"Landlords grow rich in their sleep"
- John Stuart Mill
If you are reading this eBook, chances are you're either a current real estate investor or a new investor who understands the importance of having the right information before starting on any new endeavor. You 'get' that traditional paper investments (stocks, bonds, CDs, etc.) will not help you achieve permanent wealth. You understand that only real estate - specifically multifamily real estate - has the best mix of stability, current income and long-term growth to help you achieve your financial goals.
Whether you are transitioning from other real estate assets (land, flipping, mobile homes, etc.) to just starting with multifamily investing, this eBook can serve as your essential guide to setting up and implementing a successful apartment investing strategy, step by step.
From establishing your initial strategy and determining the best match of market, asset class, and approach to developing your team and starting to evaluate deals, this comprehensive apartment investing eBook will guide you through every essential setup you should be taking to effectively invest in multifamily apartments, whether you are completely new to real estate investing or a seasoned professional.
It’s no secret how millions of people became super wealthy by investing in real estate, more specifically by buying rental properties.
It creates a source of passive income that makes you money even while you’re asleep.
The key to success is having as many rental units as possible. More rental units you have, streams of income you’ll get, more cash flow you’ll have, which translates to better, faster growth opportunity, significant profits on your capital, wealth creation.
As a real estate investor having access to readily available capital is crucial, you need it to capitalize on the numerous opportunities that are present in today’s market. One way to do this is by acquiring properties through syndication.
In essence, it’s the pooling of capital to invest in a real estate opportunity. The benefit of putting this capital together is that it might make it possible to purchase and pursue opportunities that one person may not be able to on their own.
After raising that capital, the fund sponsors must then go out to locate and acquire the right property.
A famous example of this was the syndication led by Helmsley & Malkin where they ran a group of investors to buy the Empire State Building in the 1960s for $65 million, many of whom contributed only $10,000 each.
There is a person or company that organizes this investment and that is responsible for managing the whole operation on behalf of the investors. They are interchangeably known as the Sponsor, Operator or Syndicator. Depending on the legal structure of the organization created for the investment, the Sponsor is technically known as the General Partner (GP) or Manager.
Investors are known as Limited Partners (LPs) or Members depending on the legal structure.
As mentioned before, the syndication may be created with a certain tax and legal structure. It is usually created as a Limited Partnership (LP) or a Limited Liability Company (LLC) to own the property on behalf of investors.
The goal of this structure is to create a separate clean entity for management and control and also has the benefit of also protecting the individual investors from further liability beyond this one deal.
In reality, things can get a little more complicated with different classes within these structures and we’ll go into that in further detail in a future post, but at the core, the structures look like the following:
A limited partnership is composed of general partners and limited partners. Limited partners can invest in the business and share its profits or loss, but cannot be active participants in the day-to-day operations of the company.
A limited liability company (LLC) is a corporate structure in the United States whereby the owners are not personally liable for the company's debts or liabilities. Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship. A limited liability company can have as many owners (known as members) as it would like.
For the most part, syndications are typically open only to accredited investors. To be considered an accredited investor by the SEC, you must either:
Have an income of at least $200,000 each year for the last two years, or
If you’re married, have a combined income of at least $300,000 each year for the last two years, or
Have a net worth of at least $1 million, excluding your primary residence, either individually or jointly with your spouse.
The income test cannot be satisfied by showing one year of an individual's income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test.
A person is also considered an accredited investor if he has a net worth exceeding $1 million, either individually or jointly with his spouse. The SEC also considers a person to be an accredited investor if he is a general partner, executive officer, director or a related combination thereof for the issuer of unregistered securities.
An entity is an accredited investor if it is a private business development company or an organization with assets exceeding $5 million. Also, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor. However, an organization cannot be formed with a sole purpose of purchasing specific securities.
If you qualify based on income, part of the qualification is the expectation is that you’ll continue to make that income in the coming year.
Syndications will typically ask you to provide a letter from your accountant stating that you qualify, ask you for two years of tax returns, or send you to a third party site to validate your info.
The reason for this is that syndications raise capital through an exemption known as Reg D created by the SEC. In short, this states that these offerings do not have to be registered with the SEC if they are not marketed to the general public and the investors consist only of accredited investors.
It’s usually quite expensive and complex for them to go through the SEC, so they often go the route of Reg D. With the JOBS act, some of that marketing has been relaxed but the need to have accredited investors remains basically the same.
The following is how the process typically works, using a single property investment as an example. A sponsor finds a property that they think would meet investment objectives, makes an offer, gets it accepted, tying the property up in what’s known as the escrow period. They perform their due diligence, figure out the financing necessary, then to create an investment package typically referred to as a Private Placement Memorandum or PPM.
This PPM will include:
The sponsor will then go about raising money from investors. They will decide a minimum investment amount and therefore have a certain number of shares or slots available. Once there is enough capital and the financing is worked out, the property will be purchased and the sponsor manages and operates the property.
Distributions and profits are given as outlined in the PPM (waterfall structure). Fees are taken as well. Upon disposition of the property (sale), the proceeds are given out and split up as again outlined in the PPM.
There are many ways to invest in real estate, and syndications are formed for nearly every type of investment property. Every type has its own special set of strategies and therefore you will usually see operators sticking to what they know. For example, the big multifamily sponsors typically stay in that lane and the ones in the hospitality sector stick to their own. Once in a while though, you’ll see a group venturing out.
The strategy is of these syndications is basically to improve the operational numbers of the property (increase net operating income) and ultimately sell the property down the line, for example in 5-7 years.
This is just another term for apartment buildings. This type of investment is easy for the average investor to understand to a certain degree. People need somewhere to live and with the rates of homeownership dropping particularly in metro area, rentals (particularly apartments) will continue to be in high demand.
Sponsors run and operate these properties and manage income (rent & other income producers like storage space, garages or laundry income) and expenses (utilities, maintenance & upkeep, landscaping, renovation, etc.).
Retail properties are stores like strip malls or large tenant stores with an anchor like a Target, grocery store or Home Depot. They have longer-term leases and carry it’s own set of unique challenges. Keeping vacancy low is important but finding tenants for these properties can be more difficult. You’re somewhat reliant on traffic into the area so understanding the winds of change and economic dynamics in that area are important.
Hospitality properties like hotels and motels are usually housed under retail, however, understanding how to invest in one of these opportunities conceptually seems very different. Therefore I like to put it in its own category.
Sometimes you will see these opportunities as building their own brand of hotels, but often, the opportunities I’ve seen are of syndications purchasing existing properties, usually branded ones like a Residence Inn franchise, and figuring out how to improve the operation overall.
This category is made up of warehouses and production facilities and often deal with larger and longer-term leases. Companies need places to manufacture, store, and distribute products from. Think of Amazon and the warehouses they use to do all their shipping.
Office space is easy to understand, especially for physicians. Who owns and operates the building you have your clinic in? It may be the hospital, but it also may be a syndicate. Just like it is for all of these other opportunities, keeping occupancy rates high with good rents is the goal.
Like any other investment opportunity, investing in syndications has its pros and cons. It’s important for you to understand what they are and if it helps meet your financial objectives.
