operating expense line items for commercial properties, and the rules around how these are calculated can also be extremely complex.

Every State Is Different

In the US, every state has its own unique rules related to when and how a property is reassessed, and these can vary a lot in different parts of the country.

• Some states will reassess property values every year
• Some states will reassess property values only every certain number of years
• Some states will have a limit on annual increases of assessed values
• Some states will have no limit on assessed value increases on a year-over-year basis

Even in cases where the majority of the leases at a property are NNN and call for the tenant to reimburse the property owner for their pro rata share of the property tax bill, this can still end up being a major issue for investors. This is because tenants with higher occupancy costs aren’t able to pay as much in base rent when their lease is up for renewal, and they’ll also be more likely to move to another site altogether to avoid these charges.

Some commercial leases will also call for a cap on how much a tenant’s expense reimbursement obligations can increase on a year-over-year basis, and when this happens, this also puts the responsibility back on the landlord to make up the difference.

In many cases, property taxes will not stay the same as they were for the seller after you buy a property, and these could change substantially on a year-over-year basis. Because of this, commercial real estate investors need to get clarity on how these are going to change, both when the property trades hands and during their ownership period.

#2: Rent Growth

The next thing I want to highlight is something I did not understand the impact of when I first got started in commercial real estate, and this is lower-than-anticipated rent growth early on in an investor’s hold period.

Rent growth compounds over time, so if this ends up being lower than initially projected in the first few years of an investor’s ownership period, this can lead to big reductions in net operating income down the line. And ultimately, this can have an even bigger negative impact on an investor’s sale proceeds when they’re finally ready to exit the deal.

The bottom line here is that being overly aggressive on rent growth assumptions early on can cause huge misses in underwriting (and very unhappy investors), so being conservative with these from the start can help you avoid a lot of potential headaches long-term.

#3: Credit Risk

When I first got started in commercial real estate, my assumption was that if you had a 10-year lease, the income from that lease was virtually guaranteed for that full 10-year period. However, even though that might be the case in theory, things often look a lot different in practice.

When you’re dealing with businesses and individuals that have fluctuating incomes, you’ll sometimes run into situations where a tenant either can’t or won’t pay you. And when this happens, it can be a lengthy process of negotiation to restructure terms, or you might even have to start from scratch and find a new tenant altogether.

The Real Costs of Tenant Issues

On commercial deals, things like tenant bankruptcy and the early termination of a lease do happen. These things not only lead to lost rent, but to re-lease the space and start generating rent again, property owners will often need to pay for leasing commissions and tenant improvement allowances. This can sometimes wipe out entire years of cash flow, depending on the size of the suite.

Why Credit Quality Increases Value

This is why investors will typically pay more for a building occupied by Apple or Amazon than an identical building occupied by an unproven startup. There’s a lot more certainty that Apple and Amazon will pay on time and in full every single month, and there won’t be a need to scramble and re-lease the space unexpectedly.

The key takeaway here is that just because a property is advertised at a high cap rate doesn’t automatically mean you’ll be generating higher cash flows, and the ability (and willingness) of the tenant base to pay is also something that needs to be considered heavily before investing in a deal.

Protect Against Downside Risk

If you want to get ahead of your boss as a new analyst, or you’re evaluating deals to start your own real estate portfolio, getting clarity on property taxes, being conservative on rent growth assumptions early on, and focusing on tenant credit (rather than just projected returns) can all help make sure you’re minimizing risk and protecting your downside.

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