A lesson in due diligence

As you may have read in our blog on Due Diligence (DD). This is a critical step prior to close, and will either green light a project or provide an argument to kill it.

We recently had an opportunity to partner on what looked like a strong value-add deal. On paper it checked all the boxes we look for, but the DD process uncovered too many areas of concerns and the management team decided to kill the contract.

I wanted to share the findings because with so much time and effort that goes into every deal, it would be easy to ignore the warning signs and move ahead anyway. I’m happy to know that the sponsors and I agree with being conservative, thorough, and keeping our investors at the forefront of our minds as we make key decisions.

The lead sponsors initially chose to conduct due diligence on this property for the following reasons:

  1. The deal had a lot of potential upside, including a 25% rent bump

  2. Vacancy rates in the area are very low, and no new inventory is being built

  3. The Broker labelled the property as being on the north side of the city ( generally more desirable in that area)

  4. There is a lot of economic activity in the area, including headcount expansion for multiple large companies in the area

Pre due-diligence Concerns:

  1. The population has been essentially, or slightly down, for a decade, hovering around 154,000

We chose not to do the deal because:

  1. There are significant structural and drainage issues that were not disclosed

  2. There may also be mold that was not properly remediated

  3. A partial lease audit found inconsistencies and poor book keeping

  4. There are some potential electrical issues where aluminum wiring was improperly remediated

  5. The property is located just on the border between the more desirable north and less desirable east side

FAQ - Due Diligence

Following an executed contract to purchase, we have up to 30 days to conduct all of our due diligence and decide if we will move forward with the closing.

Similar to buying a primary residence, this includes a physical inspection. But, walking hundreds of units can take several days and requires a team taking notes on what they observe and compiling a list of repairs.

But unlike residential, commercial due diligence dives into a full legal and financial review as well. It’s common to bring in some 3rd-party support for this. Property managers, general contractors and trades like electrical and plumbing come in handy to provide reports on the asset. Below are some of the reports that allow a full review prior to close.

  1. Internal Property Condition (PCA)

  2. Property Condition Assessment

  3. Site Survey

  4. Appraisal

  5. Environmental Site Assessment

  6. Lease Audit

  7. Financial Audit Report

  8. Market Condition Report

  9. Green Report

  10. Unit Walk Report

Why we LOVE Multifamily

Along with the benefits in the previous post, here are some things that really gave us the ‘aha’ moment and why we fell in love with Multifamily (MF) investing.

  1. More people are renting than ever. If you read the housing news, Millennial’s prefer to travel and don’t want own. At the same time, Baby Boomers are downsizing and entering the market.

  2. With respect to loans, there are great MF-specific products with fantastic terms that we can use to our advantage. Additionally, non-recourse loans over 1M separate our personal assets from the business.

  3. MF has the ‘scales of economy’ that single-family, Industrial and even Office do not. We prefer to have one property, with one tax/parcel and many leases paying off our debt service and expenses. Additionally, as the size of the deal goes up, the cost basis goes down.

  4. MF apartments tend to remain stable during recessions compared to other property types, and are less sensitive to changes in economic activity.

    Here’s a recent article we read that echoes above. For more great resources, please visit our Research Page.

Why Real Estate is a Great Investment

Below are some talking points that always come up when I meet with a someone considering investing with our team. In a future post I’ll be covering multifamily specific advantages.

  1. Cash Flow (Income) - stay tuned for an in depth numbers overview in a future blog. In short, after rents are collected, operating expenses are paid, and the loan is paid, cash flow is left.

  2. Leverage - Theres so much power in leverage. If you have 500K to invest in a stock portfolio, thats your cap and all you can get in terms of value. But with leverage in real estate, we use that 50K along side a loan to purchase a much larger asset.

  3. Equity Growth from loan pay down

  4. Appreciation comes both organically as well as strategically. When we buy our primary residence, we hope that it will appreciate over time. Really we have no control what will happen organically and cannot always time the market. Instead, we like to force our appreciation and create our value with strategic business plans.

  5. Depreciation - The IRS gives us this beauty, so let’s use it. We use their scale to identify our non-operating expenses as an amazing tax benefit to lower our taxable income. This is best done via a cost-segregation study, and we have relationships with national firms to perform this activity for us.

  6. Refinance - this typically goes alongside appreciation but is not available in other investment asset classes. A typical strategy is after some appreciation is seen, we can pursue refinancing to cash-out some equity, pay off the original loan or simply get a new loan with better terms.