1. You know which exact property you’re investing in, as opposed to REITs and RE Funds and you can see the exact strategy the syndicator is planning to use Pass-through tax treatment, in particular, depreciation and interest expense.
2. Can participate in a 1031 exchange
3. Can allow for diversification – Because you’re only buying a small share, you may have the ability for you to invest in other opportunities at the same time instead of having all of your funds tied up in one property
4. Access to large investments with professional management Liability protection and protection from personal credit risk
5. Very passive investment – Majority of the work is done up front by vetting the opportunity and sponsor
Lack of liquidity – Locked in for whatever the term might be. When you are invested in the syndicate, you have to be patient and understanding that you need you follow the plan and rules set by the sponsor to maximize your, your partners gain, so you can not ask for the money if the property is not set for sale yet. It may be possible to sell your interest but it may be complicated and time consuming.
Now let’s dive deeper into the specifics of the most desired and lucrative type of investment opportunity.
Multifamily Apartments have 7 important long-term characteristics you need to keep in mind:
1. Multifamily Apartments Are 100% Evergreen
2. Multifamily Apartments Are Stable
3. Apartments Provide a Unique Combination of Returns
4. Apartment Investors Can Shape Their Return
5. Time is an Investor's Ally
6. You Get Time and Money Leverage
7. Investors get an Inflation Hedge
1. Multifamily Apartments Are 100% Evergreen
After physical security, food and shelter are the two most basic needs for everyone. I know this makes sense, but many people forget about this fact when comparing multifamily real estate to other real estate asset classes and other businesses. As an owner/investor in apartment buildings you are investing in a basic need that will never go away.
2. Multifamily Apartments Are Stable
According to NCREIF (National Council of Real Estate Investment Fiduciaries) and Torto Wheaton Research multifamily apartments have the highest risk adjusted return of any real estate asset class over any 10, 15, 20, 25, or 30 year period.
Can you make more money sometimes in other asset classes if you time the market right?
Of course. You are also taking on more risk.
Multifamily apartments compare favorably versus other investments:
Stock Investments: The overwhelming majority of individual stock investors cannot beat the market. When you consider that the S&P long term average including dividends is 6.1% and that most individual investors underperform the market by 3.6%, the majority are barely breaking even with inflation before you take into account the drag from taxes.
The majority of investors barely break even with individual investments.
Residential Real Estate: Foreclosures are just south of 10% but peaked above that number and even higher in several states, most notably California, Nevada, Arizona, and Florida.
New Business: 80% of new business ventures (non-franchise) fail in their first 5 years.
Gold and Precious Metals: While they have been trending well in recent years, provide no income and are considered a hedge or speculation by most professional investors and are too volatile to be a core investment class.
Oil & Gas: Both have some excellent tax advantages like real estate but are subject to wild fluctuations in price due to world events, economic cycles, and exploration activity. Keep in mind that it is also a depleting asset. There is no appreciation and principal pay down with an oil well.
3. Apartments Provide a Unique Combination of 4 Returns
One of the reasons why apartments are much safer than most other asset classes is that they have 4 types of return that provide both benefit diversification and benefit leverage not available in any other asset class.
Each apartment building is really its own standalone business with all standard business functions - marketing/sales, operations, finance, etc., and with its own profit and loss statement - Gross Income, Fixed/Variable Expenses, Capital Improvements, Debt, etc.
The property's net income provides you with an income stream that is both highly controllable and stable.
The net income from the property- rents plus other income minus operating expenses and financing costs - provides an income stream for the apartment investor that is both highly controllable and stable.
The valuation of income producing real estate is primarily driven by the risk adjusted rate of return of the property (i.e., Capitalization Rate). This expected rate of market return for any given investment is the "market."
Since it is primarily driven by economic performance (assuming the asset is in good condition), you can increase the value of a property through increasing income (rents) and controlling expenses.
Thus you can experience appreciation from natural market rate inflation, improvements in rental rate, decreases in expenses or in many cases all three.
(3) Principal Pay Down
Depending on the terms of the loan you can get an almost automatic equity increase of 2% to 4% every year just based on principal pay down - where your tenants are paying down your mortgage.
Gain 2% to 4% of nearly automatic equity every year by letting your tenants pay down your mortgage.
This is equity you build in your sleep on top of your net income and appreciation benefits.
(4) Tax Benefits
Income generating real estate is one of the most tax advantaged investments you will ever make. Not only is each property treated like a standalone business with it's own profits and losses (e.g., expenses, interest on debt, etc.) but you get several other unique benefits not available to any other asset class.
Depreciation - This is the paper-loss you can use on your tax returns that represents the incremental wear and tear of your real property and in many ways offsets your capital improvement costs.
You can structure your investments so your depreciation benefit can offset and defer tax on all of your net income from the property for the first 7-10 years. And, even after that benefit doesn't completely wear off.
Tax-free Refinancing - You can extract excess equity in the property via a cash-out refinance (sometimes called equity harvesting/farming) and reinvest it in additional
Income producing assets. This ability to redeploy your equity lets you accelerate your Return on Equity (ROE) dramatically.
1031 Exchanges - When you sell multifamily apartments you can defer the capital gain almost indefinitely by using the 1031 Starker Exchange. While there are rules you have to strictly follow when completing an exchange (and we have done several) the ability to defer your capital gain and leverage that into a new investment removes a huge drag on performance that no other investment class has.
When you combine the unique combination of these 4 benefits - Cash Flow, Appreciation, Principal Pay Down, and Tax Benefits - you can begin to see why most millionaires make their first million from real estate of business ownership and more than 90% of the Forbes 400 use commercial real estate to retain/grow their wealth.
Most millionaires make their first million from real estate or small business. 90% of Forbes 400 use commercial real estate to retain or grow their wealth.
4. Apartment Investors Can Shape Their Return
Each time you make a new apartment investment you can adjust how and in what way you achieve the four benefits above. Need to maximize income? If so , focus on reducing debt costs, extending the amortization window and/or get interest-only debt and get as high an LTV as is safe to manage. Looking to maximize tax advantaged equity growth? Take a shorter amortization window and structure it so the property is very close to cash flow neutral. All your depreciation on the property will bank or if you have professional real estate investor status you can use that excess depreciation to offset any other source of income.
5. Time is an Investor's Ally
Because of normal inflation and supply/ demand pressure, it is very rare for apartment investments not to experience natural upward pressure in rents and income (assuming a decent market and a well kept up asset). So even if you aren't overly aggressive in improving the property and pushing rents, you can still experience increased income and appreciation over time.
"Don't wait to buy real estate. Buy real estate and wait."
I know several investors that just ride the local rental market with a relatively hands off approach that generate double digit returns every year while they travel through Europe. Not bad.
6. You Get Time and Money Leverage
When you own commercial multifamily buildings you get both time and money leverage. On the money side you can leverage lender financing (regional bank, Fannie Mae, Freddie Mac, Life insurance companies, Conduit, etc.) to control the property with safe loan to value (LTV) levels in the 60% to 75% range.
This leverage creates a multiplier effect on your invested capital.
If you purchased a 50-unit property for $2.5 Million in cash and it appreciated
$250,000 due to rental increases in the market, that's a 10% equity gain.
