Smart Money in Off-Market Real Estate

-- Graham Hill

"Secret" off-market transactions are always an intriguing topic in real estate circles.  Private, off-market real estate deals have an exclusive "backroom" quality, which makes this subject more exciting than other aspects of real property trades.   Who are these real estate operators that have access to unlisted real estate?  How do they get access to those deals?  And how does the smart money operate in this smaller pool of private, off-market buyers and sellers?

While the title of this piece references "smart money," the initial inspiration is a quote about "dumb money" in real estate, from investor David Lindahl.

Is the Smart Money in Off-MLS Real Estate?

Lindahl likes off-market real estate.  Like many real estate pros, he commonly buys property off-market (he sells off-market too, more on that later).  He is also a "straight-shooter" in terms of the style of his communication, which makes his real estate book Multi-Family Millions such an entertaining read.

In the quote below, Lindahl gets at some of the features of markets where real property is publicly traded.

"They've got all kinds of frantic buyers in the market, and it's their job to get their sellers the highest price possible. After all, higher prices mean higher commissions. Brokers therefore don't care about just relationships; they sometimes put properties out on the open market, where lots of dumb money will fight for the deal."
-- From the book Multi-Family Millions by David Lindahl

There are some powerful assumptions in Lindahl's quote:  We are to presume that there is both smart money and dumb money at play in real estate markets; that there is an open public market, where properties are sometimes made available (but not always, which points to a second, private market); that "dumb money" is perhaps more common in the open market where experience and relationships between professionals are less essential; and that a feature of that dumb money is that it fights for low-return deals. 

Lindahl doesn't exactly say, "be smart, buy off-market" in that quote, but he suggests that if a seller's agent is looking for irrational "frantic" buyers, publicly marketed property is the place to find that kind of "dumb money."  When a lot of uneducated competitors create a "fight" and bid up property prices, all that "dumb money" inflates price, and the smart money moves on to other, more profitable deals.
 
To spell it out: A prevalence of "dumb money" in a market increases property prices, sometimes above and beyond their value, and reduces the potential for return on investment (for buyers).  Because open markets create these kinds of conditions, smart money may avoid these open-market "fights" and prefer "insider" paths to identify and acquire real estate.

Also note: The focus of that quote is really about brokered deals within the relationships of real estate insiders (as opposed to open competition on easily accessed MLS listings); those insider networks are where the smart money is at work.  Lindahl says brokers may go outside of otherwise preferred inside networks seeking dumb money, higher purchase prices, and bigger commissions.  When that dumb money is less likely to be found, brokers would seldom bother to take a sale public, preferring to easier, faster deals within high-trust, established relationships.

There is a lot going on there.  Let's look at some of angles that make off-market compelling to investors.

What is "Smart Money" in Real Estate?

Smart money in real estate refers to buying property on terms that lead to a profitable investment.  This concept may be more applicable to professional investors, but the same sane buying criteria apply in personal residential purchases.  A feature of smart money is that it knows when to say "no."

For many real estate investors, buying valuable properties off-market can be a smart money play, and part of a successful real estate strategy.  While any property that is generating positive cash flow has value, the rate of return is a primary consideration for investors.  By many metrics, and particularly when cash-on-cash returns are considered, a sensible purchase price is a requirement to create suitable profit vs the initial down payment.  Cash-on-cash returns helps investors rank one opportunity vs another; given the same initial capital, getting a lower purchase price for the same investment income will yield better return on capital.

The smart money knows the market, is aware of returns from various alternatives, may be willing to sit out of low-ROI real estate markets, and will display a willingness to say "no" to deals that won't deliver strong returns.

What is "Dumb Money" in Real Estate?

This concept of "dumb money," as Lindahl so eloquently puts it, refers to buyers in a market that buy property at purchase prices that lead to low- or negative returns on investment.  If ROI is the goal, and the buyer over-pays for the opportunity, that buyer can be said to be dumb money.  "Not-so-smart" money is often unaware of the relative value of a property, the value of alternative investments, or the state of local real estate trends; or is impatient; and may be caught up in low-yield investment opportunities where the dumb money says "yes" when projected returns suggest it should say no.

For those familiar with residential buying habits, examples of what Lindahl calls "frantic" buyers are more common.  While professional real estate operators learn to make their decisions based on the numbers only, less experienced buyers - and many buyers bidding for residential homes- make uneducated, impassioned decisions when they would be better off pursing other options.  Every bidding war for property (which is what Lindahl means when says, "dumb money will fight for the deal") has the potential for this impulsivity, particularly as purchase prices exceed value (the property's income potential, the resale value for that property, purchase prices for alternative properties, etc.).

