REFIRE: It´s all about Risk (September 7, 2016)
With stock markets volatile, collapsed oil prices, the Brexit vote and now negative interest rates, investment into real estate is viewed as the safe option. With such an uncertain external environment, a direct investment in real estate yielding “3%+, cash on cash” looks attractive.
This is particularly true for Germany, currently the major beneficiary of European uncertainty. As data from the leading brokers shows, last year’s transaction volume on the German CRE market totaled €55.4bn – the highest recorded over the past 8 years – and that’s likely to be surpassed again this year.
Of course this impacts on yields, but also leads to an adjustment of investment criteria. Investors are shifting their sights to German secondary locations, and newly-identified opportunities in sectors such as light industrial, care homes and hotels.
Buy-side more aware of dealing with risks than sell-side
But do investors truly understand the risks they’re taking? Not risks related to KAGB regulation or Basel III capital requirements, or their holding period, or the form of financing – but the general risks in buying or selling a property, and joint venture risks.
Our company, Blackbird Real Estate, has advised on more than 20 transactions on the sell-side since we set up in 2011; we’ve given a second opinion on more than 80 transactions. We have frequently recommended the buyer NOT to go ahead with the opportunity.
We’ve noticed that the approach to risk is often more competent on the buyer’s side, rather than the seller’s. And this, although the seller’s risk is often disproportionally high.
This includes liability risks from incorrect, incomplete or obsolete documentation – which can lead to a lowering of the agreed price, or worse, its cancellation.
We’ve seen how the same company can behave in a totally different manner when on the buy-side, rather than the sellside.
I well remember a transaction ten years ago when acting on the buy-side team for a commercial property in Frankfurt. After holding the asset for 8 years, the well-known international owner mandated a big broker to handle its sale. Our team submitted the highest bid and our client was granted exclusivity.
After several frustrating months of meetings and conference calls, our client walked away, since the seller was unable or unwilling to deliver key documents, while those that were delivered were often faulty or incomplete – such as the rent roll not tallying with the contracts, no building permits or fire protection certificates, or an obsolete VTDD report.
You might get away with this in the used-car business, but this is no longer acceptable in real estate.
Earlier this year a transaction failed on which we’d been working for two years. After bringing the owner and interested buyer together, getting them to agree on the key points, and establishing exclusivity, it became clear during the due diligence that the two parties were at polar opposities to each other.
The seller, a private individual, had owned the property for more than two decades, while the buyer was a US investment manager committed to thorough due diligence on all its deals. Within days of going exclusive, it was obvious that the documentation was grossly incomplete, and the rent roll figures misleading. This led to a price reduction of 15%.
A further reduction of 10% followed when the seller could furnish no original building permit or other crucial documents. Our suggestion to look at title insurance (warranty & indemnity) was rejected despite the minimal costs involved. No surprise, then, when the deal finally collapsed.
We’ve had German banks wanting to give us a mandate, but instead of a professional rent roll could only offer a loose-leaf collection of 1,000 scattered pages – and all while asking a totally exaggerated sales price!
And another gripe why do so many sellers start off marketing their property on their own, or by mandating several brokers. This blunderbuss approach nearly always leads to a mess, then they come to people like us to try and fix it. This approach might work occasionally, but experience shows they’re better off giving one individual broker an exclusive mandate. Nowadays brokers appreciate this exclusivity, and are flexible in lowering their fees.
Buy-side risk is also an ever-present factor
An example of this is a single-tenant property, without the landlord pricing in a credible re-letting scenario. On such a case last year I advised a buyer that the building was heavily over-rented and there was a high risk of vacancy at the end of the lease period. The deal DID subsequently close - on the strength of a recent rent increase – but more likely, the pressing need to place capital, which obviously outweighed the potential risk of a future 100% vacancy. But, hey, let’s just hope it all works out well for the investor...
What’s the point in risk management tools and sound common sense, if we’re just prepared to simply ignore them?
Joint Venture Risk
From experience, I would always recommend to German asset managers or co-investors to scrupulously triple-check contracts before entering into joint ventures, particularly with Anglo-American investors.
A typical such co-operation begins with the identification of a suitable asset (or portfolio) for the JV. Often the bulk of the underwriting is handled by the local junior partner – usually including commercial due diligence (especially gathering market comparables), coordination of legal, technical, environmental due diligence, valuation, negotiating finance, and similar. Third party advisors for these services get paid their fee, of course – but not so the junior partner.
Of course, the junior partner will participate in future profits, and, increasingly, international investors look favourably on underwriting efforts as “synthetic equity” – but not all operating partners can financially afford to tough it out like this.
Further challenges arise during the holding period of the investment. I’ve been in several joint ventures as an advisor or a junior partner, and I’ve gathered the impression that many Anglo-American private equity investors – I call the type “Diabolic Dippers” – employ certain staff for one reason only: to cut the fees of the local operating partner, irrespective of the value they add!
Exceeding the business plan’s goals is always taken almost as a given – but woe betide the local partner if he fails to reach a specific target as outlined in the plan... then the devil arrives to slash the fee.
“Look before you leap” is a wise motto applying to Germany as well (“...drum prüfe, wer sich bindet!). It’s true not just for the local partner, but should be heeded by international investors looking for a local partner as well. It cuts both ways. I recently terminated a partnership with a “Diabolical Dipper” for his unethical approach to business – and I intend to let my network know about his unreliability and lack of integrity.
It’s all about communication
Blackbird and other results-oriented advisors like us depend on closing deals in order to eat. But why do investors view our profession merely as providers of sources for deals? We know markets as well as investors and bring knowledge, networks and experience – and sometimes co-investment capital, to join in the upside potential of a plan we’ve often developed ourselves.
We don’t claim that Blackbird Real Estate and others do all this on their own – we don’t; but we DO identify and evaluate risks, and come up with solutions, counting on their implementation by our long-term, trusted partners.
In the era of the “cloud”, with constant online communication, an article about risk management and transparency ought to be superfluous – but clearly the opposite is the case.
The gap between aspiration and reality is still wide. While few real estate owners believe it might apply to them, I’d certainly plead - as a bare minimum - for an automatic “precheck” of relevant documentation as a fundamental asset management responsibility.
Numerous professional service providers fulfil a vital role in helping buyer and seller reduce risk whenever a transaction is taking place. Some of them will even gratefully accept payment when a deal is successfully closed... So don’t be shy, feel free to contact us!
Tobias Schultheiß FRICS SIOR
BLACKBIRD Real Estate GmbH, Königstein