If on the other hand you purchased the $2.5 Million property with 30% down ($750,000) with regional lender debt providing the remaining...
The same $250,000 equity gain is now a 33% return on investment. This is a 230% increase in your returns and allows you to control an asset with far less initial capital.
Understand that leverage can work against you too if you don't know what you're doing. But with a strong market selection process, good operations, and stable asset classes you can significantly reduce your risk.
Depending on your income/lifestyle goals you can also enjoy a significant amount of time freedom. For example, I am majority owner of several apartment complexes in 3 states nowhere near where I live and I spend 10-15 hours a month on my investments. I could spend even less, but like most of you I want to optimize my returns as much as a I can so I stay on top of my staff and management teams.
This time leverage is possible because our firm hires the best regional property managers possible to manage our properties. Each year we review the property's performance, set a realistic yet beneficial operations and improvement and the manager works that plan. As a bonus the manager is paid out of the operations of the property and is directly incented to ensure the property does well.
7. Investors get an Inflation Hedge
Income producing commercial real estate is also a hedge against inflation. As the CPI (Consumer Price Index) and PPI (Producer Price Index) indices rise so do rents and building costs.
This increases the value of currently operating assets because increasing rental income generally increases the value of the property. And, increasing build costs create some degree of a value floor for operating assets.
When you put all the benefits together it's easy to see why multifamily apartments are a strong investment and should be a part of any serious investor's portfolio.
Real estate outperforms inflation by more than 5% historically.
THE RIGHT STRATEGY
What is your MAC Profile?
Every year we perform hundreds of new investor consultations and many of those conversations include reviewing prior investment projects. Invariably we will have investors that are keenly interested in real estate investing, even though their results have been less than desired historically.
Once we are able to review their portfolio and the decisions that led up to their investment we find that most new investors are troubled by the same mistakes:
They don't understand their market
They have not matched their approach to what the market favors
Their capability does not match their approach
Their MAC Profile (Market, Approach, Capability) profile is out whack.
Your MAC Profile is just one component of your real estate investment strategy but one that is critical to your success.
One example of this is when you find a storage center developer/builder building new apartment units outside of the path of growth in a market moving from absorption to oversupply of apartments. Or, when you see a new investor purchase a cash flow home to renovate and flip for retail sale in a primarily renter neighborhood when the economy is declining and they've never done a renovation/ flip before.
If your overall strategy is to stay in your local market and become a local market specialist then you will be limited by your capability match and approach.
Remember, the market always wins. There are zero exceptions to this rule.
What you have to do then, if only working in your local market, is ensure that you can be flexible in your asset class or be able to hire/develop capabilities in areas you don't have. This introduces risk and uncertainty in your business model.
Here are some of the key considerations for each area:
Capability (What are you good at?)
Real Estate Investing is a team sport.
While you will be purchasing buildings and operating them like businesses, you need to have a good team.
Depending on your approach your primary team will include something like the following roles/capabilities:
As a quick disclaimer, there's absolutely nothing wrong with self-managing your assets. In fact, I know several real estate millionaires that have done just that for years in their local markets. It all depends on your preferred asset class, local market, and your desires/capabilities.
At one point our firm had a 100 property residential income portfolio made up of single family homes, duplexes, triplexes, and quads. It was profitable but the work required to keep it profitable was 3 to 4 times what was required in our apartment assets for the same economic benefit.
Based on our experience, working with professional 3rd-party property managers for the 75+ unit apartment market is the only way to go.
A good place to start looking for good fee based management in your preferred market is through one of our associates who is in charge of the property management.
Contrary to what the latest apartment investing guru will tell you more than 90% of all commercial real estate transactions occur through brokers. You can find deals through banks, bird-dogs, auctions, etc., but the odds of it being in a good market/ sub-market are very low if it was obtained through those channels.
In fact, many of the best properties never make it to market and are held as private/ pocket listings by the strong commercial brokers. They have developed the relationships with the local apartment owners so you need to develop a relationship with them.
Real Estate Attorney
Once you have identified a good market, sub-market, and management team, it's a good idea to research and interview several real estate attorneys to help you.
Ideally the same firm/attorney should have extensive experience in your market, commercial real estate in general and your specific asset class. They will be able to help you with contracts, title research, zoning laws, transaction support, escrow/ closing services, etc.
If you are raising money for your investment projects and the people providing capital will not have direct control over the operational/investment decisions and are instead relying on the underlying asset and your management of that asset, then you have likely securitized the investment.
This is typical when you have more than 4 or more investors and a sole-purpose entity like a limited liability company or limited liability partnership are created to hold title to the property.
Learning how to be a good steward of investor capital for real estate investment may seem daunting at first. I know it was for me. But, it is one of fastest ways to accelerate your wealth in commercial real estate and along the way you get to be somebody's hero.
You also have to do it right.
Once you start taking investor capital you are now a fiduciary and fall under SEC oversight. So it's worth getting it right the first time.
Depending on where you are located and where your investment properties are located you will need one or more entity attorneys to structure your legal entities correctly.
It is important to get this right the first time if you can because switching your organization around can be expensive and complicated.
A good entity attorney team can help you navigate the right balance of business strategy, tax management, and liability.
Whether it's you, an internal resource on your team, or a CPA for hire you will need good operational accounting.
Commercial real estate as a business model is not that complex, but it does require consistent work every month to close/verify the books, reconcile rents, expenses, debt service, capital reserves, etc. Some of this will be done by the property manager, but depending on your size and business model you will take on some of these responsibilities.
A good CPA will also setup your financials for a clean tax prep and good numbers for a tax strategist to work with.
We separate accounting from tax prep/strategy based on our direct experience over the past 15 years. A good CPA/Accountant will keep you from making mistakes but they may not have the knowledge, confidence, or appropriate licensure to help you structure your business to legally minimize taxes.
Real estate investing is a highly tax-advantaged investment. So using a good tax strategist is even more important as it is possible to structure your investment business so that you can legally defer all income and all capital gain while enjoying tax-free refinance events.
This is a tremendous boost to your overall returns and why 90% of the Forbes 400 uses commercial real estate to retain and grow their wealth.
Not all commercial insurance is the same. You have to consider the traditional hazards such as fire, theft, and damage. And, you have to think about larger issues as well since you are operating a business.
Things such as commercial liability, flood, acts of terrorism, natural disasters (earthquake, tornado, hurricane, etc.), business income replacement and more.
You can't buy insurance after the fact.
So make sure you price in the appropriate coverage for your business model before your purchase. Don't ever just go for the cheapest insurance. It could ruin your career.
It is not strictly required that you use financing on your investment property, but if used appropriately it can materially increase your overall return from income and appreciation and principal reduction is only possible using a combination of debt and equity.
Having a mix of financing options is absolutely critical to your success. Some key sources of debt financing are:
By having the right mix of mortgage brokers and funding sources you can fund any project.
There are a few other specialty team members you'll need to bring on in an as needed basis:
Rent-up and occupancy specialist to get new construction or large turn projects occupied fast
Cable/Internet bundling consultants to help you provide better service to your residents at a more attractive cost to you then just ad-hoc pricing
Cost segregation professionals so that you can optimize the depreciation benefit of each asset
Tax assessment legal teams so that you can manage your property taxes down
There will be more.