As you study real estate investing, you learn that many of the best deals are traded off-market between insiders, and never hit the public markets at all.  These professional investors will often disparage investment properties that are found on public MLS property listings, as they know those properties have already been passed over by the "smart money," or are over-priced and fishing for less-educated buyers that can't see problems easily seen by professional investors.  Investors that try to buy investment property from online listings on the open market, are often less sophisticated, and don't have access to better deals.

Dumb money is less likely to recognize when to stop bidding, or to say no entirely, and can add irrational competition to a market or a given real estate opportunity.

Sellers Seeking the Highest Prices in On-MLS Transactions

For certain categories of property, the seller would indeed be wise to prepare the property for sale, and make the property's availability known on the open market.

Typically, with the help of a broker, that property would clean up any issues with "curb appeal," take care of any legal or financial hinderances, the property would be professionally photographed (perhaps staged), the property listing would be distributed widely, the agent would communicate with a maximum number of interested parties, and the buyers would be encouraged to compete on price for the property.  This process adds considerable time and expense to the real estate transaction (potentially reducing profit for the seller), but for some types of property, or in certain markets, open market sales can definitely lead to higher selling prices.

Publicly listed, MLS-featured, IDX-distributed properties reach a wider range of potential buyers, and can (and do) create conditions where the seller will receive a higher purchase price.  Some sellers and their brokers may test for that kind of buyer, if such a plan seems likely to work - even if it takes longer, is harder, and costs more.

While higher sales prices are a possibility, it is true that properties of clear value can also be sold at attractive prices in the private, off-MLS market; when the value is clear, sellers can receive compelling offers without needing to put those listings online. 

Particularly among insiders; if the price is fair, there is almost always capital that is ready to take on valuable real estate investment property. 

Smart Money has Connections, and Finds Value Off-Market

For many properties (but certainly not all), the very fact that the property is publicly listed is a sign it will sell over value, that it is flawed, or both.  While that kind of property can still be of value, it may not include the ROI that smart money real estate investors are seeking.

Smart money often finds opportunities off-market, and is less likely to try to negotiate against the added competition in these publicly accessible markets, where dumb money over-bids and inflates purchase prices beyond the kind of value that is attractive to smart money investors.

"We have a client that wants to buy a multi-family building for investment.  We started to network that deal for him, talking with brokers in the neighborhood where he wants property. The first broker said 50% of the investment property sold in that neighborhood was off-market. The next broker we talked to said 60-70% is off-market. Most of the investment deals are done off-MLS."
-- From "Real Estate Investment Strategies in Sapporo"

Instead of bidding alongside the dumb money, insiders work to buy from sellers directly, often when the property is not technically for sale at all.  They also cultivate their relationships with owners and brokers, and position themselves as ready buyers when a suitable deal is available.  Brokers know property owners, and can arrange for a buyer in advance.  These smart money behaviors allow insiders to find properties that never hit the open market, or to sometimes find property at better prices (or at least prices that aren't exacerbated by uneducated bidders).

Part of working your way into these informal, smart-money real estate networks is done by demonstrating to brokers, owners, and lenders that you understand the moves in smart money transactions.  That process can begin by not jumping on dumb-money opportunities.  New investors and operators build their networks by communicating with brokers in a community, by being clear about their investment goals and criteria, by developing a history of being a successful operator, and by being ready to move fast when a suitable opportunity is presented.  Being fast and easy to work with is a requirement, and reputation is everything.

Of course, off-market buyers want the best price.  Sometimes their goals are in conflict with the goals of the sellers... but not always.

Are Off-Market Transactions Inherently Bad for Sellers?

In Lindahl's quote, he says that brokers seeking the highest sales prices for their sellers will seek higher offers (potentially over-valued offers) on the open market.  If that is a possibility, if there is more money to be made by sellers in well-marketed transactions, when is it ever in the best interest of the seller to sell off-market?

Is it possible to have "dumb money" instincts on the selling side, where you miss upside when you sell off-market?  That is possible.  Because off-market sales almost always mean less exposure for the property, which can then mean fewer offers, there can be drawbacks for sellers that agree to sell privately. 

A perceived lack of benefits to sellers is at least one of the stated concerns in the National Association of Realtors® efforts to deter private real estate sales via their pro-MLS influenced Clear Cooperation Policy.

It is true that some of the best buys acquired by real estate buyers are indeed sub-optimal for the sellers.  Sometimes that is because the seller is unprepared to manage their transaction (many of the "cash for homes" sales fit this description), or uneducated about the value of the property, or an unethical broker forces a sub-optimal private sale between his connections so the commission doesn't have to be shared.

