How to Vet a Multifamily Real Estate Deal, 2020 Style
To say that the COVID-19 pandemic has changed the way we live is a major understatement. Just take a trip to the grocery store and you’ll see everyone wearing masks before entering the store, employees wiping down shopping carts, and customers using hand sanitizer as they travel throughout the store. It’s the “new normal,” and until a vaccine is developed, it will continue to disrupt our way of life.
The pandemic has also changed the way investors look at multifamily real estate deals. One group is convinced that it’s a time to step back and wait on investing until the pandemic settles down or is brought under control. Another group feels that there are currently great investment opportunities available and continue to move forward. I’m a big supporter of the second group, both as a sponsor and as a passive investor. Despite COVID-19, there is money to be made by investing in multifamily properties.
Whether you’re a sponsor or a passive investor, there are certain steps that should be taken prior to investing or purchasing a multifamily property. Due to the pandemic, these steps are now even more important to follow in order to protect your investment. Let’s look at the steps to take for peace-of-mind during these uncertain and unusual times.
Vet the Sponsor First
Finding the right sponsor is just as important as finding the right property to invest in. A deal is only as good as the sponsor who manages it. The best way to vet a potential sponsor is to ask several key questions that will provide you with a good insight into their approach and help you determine if he or she is a good fit for you.
First, ask the potential sponsor about their own unique investment philosophy. It’s the same with investors — some want high returns and aren’t interested in the risks involved in the deal, while others are more conservative in their overall approach and are willing to accept a lower return in exchange for having a lower risk. Make sure you have a good fit with the sponsor’s investment philosophy, or you’ll be disappointed with the results.
More importantly, ask the sponsor about their performance during COVID-19. Were they able to pay their distributions on time? Did they hit their projected returns? Ask about their prior investments as well. If they demonstrated performance in the past, chances are they are performing now, during COVID-19. It may seem like an uncomfortable question to ask a potential sponsor, but it’s a fair question.
Even if the sponsor isn’t performing well during the pandemic, see how they answer an uncomfortable question. If they’re upfront and honest about their results, that shows a sponsor you would want to work with. If they skirt the question and deflect, walk away — that’s probably not a sponsor you want to be involved with. Other questions to ask include their occupancy, rent collections, cash flow and whether they have reserves available to pay the mortgage if vacancy rates rise.
Research the Location
Once you have answers to questions about the sponsor’s performance during the pandemic, your next focus should be on the area they’re planning to invest in. I recommend using an interactive website located at www.citydata.com. If you have the exact location of the proposed property, you’ll be able to look at the area’s crime rate, median household income and other pertinent data that will provide you with an overview of the type of people who live there.
If the area has a high crime rate and a below-average median household income, it probably isn’t an area that will perform well during a pandemic. In fact, with citydata.com, you can even check the infection rate for COVID-19 to see how prevalent it is. If there’s an exceptionally high number of infections, you probably won’t want to look at that particular deal.
Take a Closer Look at the Numbers
When it comes to reviewing the numbers, one of the key areas to look at is the debt, and that’s one area that most passive investors tend to overlook. What you want to see is whether the debt is conservative — in other words, there isn’t high leverage in the deal. For example, if the sponsor has a very high loan to value (LTV), of 80% to 85%, it could spell trouble down the road. The reason is that the mortgage payments would be extremely high with an 80% to 85% LTV, and if vacancy rates rise, the sponsor may not be able to make debt payments in a short period of time.
Pre-COVID-19 LTVs were in the 70% to 75% range. Most LTVs during the pandemic are now at 50% to 55%, which is a conservative loan-to-value number and one that is appropriate and manageable. Another factor to consider is whether or not there is a bridge loan involved. I personally do not like high-interest bridge loans. It’s a personal opinion, and other sponsors may find a bridge loan acceptable, but I like properties that have a conservative LTV, no bridge loans and a fixed interest rate. Having a fixed rate is important, because if I base returns on a specific rate, and it increases the following year, it impacts the returns for investors.
In addition to debt, you need to look at a deal’s projections, particularly the renovation plan. You don’t have to be an expert to realize that projections that assume renovation work will begin as soon as the property is purchased, along with achieving a premium increase of $250 — $300 per unit are far too aggressive.
Unlike the aggressive example, we assume that any renovation work will begin between six to twelve months after we purchase the property. This gives us some flexibility in case it’s not the right time to begin renovation immediately after purchase. We do have a “renovation on demand” program that lets tenants decide if they want to rent a renovated unit or one of our “classic” units, which doesn’t include any renovation. Surprisingly, we were able to get up to 29% rent increases, with 50% to 70% of new tenants opting for a renovated unit. However, we’re not sure we can duplicate this success on a new purchase, so we always plan to postpone renovation until a later date.
The other area to look at when reviewing projections is rent increases. This is in addition to “premiums” achieved with renovated units. It all comes down to the market. A year prior to COVID-19, we saw rent increases at some of our properties of 3% to 8%. These were based on the supply and demand in the market, and not because any improvements or renovations were made. Initial increase projections during the first year or two should be small, but if you have any questions, or there’s no provision made for rent increases in the projections, ask the sponsor.
You should also look at projections of bad debt and delinquencies. As sponsors, we always look at delinquencies over the past 12 months, and project what we think the numbers would be after purchasing the property. A figure of 3% for delinquencies is a reasonable number, although the lower the number, the better. During COVID-19 that number might increase to a figure between 5% and 7%, but fortunately we haven’t seen that happen at our properties. Just be sure that the number submitted makes sense. If a sponsor puts zero percent for delinquencies, it means the sponsor thinks that he or she will collect 100% of the rents, which is not realistic.
Finally, take a look at occupancy rates. Sponsors are very optimistic when projecting occupancy rates, so be sure you’re comfortable with the projections they provide. You can assume that during COVID-19 the occupancy rates will drop, so if a sponsor indicates that the occupancy rate will remain the same as it was in the previous twelve months, ask questions as to why they feel that way.
With the pandemic affecting just about everything, it’s especially important to look closely at any potential deal during this time period. Start by vetting the sponsor, because the sponsor’s track record is just as important as the property itself. Ask about their previous track record as well as their record during the pandemic. Research the location, paying particular attention to the crime rate and the median household income. Take a closer look at the numbers, including debt, the renovation plan, projected rent increases, delinquencies and occupancy rates. Be sure you’re comfortable with the projections, and if you have any questions, ask the sponsor for an explanation.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don’t have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the “APS” of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.