Just keep in mind that commercial multifamily is a team sport. So get good at finding and directing the best talent possible.
The overall market you invest in is arguably the most important determinant to your success in apartment investing.
The metrics that control your success - population and employment - are a function of your overall market.
The bad news is you have no control over the market.
The good news is the data regarding the overall health of the market is readily available if you know where to look, changes very slowly and the trends last for a very long time.
There are 17 different metrics and data points that we look at for the Metropolitan Statistical Area (MSA) alone. In this chapter, I'll cover 5 of the 17, approaches we use to reliably get the information.
5 of the most important metrics to review when analyzing an apartment investment market are:
Population Growth Rate
Employment Growth Rate
Components of Job Growth
Of all the metrics that predict future market volatility, population growth is probably the most important.
The housing requirement - single family vs. rental home vs. rental apartment - will vary based on the components of population growth, but ultimately:
More residents = More demand.
The more new residents that are coming into the market, the more housing is required.
Keep in mind, that what we care more about is steady population growth over the long-term rather than being a top 10 location for population growth. For us average to above-average population growth is fine as long as it's positive and long term.
You can see how this plays out in apartment pricing, new construction, rental rates, etc., with every major market. Where you have either rapid or gradual declines in population, you also have stagnant to negative performing apartment assets.
So, if you live in a market with flat to negative population growth be very cautious about purchasing apartment assets as the most underlying fundamental is working against you.
To get the population numbers for any major market simply check www.census.gov.
The largest driver of rental demand is population growth and one of the largest drivers if not the largest driver of population growth is employment growth.
Simply put, more new jobs equals more net migration, which equals more residents.
When analyzing a market you want to understand it's job creation trends. Is it a steady jobs market? Does it fluctuate at a greater rate than the overall economy? Over what period of time has it been stable? If the employment growth rate ebbs and flows in a more volatile way than the overall economy, what forces are driving that?
In general, the larger the market the more stable the job growth because there are many more job creators (existing and new business).
Three general rules to keep in mind:
1. Healthcare, government (federal/state/local), and higher education jobs rarely relocate and tend grow over time.
2. Military jobs can fluctuate more than you think. BRACs (Base Realignment and Closure) and deployments can and will impact you especially in markets where the military is the bulk of the job growth.
3. Manufacturing and virtual service jobs can be volatile regardless of the economy.
Components of Employment Growth
In addition to the overall employment growth numbers, it's very important that you understand where the jobs are coming from.
Specifically you want to know:
How stable is the job source? If service and retail jobs, be very cautious.
What types of jobs are they? Does it attract white collar college educated residents or blue collar trades or minimum wage?
What age group is the dominant employment growth drawing? The 18-34 group is the largest group that rents. Is that where the jobs are being created?
Looking at unemployment and components of unemployment is different than employment growth.
While not typical you can see a market with rising employment growth with no corresponding impact on unemployment. This occurs when the new job creation demographics/capabilities are different than the current unemployed base.
What you want to look for in general though is a market where unemployment is less than the overall US market. If you have a steady trend here, then odds are your market will be comparatively better for apartment ownership than those with unemployment rates that are either very volatile or greater than the US average.
Multifamily apartment investments sit in the middle of several different local and federal policy influences:
Federal equal housing laws
Federal state, and local business practices
State and local landlord/tenant laws
Shelter. It's not only a business, it's a basic human need. So, you have several voices impacting how and in what way you operate your apartment investment.
This impacts your tax bill, your allowable marketing practices, required property living standards, and specific to this conversation, your and the tenant's rights.
Evictions can and will happen. Even in brand new A grade apartment complexes. The percentage of eviction and bad debt activity increases as you move down the apartment grades from A to D, but it's an issue for everyone. So you want to be in a state that provides favorable or in the very least neutral treatment to the landlord in eviction and bad debt scenarios.
For example, we tend to work in relatively neutral landlord/tenant states where evictions can take anywhere from 30-45 days and if a tenant breaks a lease (a legal contract) they are responsible for the economic harm caused to the landlord.
What you don't want to do is work in locations where evictions can take 3-6 months and during the whole time you have no rental income and no recourse to the lost rental income after the resident is eventually evicted.
In fact there are several states, California being the most notable, where you can find websites on how to game the eviction system and stay in a property rent free for 6+ months while working/dodging the legal process.
Markets (MSAs) are critically important to get right and all professional investors will ensure they are working in a strong market or one they know intimately before they ever look at an asset.
Find, evaluate and invest in only the best markets. You don't control the market so if you invest in a bad one it will limit your returns and increase your risks.
Good overall markets are characterized by stable population, stable employment, solid growth in the primary rental groups of 18-34 and over 55+ and several other metrics.
But what do you do once you have a good market?
Can you just buy anywhere in that market safely? The answer is no.
Every market has its own submarkets and neighborhoods that have and will continue to perform better than others. And, they have particular characteristics that you can research and verify prior to any investment. I've summarized a few submarket considerations below.
The first and arguably most important statistic is crime. Nothing will reduce the overall grade of the surrounding area more than elevated crime levels. And, not just any crime either. It's not uncommon to see very nice neighborhoods have slightly elevated petty theft and burglary numbers. It's worth watching but not that critical.
Nothing will reduce the overall grade of a market like elevated crime levels.
The most important crime stats to track are violent crime and drug crime. I know this is obvious, but it's also surprising just how many times new investors don't check this all important metric about their area.
We have seen and worked in areas that are solid blue-collar neighborhoods with very profitable B grade apartments that look the same or slightly older than neighborhoods with high drug crime. It will absolutely impact the performance of your property and your ability to sell/refinance down the road.
The best way to get this information is to call the local precinct. They will have the local crime stats and should even be able to point you to the stats for the entire city.
Some of the internet sites like Spotcrime.com and others are useful, but they can be inaccurate and can rely too much on self-reporting and data scraping from other websites.
One item to note, is that crime is not an objective standard. Across different MSAs crime reporting can be better or worse and "good" crime numbers also vary by state/city.
What you want to look for is relative crime compared to the rest of the market. We can tell you from direct experience ourselves and working with other property managers and real estate investment firms that the neighborhoods in the top 50% of crime compared to their local market will materially underperform the other half in terms of rentability, rent growth, eviction rate, bad debt, etc.
Retail, Jobs, Entertainment Grade and Proximity
People want to live close to where they work, shop, play, and go to school. This is a basic human fact. When considering strong markets/submarkets to invest in then, it's very important to understand the match between property/resident grade and the grocery stores, retail, education, entertainment, etc.
The quickest but not the most comprehensive method to verify this information is the Google maps (maps.google.com). Using Google maps you can switch between map view and satellite view and even zoom down to the street level. Using this tool you can in a few hours or less understand the general job center, retail center, grocery, entertainment, and education options in the 1-3-5 mile area surrounding any prospective property and the characteristics of the overall submarket.
Then once you have a property under LOI (Letter of Intent) and/or PSA (Purchase & Sale Agreement) you can perform the actual 1-3-5 analysis via your drive around to confirm your Google maps findings and get better detail around surrounding property conditions.