There are many cases of sellers losing value in the private market, that is true.  And yet; off-market transactions are popular with both buyers and sellers.  There must be an upside for sellers, or those deals would not be so common.

When Are Off-Market Sales a Good Choice for Sellers?

Earlier we stated that David Lindahl likes to buy off-market property.  Interestingly, he is also often the seller in off-market transactions.  He is a savvy trader of real estate; if public sales are so lucrative, why would Lindahl be so willing to forego all that "dumb money" when he sells off-market?

There are, in fact, several scenarios where the seller has rational reasons for choosing an off-market sale.  Often, the seller gets a great price, and is not sacrificing anything at all.  When a seller does sell at a discount vs open-market rates, there is often upside for that seller from the nature of the off-market transaction.

Sellers that discharge property off-market often prefer the privacy of those transactions (neighbors and competitors don't need to know the property is for sale, nor the selling price); they can sell property "as is," and don't need to make repairs or clear legal or maintenance issues that would be required for a maximum private-sale price; private sellers may arrange for prescreened buyers that are ready with all-cash offers or with more-certain financing; and private sellers may be able to arrange for a sale very quickly, perhaps to free up equity to be used as they trade up into another property they are actively trading. 

Private sellers are more likely to work with prepared, professional buyers, that make the transaction much faster, easier, less costly, and more certain than the buyers that are attracted in public real estate sales.

It may not be obvious to outsiders, but all of these favorable conditions for sellers are pre-established; there is a ready market of well-capitalized buyers that off-market sellers can tap into at any time.  When faster, easier, more professional transactions are available, longer, more-costly public market sales are unnecessary and undesirable.   Off-market sellers may in fact receive as much as they might on the open market, but trade within networks of established players that make transactions more enjoyable and more certain.

Without Public Bidding, How Do Off-Market Buyers and Sellers Ever Agree on Price?

In publicly marketed real estate transactions, marketing the property via MLS systems ensures that the availability of the property is well known, enables more offers, and via negotiation, the range of offers helps to establish a market selling price.  In off-MLS sales, when there are fewer bids (and sometimes only one buyer is involved), how do these insiders establish a fair price, if there is no- or less bidding for off-market properties?

Part of the answer is that this group of real estate traders are more experienced (that is the "smart," in smart money), and they base their pricing and offers off of objective valuations for the property.  When everyone involved in a given transaction is an insider, and the property's income potential is out on the table in black and white (or red), the basic valuation is known; as the players know what something is worth, brokers can float fair offers and prices from that shared understanding to prepared, educated buyers.  Highly experienced players are more likely to agree on value.  When that happens, transactions are faster and easier, and carry less cost that sorting through offers from a less-educated general public.

The potential for value-plays in off-market is still a part of many investors' calculations.  It is very possible that a given investor might buy a building with expected returns, and then through better management (or other efficiencies) create more income than the previous owner.  In those scenarios, those buyers may appear to overpay based on the seller's current valuation (which can create easy willingness in the seller).  Those kinds of value-plays, executed by experienced investors, are not the same as uneducated dumb money buying property that will not generate sufficient returns.

How do Sellers Behave More Like Smart Money in Off-Market Deals?

Incidentally, David Lindahl offers some interesting advice to sellers that want to utilize the best of on-market features in off-market deals.

"Good brokers will do this by preparing a call to offer. They will create a property package and send it to their entire list. By not putting a price on the property, brokers are asking for the highest bid. They are truly letting the market set the price."
-- David Lindahl

Here Lindahl describes a strategy where he asks his broker do limited, private marketing where offers on the available property are actively solicited from existing relationships.  This kind of transaction may still involve multiple (prescreened) bidders without ever being "publicly" marketed.  By making the availability of the property known to multiple, experienced, pre-qualified private buyers, an equilibrium can be found where the seller can explore a ceiling for selling price, from buyers that can easily recognize the potential for profit (or not) in the purchase.

Win/Win Relationships in Off-Market Real Estate

"Good brokers price their listings fairly and want to work with good investors. Those investors run their properties profitably and turn back to the brokers to sell them. Everyone wins."

-- David Lindahl

By watching the way sophisticated segments of real estate operators find win/win deals with each other, students of real estate can improve their understanding of how markets work, and make decisions that will bring them closer to being "smart money" investors.

Buyers, sellers, and brokers that are recognized as professional operators in off-market real estate do well on initial transactions, and also build lasting relationships where they can trade among themselves, again and again.