March Madness – The Sweet 16 of Real Estate Decision Making
I am often asked by our real estate investors one of the following questions:
- How do we determine what properties to invest in?
- What is our acquisition vetting process like?
- What are the analytics we use in coming to a “yes” decision?
I have written about certain aspects of this process previously. However, since March Madness has been cancelled this year as a result of Coronavirus, I thought I would present it in a bracketology format. You may now be asking - Huh??? How is that possible? Well effectively, I am asking you to think about pitting two decision-making processes against each other, both having validity, but questioning – “are some processes more valuable than others?”.
In my decision-making bracketology face-off, as well as in performing an actual real estate investment analysis, we must recognize that some decision-making processes outweigh others. It’s the only way to get to a decision and the only way we can move through a basketball bracket. Each winner then moves on to the next round of the bracket, just like a winning team in March Madness.
As you advance further into the bracket, the decision-making processes continue to be pitted against each. And just as in the basketball version of March Madness, pitting various decision-making processes against each other becomes more difficult as one moves to the elite eight or to the final four. But ultimately there must be one victor; otherwise you can’t reach a decision about what to do with any surety that you’ve made the right decision.
How is this even possible? How in the world could this ever be applied to making an informed decision about a real estate investment? So, let me give an example. Here’s some background information. A property that we are considering for purchase is in a good location. A simple premise – right? Now, let’s apply two decision-making processes to that potential real estate acquisition.
First, Hypothesis by definition is a supposition or proposed explanation made on the basis of limited evidence. Second, Theory by definition is an explanation of an aspect in the natural world that can be repeatedly tested and verified in accordance with a scientific method using accepted protocols of observation, measurement and evaluation of results. Perfect, we now have our first two decision-making process competitors – Hypothesis and Theory.
Now let’s apply these two concepts – Hypothesis and Theory - to the real estate example noted above. Most people understand that location is very important when it comes to picking a good real estate investment. So, your Hypothesis is - this property is in a good location. You base this Hypothesis on the fact the city where the property is situated is well known, the local population is growing, workforce is stable, and the vehicle traffic by the property appears to be brisk. But is that really enough to make the most informed decision?
Now let’s apply the definition for Theory to this same question – is this a good location? Theory by definition means you would investigate more deeply into the location’s analytics. You would look beyond simply saying that traffic looks brisk, and instead look at the traffic counts (the actual number of vehicles that pass by the property every day). You would look beyond just recognizing that the population is growing and instead you would determine the property’s proximity to housing and the number of rooftops within a certain radius of the property. You would also investigate the property’s Walkscore – meaning how close are amenities in relation to the property and if they are a walkable distance. You would also consider the property’s proximity (actual mileage) to highways and major arteries. As you can see, this analysis is more detailed than that performed under a Hypothesis.
Going back the bracket and the concept of pitting two decision-making ideas against each other – Hypothesis versus Theory – they become our first match-off. In this case, Theory wins because the analyses used by Theory are more valuable to the final decision about purchasing the property than the information that Hypothesis produces. Theory moves onto the next round. Get it now?
So how did I determine what elements of a real estate decision-making process should even be considered for the tournament? After years of experience in evaluating commercial properties and questioning myself on various elements, considering both the short term and long term, and recognizing which specific decision-making elements should be considered in making a real estate investment decision, I generated a list of 16. Let’s call them my Sweet Sixteen of the real estate investment decision-making process:
- Discipline – Acting in accordance with rules, plans and a process
- Instinct – A natural impulse, inclination, or tendency, not necessarily based in fact or logic
- Persistence – Firm or obstinate continuance in a course of action in spite of difficulty or opposition
- Cautiousness – Being attentive to possible unwanted outcomes
- Experience – Previous contact with or observation of facts or events
- Intuitiveness – The power to discern the true nature of a situation
- Idea – A thought or suggestion as to a possible course of action
- Inquisitiveness – Eager for knowledge and the ability to question and re-question the facts and conclusions
- Theory - An explanation of an aspect in the natural world that can be repeatedly tested and verified in accordance with a scientific method using accepted protocols of observation, measurement and evaluation of results
- Hypothesis – Is a supposition or proposed explanation made on the basis of limited evidence
- Analysis – A detailed and thorough examination of the opportunity, utilizing sensitivity to various assumptions
- Anecdote – An account of something that may or may not be accurate, even if heard from multiple sources
- Determination – Firmness of purpose, intent on achieving a goal [Spoiler Alert – aka Cinderella]
- Confidence – The feeling or belief that one can rely on something
- Sureness – A fact or condition of being without doubt
- Conviction – A firmly held belief or opinion and to act on it
So, let’s get back to the tournament and find out which of these elements are more valuable to ultimately make the best real estate investment decision. Let’s put these elements into a bracket, pit them against each other in an ultimate dual, and find out the winner. The one single element in our real estate investment decision-making process that outweighs everything else. Here’s the bracket, including of course, one Cinderella team.