I think it's obvious, but you don't want to own an A or B grade asset surrounded by C grade retail. There's a concept in commercial real estate investing called "market gravity." And that eventually all real estate in a particular market will trend towards the average grade. If you have a under managed C grade asset in a B market this can be a great thing. The reverse, however is a recipe for a frustrating investment.
Unless you are only marketing to renters that will never have school aged children, schools matter.
They impact your resident based, the local housing grade, the retail surrounding the property, and more.
That said, you don't need to be located in the very best school system ... just one that is comparatively strong in the market. For B grade apartments you want to see school grades for your surrounding area in the top half to top 3rd of all schools in the MSA.
Better schools equal, better and more involved parents. Better and more involved parents - regardless of socioeconomic class - equal lower crime and better housing grades.
There are several more submarket/neighborhood considerations, but just understanding crime, schools, and retail match will help improve any new investor's results.
We actively use and teach more than 10 ways to find solid apartment properties.
I'll share with you two of the most readily available, how to get started, and some ways you can get dependable deal flow from these sources.
Remember from the first few chapters, don't even begin to start looking for an apartment investment until you have a well defined approach, market, and asset class match. This includes a strong property management options, whether that's you or a third party.
and are both viable new apartment investment sources, but you have to know how to use them and it's different than you may think at first.
First off, you have to understand that there is no legal requirement that a commercial property being represented by a broker has to go to a public listing of any type. For example, a commercial broker could get the listing agreement from a seller, never list it on any MLS service and sell it to a buyer in the market with no public awareness at all. We have acquired many projects this way.
We have also worked with brokers that go directly to prospective sellers on our behalf. If the property type, location, etc. fits our profile in a local market, they will go direct to the seller and look to negotiate a deal - again with no listing exposure.
So then how do you use the listing services?
First off, many national and regional brokers will list their properties on LoopNet and CIMLS solely for Publicity and Search traffic. This creates more awareness for their brokerage, their local team, and their market. If a materially qualified buyer comes through via those sources, that's fine. But realize most of the time a good broker will already have their buyer network developed and interest already working prior to getting the listing for a project.
You can leverage LoopNet and ClMLS to find out what brokers are moving your desired property type in your market and depending on whether it's a disclosure state, what the properties are selling for.
Scan the free subscriptions of LoopNet and CIMLS to find out what brokerages and what brokers have the most listings in your property type and submarkets. Odds are they can be a good source for you or may know of others that are.
Second, you can use the listing services to understand how properties are being communicated and sold in your market. From a valuation perspective some markets focus on price per unit. The larger tier 1 markets tend to be price per rentable square foot. Others are purely cap rate focused.
By using the listing services though you can find out that language used to communicate price comparisons in that local market.
The third way to use the listing services is for submarket insight. I don't mean the demographics and statistics included in the offering summaries for the listings. In many cases this information can be useless. The real way to use it is to understand trends. Specifically, are you seeing multiple properties in a submarket go up for sale - especially far more than normal? Understanding the trends at the submarket level can help you get better deals.
Are several projects being sold by the same seller? If so, perhaps you can create a relationship with the seller to buy properties from them over time. If you have a buyer trading up or consolidating but they have assets that meet your profile, it can be a great long term acquisition relationship. Are several projects for sale in an area due to a downward trend in that submarket? Perhaps a major job center closed down. A military base moved. Crime has escalated. Or, it could be one of several other reasons putting downward pressure on a submarket. If so, you might see an uptick in sales activity.
Of all the properties in our portfolio were found using our custom search methods. But, we do look at the listing services for our preferred markets weekly to get a sense of the local market, brokerage activity, etc.
You should do the same.
With regards to item 2, there is no such thing as objectivity.
If the broker is representing the seller than it should be very obvious that they have the Seller's best interests at heart in the transaction. If they are representing you, then they may have your best interests at heart, but they also don't get paid unless a deal closes. Regardless of the broker this creates material conflict of interest. it can and does work, but you need to be fully aware of the dynamic.
You are 100% responsible for your own due diligence on a property.
The best thing you can - and get this prepared as part of your Asset, Market, Approach alignment from beginning of this guide - is to be very clear on the type of property you want. If you can specify just the following to brokers in your target market, you will go a long way towards finding a good broker relationship and your preferred investment type:
Unit Count Range (e.g., 100-200)
Submarket and Asset Grade
Physical Condition(e.g., physical distressed, operational distressed, market perform, etc.)
Build Vintage(e.g., 1980 -1990)
Physical Characteristics (roofs, 2-3 story, garden style, etc.)
Cap Rate Range and Rent, Growth Range
There's more, but the above will give you a great start.
I used my own money when I purchased my first two apartment projects. And when I wanted to buy a third project. ..well, I had no more money.
It is not a requirement that you learn how to raise capital to purchase more buildings or to purchase more units per closing, but it is the fastest way to accelerate your wealth.
It's just a function of your goal. If you had $200,000 to invest in smaller multifamily units you could probably buy one $700,000 to $800,000 building (with 75%) LTV or two $350,000 to $400,000 buildings with the same debt level. But once you were in these deals you couldn't buy anymore until a) you accumulate more of your own capital or b) you get to a liquidity event (refinance or sale) on the existing properties in the next 5, 7, to 1O years.
With my first two smaller projects I invested $415,500 of my own money with a return expectation of 7% cash on cash and an overall IRR (Internal Rate of Return) of 13%. For a small business owner and prior stock and options junkie this was palatable especially when you consider the demographic trends, reduced volatility and inflation resistance. Apartments just made much more sense to me.
And I wanted to do more, but I couldn't at the time. I didn't know how to syndicate projects and bring in other investors. I didn't know the SEC requirements or hurdles to avoid. I didn't know anyone who could teach me what I needed to know.
Because, I didn't want to screw up with either my money or more importantly investors' money. Until I met my first mentor...
After working with my mentor for less than a year I was able to put together a 112-unit $4.7 million apartment building raising over $2 million in investor capital. This added over $150,000 to my personal balance sheet (just my share, not the whole project) and over $45,000/year in passive income.
I used $0.00 of my own capital.
And since then we have gone on to refinance that property extracting over $1.1 million in equity, increasing our monthly income and making our investors very happy. This is the power of capital development.
Just learning how to develop 10 investors at $100,000 per investor ($1 million total) could change your financial future forever.
That would allow you to purchase a $3 million to $3 .5 million apartment project.
Developing just 10 investors at $100,000 each could change your financial future forever.
Then over 15-20 years and a few refinance events you could increase your ownership share in the property tremendously and have created $1 million or more in equity for you and your family just from one project (all very part-time).
There are several different ways to fund your apartment acquisitions - all equity, all debt, and the most common combination debt and equity. Let's cover the most common scenario first.
Debt & Equity
This is the scenario most investors are accustomed to and how you most likely purchased your personal home. 70% to 80% of the purchase price will be debt sourced by a local bank or national lender. The rest will be cash. For your personal residence it must be your own cash. For commercial multifamily, the cash can be sourced from you, other investors, or a combination of both. This is, in most scenarios, the best combination of yield, leverage (helping appreciation) and principal pay down.
