Education and Articles

The Power Behind the Property: Why Operator Due Diligence Matters

Why Operator Due Diligence Matters

We are looking to score big in real estate investing.

Well, that charming apartment building with a good neighborhood is looking good, right? 

Did you know that one single factor can impact your investment? It’s the operator.

Today, we will discuss how a skilled operator can turn a so-so property into a cash-flow machine. We will also discuss how to avoid costly mistakes and smart real estate investing.

Key Points

  • Real estate investors focused on property characteristics like location and rent growth.
  • The operator has a bigger impact on investment returns.
  • A skilled operator can find tenants, maximize rent, control costs, and adapt to challenges, while a bad operator can lead to vacancies, lower income, and higher costs.
  • Current market conditions like inflation and staffing shortages make good operators even more important.
  • Inexperienced operators can make mistakes like mismanaging debt, underestimating risks, and expanding too quickly.
  • Even well-known operators can struggle with unrealistic assumptions.
  • Brian Burke, a real estate expert, emphasizes that operator due diligence is more important than the property itself.

Why Does a Good Operator Matter?

In the past, real estate investors placed significant emphasis on a property’s location, condition, market trends, and potential for rent growth, believing that these were the critical factors for generating good returns. However, this narrow focus often obscured the value of the operator.

Think of the operator as the coach of a sports team.

A physical property is like a team’s star player. It gets the glory, the spotlight, and the attention. But the coach’s leadership, or in this case, the operator, can truly shape outcomes- for better or for worse.

As the person or company responsible for finding, closing, and managing deals, a good operator can help keep occupancy high, maximize rental income, control costs, and adapt to changing regulations, markets, and tenant challenges. On the flip side, just as an inexperienced coach can lead to a team’s downfall, an ineffective operator can result in poor property management, increased vacancies, reduced rental income, and spiraling costs.

Understand The Current Market Scenario (A Few Examples)

Recent articles have underscored multifamily sector challenges, from foreclosures to struggling deals. For instance:

  1. An article titled “2023 Multifamily Market Outlook: Turbulence Ahead” by Fannie Mae Multifamily and another by CBRE noted a significant drop in multifamily demand in late 2022. Factors like ongoing inflation, dwindling household savings, and recession concerns remain headwinds.
  2. In June, Gray Capital reported that over $4 billion in commercial mortgage-backed securities loans linked to multifamily properties would mature in October. Well, now that we’re in October, this “impending wall of maturities” is no longer impending.
  3. An article in Forbes discussed how staffing shortages have affected companies across all industries, including multifamily operators. These shortages can impact customer experience and efficiency, adding to the challenges.

Market conditions like the ones mentioned above are undoubtedly concerning and play a role in multifamily challenges. But poor operators play a role in it, too.

Skilled operators can weather market challenges effectively, while poor ones can worsen situations with ineffective management, an unresponsive approach to market shifts, and inadequate property maintenance. 

Poor operational efficiency can result in lower tenant satisfaction and increased vacancy rates, undermining the financial stability of operations. Furthermore, low employee morale can hinder multifamily operators from delivering exceptional service.

Perhaps that’s why over 60% of property managers rank operational efficiency among their top professional challenges.

7 Common Mistakes Made by Inexperienced Operators

Real estate is replete with stories of new entrants who, on the back of a few early successes, experience meteoric rises. However, quick success without a solid operational base can be risky. While in the limelight, these novice operators may be ill-equipped to handle the industry’s unexpected challenges and complex demands. Common mistakes include:

  1. Mismanagement of Variable Debt: New operators might need a grasp on effectively managing variable debt, which can expose investments to unnecessary risks.
  2. Inadequate Hedging: Inexperience often translates to a need for understanding how to hedge against fluctuating market conditions.
  3. Overly Aggressive Underwriting: Optimism is essential, but when left unchecked, it can lead to unrealistic financial projections and misalignment between expectations and outcomes.
  4. Misjudgment in Loan Agreements: Many new operators are lured by attractive loan terms without understanding the underlying risks, leading to burdensome commitments. Failing to scrutinize the fine print can result in deals too good to be true.
  5. Unpreparedness for Market Downturns: Not every phase in real estate is a boom. Market slumps might catch inexperienced operators off guard, resulting in ill-advised panic decisions.
  6. Falling for The Guru Syndrome: It’s easy to be enticed by the allure of real estate “gurus” promising quick success. Without proper vetting, new operators might adopt flashy but ineffective strategies.
  7. Struggles with Rapid Expansion: Scaling too quickly without a solid foundation or strategy can overwhelm new operators. They might struggle with implementing systems, streamlining processes, and recruiting effectively. Yet, even high-profile operators can struggle too.

Many mistakenly believe that a renowned brand ensures flawless operations. The truth, however, is far from this. Even prestigious operators can face challenges. Overambitious assumptions on cap rates, high rental expectations, or optimistic capex projections are common pitfalls that can lead to turbulence. Falling short of these forecasts can harm both reputation and finances.

Brian Burke’s Emphasis on Operator Due Diligence

Brian Burke is a renowned expert in the world of real estate syndications and has a strong association with Reed, stemming from their collaborative participation in an elite mastermind group. Drawing on his vast experience, Burke wrote “The Hands-Off Investor: An Insider’s Guide to Investing in Passive Real Estate Syndications.” But the entire focus of the book’s first third wasn’t on deal-making or market research. It revolved around operator due diligence.

Why All the Talk About Operators?

Burke dedicated the initial third of his book to emphasize the paramount importance of operator due diligence, placing it above even the deal’s review. He believes that while a stellar operator can turn a mediocre deal into a profitable endeavor, a lacking or dishonest one can ruin an otherwise promising investment. It’s the operator’s expertise, integrity, and decision-making that set the course of the investment. Burke equips readers to understand income, cash flow projections, and investor waterfalls while offering insights on evaluating operators and helping distinguish between genuine opportunities and potential traps.

Wrapping Up

You’ll be on your way to building a strong real estate portfolio. Please remember that even the most stunning building needs a great team behind it to flourish.

At RSN, we believe in the best solutions. We take pride in delivering transparent strategies and building valuable investor relationships. Our strategies have been working out for reputed investors for so long, and we hope that we will be helpful to you as well. Happy investing!

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