In the first round, I have set up Discipline vs Instinct, Persistence vs Cautiousness, Experience vs. Intuitiveness, Idea vs. Inquisitiveness, Theory vs. Hypothesis, Analysis vs. Anecdote, Determination vs. Confidence and Sureness vs. Conviction.
The sweet sixteen winners are…
Discipline because following only your Instincts may feel like a good path but it is too shaky of a foundation to base a significant investment decision upon. Persistence wins over Cautiousness because finding good real estate opportunities isn’t easy. Experience wins big over Intuitiveness. Subtle differences make championships and Experience carries the day. Idea loses out to Inquisitiveness. It is very important in real estate investing to constantly question your plans and assumptions.
No surprise that Theory tops Hypothesis. Looking deeply into the facts and the market will always win out over unsubstantiated beliefs. Analysis handily beats out Anecdote, even when the herd believes the same anecdotal evidence. Sometimes this is the most important lesson behind being a long-term winner.
You may be surprised by this but Determination upsets Confidence. I’ve seen situations where people are very confident in the answer or result, but sheer Determination to achieve an outcome can and should prevail. It’s a close one, but Cinderella Determination wins at the buzzer. Lastly, Conviction crushes Sureness. Conviction carries a standout player who is willing to act the belief; whereas Sureness may be correct but doesn’t always act.
In the elite eight, now Disciple plays Persistence, Experience tips off against Inquisitiveness, Theory goes against Analysis and, lastly, it is Determination (Cinderella) versus Conviction.
The winners moving onto the final four are…
Persistence and Discipline were tied at the half, but Discipline outlasts Persistence because it followed a process and plan that Persistence alone doesn’t offer in its playbook. For game #2, Experience outlasts Inquisitiveness. Experience offers many similar qualities as Inquisitiveness, but it adds some wisdom to the equation.
In the third game, Theory played strong, but it really only offers a one-dimension perspective and doesn’t see the broader picture. Analysis has a deeper bench, because it considers multiple options, such as if the space is leased to a 4,000 sf tenant, what other options are available if this tenant were to vacate. Lastly, in game 4, Determination (our Cinderella) was a big underdog versus Conviction, but Determinations unyielding purpose and intent wins out over a firmly held belief and the desire to act on it.
Our Real Estate Madness Final Four participants are Discipline versus Experience and Analysis versus Determination. These four decision-making processes not only represent four critical elements to make any good real estate decision but also collectively are an unbeatable group that increases the likelihood of success with any investment opportunity. All of them are really needed to determine if the potential real estate investment should be pursued.
At Kenwood every one of these elements are represented in our final decision-making process. However, in this tournament, we can’t have a four-way tie. Some elements still must outweigh others, even if ever so slightly.
In the final four, Discipline tops Experience. Experience is critical in making a good decision but having a plan and process is still more critical. Our investment decision-making process always includes talking to real estate brokers in the market, having contractors evaluate the roof, parking lot, HVAC systems, and elevators, engaging mortgage brokers to secure the best loan terms, and understanding the key assumptions used in our financial model, such as rental rate, rent growth, renewal probability and lease transaction costs. This can be an exhausting process, but if you do the homework, it vets the property, the plan, and the process.
In the second game, Determination, our Cinderella, finally loses out to Analysis. At Kenwood we use multiple metrics to determine a property’s value and to develop a plan to execute. That process includes, at least, preparing discounted cash flow models, examining the competitive property set, evaluating price per square foot in comparison to the comparables as well as historically high prices per square foot in that submarket, replacement cost, available sites for new development, costs to perform tenant improvements, and understanding the property’s capital needs over time. Analysis sets the agenda and guides the process logically.
So, we are finally at our Real Estate March Madness decision-making finals - Discipline plays Analysis. This is a tough battle because both are multifaceted processes that are needed to make the ultimate decision. Both also produce well-founded arguments and conclusions. Once again, we must have one winner.
And the champion of our Real Estate March Madness decision-making tournament process is DISCIPLINE.
Discipline trumps Analysis to be the single most important element in making our real estate decisions. Discipline, throughout the years, has kept Kenwood out of trouble. When the real estate investment markets have become too frothy, and brokers have said to me that I should ignore market fundamentals, Discipline has kept me from listening and following the herd. It is by far the hardest element to remain true to and to follow as economic conditions change.
However, my experience has been, it not only keeps me out of investment trouble but also increases the odds of a successful real estate investment and improves the advantage in the risk-reward spectrum. So, forget location, location, location. If you really want to improve the likelihood of success, replace it with discipline, discipline, discipline.