This is basically an all cash transaction to the Seller. For you, it can be all of your own cash some combination of investor cash and your own, or all investor cash. All equity tends to be the best solution for distressed assets where you can create value quickly and where it's hard to get lending. If you are optimizing for yield in the short term however, it is not the most effective way to purchase new projects.
All debt is actually a hybrid project. You will have some type of traditional multifamily debt capital and the rest will be sourced by secondary and tertiary debt.
Investor debt (collateralized in second position against the asset or the Sole Purpose Entity that holds the asset or as unsecured debt. Note, your interest costs will go up the more you move away from strong collateral.
Specialty construction/rehab debt from local lenders
It's difficult to address it completely via a few pages in this guide, but if you are raising investor capital to purchase apartment buildings then you are more than likely creating some type of security. This is called syndication.
If you are creating a syndication, then ensure you work with a qualified SEC attorney that can help you structure your communications, education, documentation, and processes so that you stay 100% SEC compliant.
It's not that hard to get it right, but you do need to follow the rules . A SEC "cease and desist" order will ruin pretty much any deal you're working on and make your life very difficult for the next few years.
Your funding choices will dramatically affect your returns and risk exposure. While we know of a multitude of ways to fund deals, we tend to stick with the most proven combination of 25% to 30% equity and the rest high quality debt (good rates, terms, lender relationships, etc.)
We could fill a couple hundred pages on the full property evaluation process that we use, but I think you can get a very strong start by just using the right sequence and focusing on a few key items.
First off, you have to avoid at all costs, any premature evaluation.
This is when you evaluate a property via the Offering Memorandum from the selling broker and the respective financials before you fully understand and approve the following:
1. Metropolitan Statistical Area (MSA)
2. Submarket & Neighborhood
3. Future Property Management
You have to go through this process first to reduce and if possible eliminate observer bias.
Observer bias is when you filter the observations to only see the facts that confirm your desired outcome.
It will kill you in commercial real estate investing. So, you have to follow the strict process.
That said, one nice development about investing today is how much information is available via the internet.
In most situations you can complete a very detailed remote property evaluation - enough to trust your Letter of Intent submission (LOI) and reduce observer bias with just:
The Offering Document,
The Current Rent Roll, and
An Internet connection.
Once you have that initial set of information, it's time to start your initial screening. At this stage you are filtering, not analyzing. And, from the very beginning keep in mind that "you can't control the market."
Follow this sequence:
From the Offering Memorandum look at the property build year (anything built before 1979 could have lead based paint and/or increased asbestos material usage) and style.
Seriously consider whether you want to buy an asset older than this without an environmental remediation certificate.
Garden style 2, 2.5, and 3 story assets are the most common suburban apartment type. As you move to coastal and urban markets, you will see complexes add floors and go vertical. This will increase your density, which will typically reduce your shared grounds per resident, add elevator expense and other nuances.
Then look at the unit count and mix. Are you looking for 100 unit complexes in the 50k/door range? If so, you're probably shopping for 80 to 130 unit assets that are
~B/B- grade assets (depending on your local market).
Also look for a mix of 1, 2, and 3 bedroom apartments. A good mix (not in a student or urban location) is 60% 2Br, 25% 1Br and 15% 3Br.
Using the property address verify the surrounding school and crime stats in the 1-3-5 mile areas. Schools in the bottom 113rd and violent/drug crime will be immediate knockouts.
Sites like the following are good resources.
Only after you have verified age, property grade, unit count/mix, and neighborhood crime/school stats will you evaluate the financials.
Your market controls a lot of your property's performance. So there's no sense in looking at financials - especially Seller/Broker prepared financials - until you're comfortable with the items you can't control
Ok, financials. This is where you have to take off your real estate hat and put on your business hat.
To complete your preliminary financial evaluation, you will need the trailing 12 financials (also called T12) or even better current year financials and prior 2 full years. This will include the income statements, balance sheets, and current rent roll. All should be available before LOI submission. If you can, try and get the current delinquency report too.
With this information from the Seller and your own market information collected through comp research and your future property management company, you should be able to perform your financial analysis.
It's outside the scope of this eBook to perform a detailed financial analysis, but I do want you to have some very important rules of thumb.
Just following these will help you avoid some of the largest mistakes new investors make.
Rule #1 - Only underwrite current reality
Underwrite the property based on the current rent roll for income (but include market vacancy and loss). Use the T12 for operating expenses, but include the property tax rate based on the new purchase price as worst case scenario. Note, this is highly market dependent.
Never underwrite the deal based on future performance.
You are buying the current state of the asset.
Rule #2 - Assume adequate reserves
When you are putting any project together ensure that you are taking into account sufficient reserves. Your returns are a function of cash/equity out compared to cash in. So make sure you bring a strong reserve balance to the project and build it into your numbers.
A good rule of thumb is to have 6 months of debt service (principal and interest payment) as your initial rainy day reserve.
This is in addition to your capex replacement and capex improvement reserves.
Rule #3 - Assume conservative return metrics
Try to underwrite the project with the following minimum standards:
DSCR (Debt Service Coverage Ratio) = 1 .4 or higher.
You really can't get financing below 1.35 in the current market anyway and 1.4 is just a higher degree of free cash after debt service.
Breakeven Occupancy = 80% or lower
If you're in a market with 10% vacancy then the property can double market vacancy for the entire year and still not need to use reserves.
L1V (Loan to Value) = 75% or lower
Leverage is an important tool but too much isn't worth it. We've found that LTVs between 65% and 75% are the "goldilocks scenario" balancing risk and reward. Any higher and you create unnecessary risk and any lower you have no meaningful increase in safety but with reduced yields.
If you're working in a stable MSA, in a stable submarket, with a strong property management team, then the three rules will help you - at a bare minimum - evaluate an asset with a good mix of both return and safety for you and your investors.
We picked up 2 additional properties from one seller because we provided a clean sales process for him and his team. We got a fair price for a strong product just by keeping the transaction clean and hassle-free.
Now, the typical scenario is a 30-day due diligence window starting when a select subset of all documents have been received by Buyer with the rest due within 10 days of the effective date.
Note, I have seen people recommend that all documents be sent to you electronically or copied and shipped to you including all leases, addendum, contracts, etc. I'm not going to hedge on this one. This is ineffective.
It's penny-wise and pound-foolish. The intelligence and insight you get from reviewing the lease files onsite with your property management team and their team is priceless. And, any incremental pursuit costs you may incur are 100% worth it.
As soon as you can in the due diligence process ensure you get the following. In many cases we require these before the due diligence window even starts.
A copy of the prior Phase I Environmental Report and Phase II if one was done
The most current survey (ALTA preferred)
The current title extract
The insurance loss run for the past 5 years plus the current policy
The current rent roll and delinquency report (if not already received during LOI negotiation)
The last two years of financials
A list of all vendor contracts
The rest can be received within 10 days of the effective date or be made available as part of the onsite lease/file review.
Along with the financial/contract/lease audit you will need to physically inspect every unit, parking, fencing, landscaping, walk around all buildings and check for foundation/wall issues, visually inspect the roofs, review all exterior HVACs and other protrusions, centralized boilers, etc.
We have an exact step-by-step process to inspect 100 to 300 unit apartment buildings (site, grounds, exteriors, interiors, etc.) that virtually ensures we cover everything each and every time we do a property inspection. Mistakes made here add up quickly.
