Counter Party Risk

Why knowing who is on the other side of the table means everything 

A casual client, Tony for the purposes of our story, called me in the summer of 2021 to chat about an 8-unit apartment building he saw on Redfin. The building was about an hour north of Atlanta in a small manufacturing town. It was totally outside anything he and I had discussed in the past but he was intrigued. He said he had already back of enveloped the numbers and wanted my opinion on an appropriate offer. Alright, let’s see. We talked through the underwriting process I use for deal analysis. Tony and I underwrote the deal based on the numbers provided by the listing agent and again with our own numbers based on where we saw market rent, expenses for the property based on represented condition and where we thought we would be at the end of his business plan for disposition. Surprisingly, the deal made sense to us and after a quick back and forth we were under contract.

The summer of 2021 was a crazy time. Honestly, it was a market I hope we don’t return to any time soon. Deals rarely penciled even with moderately aggressive assumptions. Sellers and listing brokers were in total control – that is if you even had a sniff at the deal. Most, mine included, were getting snapped up within the listing broker’s sphere. This building, however, had reach open bidding and we won. There was skepticism but also optimism. Real Estateurs are optimistic by nature. Who would buy a building expecting the value to decrease or the tenants to all default? Who would go through all we go through just for a “real estate return” if not for optimism?

The property tour soon brought other feelings. The first feeling was a sense of unease when we first arrived. Many repairs we were told were done looked as if they had been attempted, but certainly not completed. Fascia hap-hazardly patched, a few very suspicious staircases. We couldn’t locate any AC condensers that had been replaced as billed. The parking lot restriping supposedly from a year before was just a few fill jobs. The building was in disarray and we weren’t even in the units yet. I’ve sold plenty of Class C apartment buildings and know what to expect but it wasn’t looking good from the outside. I told Tony that our assumed CapEx budget was useless at this point.

The property manager arrived and another feeling came – sheer disappointment. We asked him about the repairs, the leases and our normal slew of inquiries. I’ll save the details for brevity and some anonymity, but the point is the deal unraveled and the story became clear. The ownership, tired of managing troublesome buildings had decided to sell its portfolio. When ownership sold its first building, the market went crazy. 1970s tertiary Sunbelt value-add of a certain unit count. On that building the market looked past everything and just wanted the deal. The ownership expected to do the same on this building, save one small difference. It knew the bank had certain document expectation so for this little 8-unit building, it created documents – leases, T3/T12, rent roll, AR, etc. Detached from reality, but documents, nonetheless.  We made the decision to terminate then and there.

Now that story may sound like an adventure in due diligence and a CapEx disaster avoided, but I am using it to highlight an underdiscussed risk in Commercial Real Estate – Counter-Party Risk. In the above illustration, we were running the risk that the other party was flat out lying to us. That nothing we were led to believe about the property was true and that getting to a reasonable level of comfort would have been lengthy, if not impossible. My experience is that extreme examples like this are rare. How about other types of counter-party risk?

Counter-Party Risk is inherent in CRE. A large portion of the value in the industry lies in the inefficiency of the market and information. Simply put, in every transaction there is someone across from you at the closing table making a different bet on the property than you. What information are they using to make a decision that you don’t know? What is motivating their decisions and actions?

Opposing Bets

In every transaction there is someone across from you at the closing table making a different bet on the property than you. It can’t be to the point of stalling any deal-making, but we must ask ourselves, why is this person sitting across from me willing to trade their US Dollars for my property? Why am I willing to trade my US Dollars for their property? Some of the largest fortunes in real estate are made with asymmetric information. Let’s look at some examples of asymmetric information.

Maybe it is straight forward: the buyer of a vacant lot knows how to build a home on the lot and you don’t. The buyer values it more than you.

 Maybe it is nuanced: the buyer knows a few buddies starting developments near your property and your seemingly sleepy corner is now in the path of development. They are banking on the upside.

Maybe it is a looming decline: the seller knows the largest manufacturing plant in the town is receiving government incentives to move elsewhere and the resulting employment loss will hurt the town economy.

Maybe it is a seasoned Real Estateur: the buyer of your vacant retail store knows how to entitle it to allow for a drive thru, has capital partners willing to pay for a building to be built and knows the real estate manager at a chicken joint willing to sign a 20-year lease.

Knowing why the other side wants to transact on this property is crucial in making sure you’re making a wise trade. Knowing allows you to negotiate for maximum return and to mitigate your risk.

Slow Talking, Fast Signing

I fancy myself a smart guy. After all I have three college degrees, subscribe to (and read daily!) four newspapers and follow the markets way too closely. This has actually been a liability numerous times! Sometimes the liability arises in over analyzing and over thinking a simple question. More often, it arises in the most common counter-party risk I see: not clearly recognizing who is across the table from you.

I was early in my brokerage career and wanted to make a big splash with a development project. I started bird dogging one neighborhood and eventually came across an owner willing to talk. His land was perfect for the in-fill development project I had in mind. We started talking and I threw out a few crazy low numbers, foolishly thinking he didn’t know what he had. In retrospect, it was then he knew that I was underestimating him and he had (initially) overestimated me. By the time closing came, he secured his sales price, his terms and I was doing the deal for free! I let it slip that I was trying to build a book of business of in-fill development projects and he used all the information I gave him to get me to broker the exact deal he wanted.

It can be tempting to look a seller with rents written down in a spiral notebook or with a facility with no marketing effort and think they are unsophisticated and you have the advantage. When I talk to these owners, I see the wolf’s teeth under the sheep wool.

On the opposite side, it can be easy to look at a buyer with a decent track record and believe them to be competent buyers. You see they own $20 million in shopping centers and are a logic buyer for your asset, but what is really going on? Are they puffing up capital partners, in actuality do they have too much in the pipeline and are going to cut deals loose?

Knowledge is Power

Hopefully these three examples of Counter-Party Risk have stirred up some similar learning lessons for you. At the end of the day, commercial real estate is straight forward: lease a good product to a good tenant pool, manage well and reap that illustrious real estate return. Getting there is the complex part. Knowledge truly is power. What is motivating and guiding the other side of the table? How do I ensure I’m understanding the landscape and making the best decision?

It all comes down to information gathering. Asking the right questions to get the right information. Conveniently enough, my entire negotiation strategy relies on the same method: asking the right questions to get the right information. More on that in a future letter.