  7. Asset Protection in the form of insurance. Whether is a natural occurrence or an accident, we mitigate risk with strong policies to protect us.

  8. Consumption - owners can enjoy their properties and is a unique advantage to real estate.

FAQ - What is an accredited investor?

There are specific requirements to be met in order for the SEC to consider a person accredited. The good news is that we work with both Accredited and Sophisticated Investors for our deals.

Without diving too deep here, it’s important to note that we utilize an exemption that allows us to partner with both types of investors below after we’ve discussed their goals and our business model.

Accredited Investors:

  • have earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and

  • a net worth over $1 million

Sophisticated Investors:

  • have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment

Increasing NOI to add value

As you know from earlier blog posts, the value of a multifamily asset is directly proportional to Net Operating Income (NOI) because of it's relationship to the capitalization rate.  Very simply, by increasing operating income and/or decreasing operating expenses, we increase NOI and force appreciation.

So here's a list of ideas to consider implementing on any asset post-acquisition.  There is not one best way, as each asset and market scenario are different. Some are certainly more common, but the more tools we have in our toolbox, the better.

Increase income via:

  • Increase rents (with or without unit improvements)

  • Built-in renewal increases to rent rate

  • reduce/eliminate rent concessions

  • Add units (e.g. convert model units to rental space)

  • Install laundry

  • Add cellular repeaters or tower for one or more carriers

  • Bill back utilities via Ration Utility Billing (RUBS)

  • charge pet fees

  • charge late fees

  • charge application fees

  • provide and charge for storage units

  • provide and charge for renter's insurance

  • charge for covered or reserved parking

  • rent a visible billboard

 

Decrease expenses via:

  • Implement energy savings programs

    • LED bulbs

    • Thermostat timers for heating/cooling

    • low flow water toilets and faucets

  • Renegotiate utilities or change providers

  • Negotiate cable provider exclusivity

  • Cost segregation study

  • Annual vendor re-bidding

  • Challenge property tax assessment

Multifamily market cycles; what are they and why are they important?

Similar to the broader economy, commercial real estate is a cyclical market. We’re always monitoring key market indicators via multiple industry news outlets and research resources. Please refer to our Research Page for some great resources.  

There are four phases to the real estate cycle, namely:

  1. Recovery

  2. Expansion

  3. Hyper Supply

  4. Recession

 

These four phases move in a continuous wave pattern with the end of the recession phase connecting to the beginning of the recovery phase. The sequence always remains the same, although the time spent in each phase varies market to market. It may take 8-12 years to complete the full cycle, commonly with 3-5 years in each phase.

Knowing where in the cycle a market sits, drives very strategic decisions for us as far as underwriting/valuation, ownership business planning, and exit strategy.  

Below is an industry accepted list of market cycle phase indicators, 

Recovery

  • Decreasing Vacancy Rates

  • Cap rates trending down

  • Low New Construction

  • Moderate Absorption

  • Low/Moderate Employment Growth

  • Neg/Low Rental Rate Growth

Expansion, a.k.a Seller's Market or Emerging Market

  • Decreasing Vacancy Rates

  • Lowest Cap rates

  • Moderate/High New Construction

  • High Absorption

  • Moderate/High Employment Growth

  • Med/High Rental Rate Growth

Hyper supply

  • Increasing Vacancy Rates

  • Cap rates trending up

  • Moderate/High New Construction

  • Low/Negative Absorption

  • Moderate/Low Employment Growth

  • Med/Low Rental Rate Growth

Recession, a.k.a Buyer's Market

  • Increasing Vacancy Rates

  • Moderate/Low New Construction

  • Highest Cap rates

  • Low Absorption

  • Low/Negative Employment Growth

  • Low/Neg Rental Rate Growth

FAQ - What is absorption?

One market fundamental we monitor is the absorption rate.  Absorption is the amount of space or units leased within a market or submarket over a given period of time (usually one year).  Essentially absorption accounts for all inventory, and represents the market supply or demand in either a positive or negative net rate.

So remember,

If supply < demand, then vacancy decreases and absorption is positive

Whereas if supply > demand, then vacancy increases and absorption is negative

 

 

 

 

FAQ- what does non-recourse mean?

Non-recourse debt is peace of mind and security for borrowers. With non-recourse debt, the loan in question is secured by the property alone and there is no personal liability.  For example, if the borrower defaults on the loan, the lender cannot obtain any further compensation from the borrower beyond the seizure of the property, even if the property collateral does not cover the full value of the defaulted amount.