We use an exact step-by step process to inspect properties to effectively avoid mistakes.
Once you have completed your due diligence you will do one of 3 things:
1. Accept the physical and financial due diligence
2. Reject the project due to serious concerns that are outside of your approach to the asset
3. (Most likely) Respond to the Seller with an addendum to the PSA that outlines items that need to be addressed either through price reductions, seller credits at close, or seller repairs before close.
Depending on how you position #3, you will then negotiate with the Seller until Due Diligence is either approved or you pass on the project. Once Due Diligence is approved you will move into closing/financing.
If you are using financing for the project, you will either have started to line it up or will be well into the underwriting at this point. You should be able to close within 45-60 days of physical due diligence.
If you are using cash then you can structure your project to close within 10 to 20 days of DD approval assuming you have your property management team lined up and ready to go. Ideally, you have worked with your PM during the property due diligence.
Review Step 7: Funding above for more information.
A commercial closing is typically a hands off affair for the buyer and seller.Their respective legal teams and the title/closing attorney are handling most of the transaction.
In most cases your last step before a closing is signing any last minute documents and sending them via FedEx to the closing attorney a day or two beforehand.
And, unlike purchasing a home where the keys are handed over at the closing table or the dining room table, the key handoff will happen between the current property management company and your property management company.
You will have anywhere from 30-60 days before the closing to review and finalize loan documents and agreements with your legal team before the closing. So, most if not all of it should be lined up 10-15 days before the closing date.
You spend most of your time finalizing any capital needs for the close and working with your property management team to ensure a clean transition.
A strong property management company will already have a property takeover process. But, it's worth understanding how they do what they do and start incorporating, as quickly as possible, your asset management strategy.
You can review your assessment management strategy with one of our experienced advisors. Schedule a free 15-minute consultation.
There's a pervasive awful myth (or at best half-truth) in real estate investing that "you make money when you buy."
This isn't technically true and this level of soundbite education has led to many poor decisions over the years. All you really do when you buy is establish your baseline profit (if you can sell at market today).
You actually make real money when you operate and/or sell.
I note "and/or sell" because I have met many retired millionaires and multi millionaires who own cash producing apartment buildings in good market that have never sold an asset, ever. They get that operations (property and asset management) matters.
Now, before we dive into management and operations I want to summarize the major differences between Property Management and Asset Management.
Property Management involves the day to day operations of the property, such as:
Repairs and Maintenance
Management (application, pet, late, laundry, vending, etc. )
Paying all operating and debt invoices, etc.
Essentially, the property management team ensures the care and feeding and day to day operations of the apartment complex.
Asset Management involves the strategic and capital decisions for the property:
Investor Relations (if applicable)
Qualifying for any debt (if applicable)
Capital Expenditure Approval
Distribution Management, etc.
And contrary to what you see in the smaller unit property management business, there are some very good professional 3rd party fee-based managers out there who can help you.
Our real estate investment company does both Acquisitions and Asset Management. And, based on our direct experience, we've found that investors and owners tend to manage their properties based on one of three models.
Model 1 - Market Neutral
One of the compelling features about multifamily- the safest and most profitable real estate asset class over any 5, 10, 15, 20, 25, or 30 year period - is that you
can literally make money by being lazy.
Investing in multifamily is compelling because you can make money with passive investments.
We know and have purchased assets from owners that talk with their local property manager 3-4 times per year, get distributions 4 times a year, a K-1 at the end of the year and make 8% - '15% on their money with excellent tax advantages. And they spend a sum total of 40 hours (or less) a year on that property. That's not a 4 hour work week. It's a 1 hour work week with 3 months off!
Did these investors spend the time to get good at this?
Of course. If you had to spend 2-3 years to get to that level but could then semi-retire financially free, would it be worth it?
Now, this approach is only possible as long as they own in the right market, have solid property management incentivized the right way, and have the capital to keep the property in decent condition.
We call this strategy market neutral, because the owner is focused on the best possible day to day income with the least involvement/hassle.
Some key characteristics of this approach:
They will raise rents slowly and always at or below market
Occupancy will hover at the market occupancy rate or slightly higher
Maintain property grade but rarely improve it
As long as they are in a stable market, this strategy will be profitable and relatively hands off.
Retention/turnover will be at market level or lower due to conservative rental increases.
You will want to discuss your intentions with your property manager and create an agreement and annual budgets that promote this approach - average performance with least possible asset manager involvement.
While this is not our asset management approach, it is perfectly legitimate and one of the great features of multifamily investing.
Model 2 - Market Outperform
The goal here, as the label implies, is to do better than the market.
And "doing better" means operating at higher occupancy levels, with higher rents, with higher retention rates, and with lower operating and debt cost ratios.
To do this takes focus and work, but the rewards can be pretty amazing.
For the sake of example, let's take a 100-unit property with a rental range of $750/ unit to $800/unit in that market for that grade of asset.
With everything else being equal, if you were able to achieve $10/month more in rent than another property simply through focus, better marketing process, and friendlier staff you would generate $12,000 more a year in incremental revenue before vacancy/loss. Not a huge deal, but not bad. From a valuation perspective though, that same $10/month in rent adds $171,428 in incremental value to the property in a 7.0 Cap market.
Through active asset management you can more than double the returns of market neutral strategies.
Now, what happens if you achieve better effective rents, lower turnover, and higher referral rates than your competition in your neighborhood? And, that this resulted in $45,000 more in NOI than the other properties?
Not only would you have more money to spend on marketing, promotion, referral incentives, retention marketing, property improvements to attract more and better tenants, but you would have increased your property's value by $642,857 - just through better operations.
You will be in the top 20% to 30% of all properties in your grade and in your 3-5 mile market area. However this comes with the expense of additional time, focus, and energy from asset management and property management.
Discuss and work with your PM. They will be open to this but you will need to incentivize accordingly and track/manage closely, which takes time.
Model 3 - Grade Shift
This is much different and far more intensive than the other 2 models, but is also the most rewarding financially when you're done.
Not only will you force appreciation similar to Model 2, you will also be investing new capital into the property. Here is the proven sequence:
Perform an intensive market survey in your 1-3 -5 and even 7 mile radius to understand where the market is going and the full competitive landscape. Average rents, amenities, finish levels, layouts, marketing approach, advertising, landscaping, etc.
Compare your asset to all other like-grade assets in your market area. Understand the exact gaps that exist in your property compared to the grade you want to achieve and where you can differentiate.
Develop your business plan and capital investment approach to make this happen.
Test Implement some of the exterior changes and do a full interior upgrade on 1-3 units as your initial test. If you are able to successfully get the rent increases appropriate to your grade shift, then continue the process until you are complete or the effectiveness slows down.
Using this process you can increase income from $90 to $250 per door (or more) per month.
On a 100 unit building in a 7.0 cap market, that's a $1,542,857 to $4,285,714 increase in value.
It's a proven repeatable process. You'll have to earn it by being smart about your market and your asset and you're going to have to spend money to achieve it.
And, it will take time.
In our business we look for a 3 to 1 return on our capital improvements and grade changes. If we invest $100,000 we expect to see $300,000 in value increase on the property.
Note, this can take anywhere from 18 months to 30 months to fully implement a grade shift implementation on a property. The faster you can do it the better, but you also need to maintain good resident relations and continued cash flow from the property.
You can also see how to generate $1 million and beyond by smart management over a 3-5 year holding period.
This is not something you'll want to go into lightly. It requires a strong capability base on your part and a very good relationship with a good property management partner.
You'll want to make sure that they have both the proven capability and the incentivized interest to help you make this a reality.
In the right scenario though, it's well worth the effort.
REFINANCE OR SELL
There are as several philosophies around when to buy versus sell.
I won't pretend to know them all, but in this section, I'll outline several criteria you need to keep in mind for every refinance/sell decision.
I have seen some commercial real estate investors believe, almost as a religious decision, that they will never sell. I've also seen the opposite. And, they will never hold past the original financing period of 5, 7, or 1O years.
In general, it just boils down to "what's your goal?"
If you are focused on optimizing yield, then a long term hold is going to typically be the most profitable method. You will have fewer transaction costs and you'll be able to incrementally manage operations on the property as you hold it longer. Each year you will be able to optimize income and decrease expenses more and more as you get the asset and market dialed-in.
If you are looking to maximize equity, then you may have more of a short term strategy. Sometimes you'll have investors that require 5 year liquidity. Or your goal is to do a 1031 Exchange and defer the capital gains tax and purchase a larger project.
What we've found in general though is that 3-5 year holds need to be optimizing for an equity event or they are just leaving money on the table.
Many times though, you're not focused on a specific hold period. You are just looking to optimize for total return. In that case you need to flex with the market.
Regardless, for every market and sub-market, you'll need to keep informed and up to date on a few key metrics:
Cap Rate trends for your asset class and grade - are they moving up, down, or stable. If moving (regardless of the direction), what's causing it?
Occupancy trends for your asset class and grade - is it getting better or worse? If so, why?
Average rental rate range for your asset class, grade, and unit type - is it
improving or flat? Are concessions increasing or decreasing?
Are you seeing downgrades in school ratings and/or increases in crime stats? This may not always directly be reflected in your rent roll, but it's something that you have to keep an eye on at least annually.
Assuming that you're seeing good performance for your asset and in the local market as a whole, then you want to consider the following items at least 18 to 24 months out from your refinance event.
Key considerations for refinance
Market is performing well and looks to continue
There is no other better alternative for you to invest in
Cap rates are range bound (not much lower or higher than what you bought it for)
Flat to reduced interest rates
Defeasance or prepayment can be avoided or reduced
The bulk of our deal flow comes from commercial brokers. Specifically, they come from specialized multifamily brokers that have good regional relationships and spend the time to learn or model, preferred property type, and size.
The most important thing that you have to fully internalize is that brokers put food on the table from transactions. They don't get paid to talk to you, answer your phone calls, send you research reports, walk properties, etc.
They only get paid when deals close.
Two dynamics are then obvious:
1. If they are good at what they do, you must be worth their time.
2.There is no such thing as an unbiased opinion from a broker involved in the transaction.
With regards to item one, a good commercial multifamily broker will spend time with you, help understand your target property, your acquisition methods (equity & debt, all equity, bridge, etc.) and more. Ultimately, they will want to understand very quickly if they can a) help you get what you want - either because they already have it listed, they know how to get the list locked up, or that it exists in the market and b) if they do source the property, can you close.
Purchasing an apartment project is the same as buying a single family home with three major distinctions.
It takes longer - anywhere from 45 (rare) to 120 (typical) days
Requires more knowledge, experience, due diligence, capital and analysis
There are more players and more steps
That said, for any given apartment investment or any commercial property in general, you will follow these steps once you have identified a potential property.
1. Letter of Intent (LOI) Negotiation
This is a 2 to 5 page document that outlines the summary terms of your offer, and will include:
Due diligence window
Financing window (if any)
Good faith deposit
The purpose of the LOI is to understand and agree on the large parts of the deal, price, basic terms, and timing.
The LOI is then negotiated until both parties are in agreement on the general terms. Most if not all of the major items are worked out during the LOI negotiation phase and before the PSA is started, which is when attorney's fees can start adding up.
2. Purchase and Sale Agreement (PSA) Negotiation
Once the LOI has been approved (typically a 10 to 20 day process) then the purchase contract is started.
The LOI should specify who will prepare the initial PSA. Keep in mind that commercial real estate PSAs do not normally use a standard form. We have purchased or consulted to over 100 commercial real estate transactions and in only 3 cases was a state generated or standard form used.
That's because in commercial real estate, everything is negotiable.
During the PSA development, negotiation, and approval process you will confirm all legal terms, deal timing, total costs/fees and paying party, indemnification, confidentiality, representations and warranties, and more. This is the legal document that will bind the sale and you want to get it right.
This is where a good comprehensive starting document (typically neutral to both buyer and seller) and a good legal team pays off tremendously.
Mistakes here can haunt you because they are wholly avoidable as long as you know what to look for.
Once Buyer, Seller, and their respective legal teams have approved the PSA, then it will be signed by both parties and become "Effective."
The "Effective Date" is what starts the clock. And the typical very next step is physical due diligence.
Depending on how you structured the PSA, you may need to deposit all or part of a Good Faith Deposit/Earnest Money within 3 to 5 days of the effective date. That said, there are some interesting ways to delay earnest money until later in the due diligence phase. We cover 3 proven models that we use to reduce or defer our Good Faith Deposits. Schedule a free 15-minute consultation to learn more.
3. Due Diligence
After the PSA has been executed you will typically start right into the due diligence window. This can be triggered off the Effective Date, the receipt of all documents from the Seller, the latter of the two or some other different combination entirely.
You have to create a balance here.
You want to have the greatest amount of time possible with 100% access to all data in the most convenient and cost effective way for you and your team. But, and this is very important, you also need to be easy to work with and relatively unobtrusive to the current staff and tenants or else the Seller will not want to do business with you.
I can't stress this enough. You never know if the seller owns other properties in that local market. If they do and you were a pain in the butt, then odds are they won't want to sell to you.
Key considerations for sale
Cap rates have moved materially lower (e.g., purchasing at an 8 Cap and selling at a 6.75 cap)
You have a need for the capital
Better, larger opportunity available
Requirement of your investment group
Market healthy enough to sell but material head winds in the future
Larger capital contribution pending and no desire to pull from reserves to sell
Regardless of which decision you make, one of the biggest tips I can offer is
prepare well in advance of your planned transaction date.
The property will need to be in good physical and aesthetic condition and you will want the best possible T-12 (trailing 12 months) financials possible. Since your valuation will be based on the T-12 to T-6 financials (depending on the lender) and the current physical condition (little to no deferred maintenance/capital) you'll want to start your refinance or sale ramp up 18 to 24 months out.
If you can use that time to add just $10,000 to $20,000 more in verifiable NOI to the asset you can easily add $250,000 more in value to your transaction.
It's outside of the scope of this guide to go through all the steps required to optimize the liquidity event, but we have a special report with over 100 proven ways to optimize property value during operations. Get your copy by scheduling a
15-minute consultation with one of our advisors.
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