Ask the Real Estate Investing Expert

 by Travis Watts

Turn a Decade Into a Year – How to “Knowledge Hack”

I love helping other people cut the learning curve. There have been several instances in my life where I condensed years and even decades of time by using a simple “Knowledge Hack” strategy. 

 

I Have a Question For You…

Have you considered having a mentor? Is it worth your time to read books, listen to podcasts, watch how-to videos, and network with others? 

 

Today I was researching some of the most successful people in America from the Forbes 400 List and realized that almost all of them had mentors at some point, and many still have mentors today. 

 

A Few Examples Include:

 

  • Bill Gates had Ed Roberts as a mentor
  • Oprah Winfrey had Mary Duncan as a mentor
  • Mark Zuckerberg had Steve Jobs as a mentor
  • Warren Buffet had Benjamin Graham as a mentor
  • Sam Walton (And family) had L.S. Robson as a mentor
  • Michael Dell had Lee Walker as a mentor 

 

Rather than thinking about having a “mentor” think of the word “coach” instead. It’s essentially the same thing, but using the word “coach” helped me put all of this into perspective years ago.   

 

A Quick Story

From 2009 to 2015 I did everything on my own as an active real estate investor in the single-family home space. It wasn’t because I thought I knew it all, it was because I did not see the need for a mentor or coach at the time. 

 

What I finally realized in 2015 (after 7 years of trial and error), was there were other people in the active real estate investing space who were operating much more efficiently than I was. They had more connections and were finding better deals and had a broader range of skill sets and ultimately… they were more profitable than I was. I had to do some soul searching, self-reflection, and take a long, hard, look in the mirror. Was active investing really the best use of my time and skills? 

 

What Happened Next?

I made a decision to start partnering with investment firms who had better skill sets, track record, connections, and efficiencies than I did. I essentially “piggybacked” off their success by becoming a limited partner investor in other people’s private placement offerings (mostly in multifamily apartments). This provided a hands-off approach to investing where I had the best of both worlds. I could participate in real estate, which I love and enjoy, while not having to be “in the business” of real estate in an active way, which I did not enjoy. 

 

After dedicating some time to networking, reading, listening to podcasts, watching how-to videos and seeking mentors, I inevitably became a full-time passive investor in real estate. I left the active single-family strategy behind because I was tired and burned out from trying to do it all myself, trying to make the right calls and know all the ends and outs. In addition, the hands-on approach was taking too much time away from the things I loved doing. I had far less spare time because my real estate projects were consuming more and more of my availability. 2015 was the beginning of an entirely new education process that has been life-changing to say the least.  

 

Takeaway

Mentors can come in many forms. The best advice I ever received was to seek out a mentor or “coach” who is doing what you want to do and is successful at doing it…because success leaves clues. 

“If I have seen further than others, it is by standing upon the shoulders of giants” – Sir Isaac Newton

 

To Your Success

 

Travis Watts

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 by joefairless

1031 Exchange: The Rules

As the owner of investment properties large and small alike, there’s a vehicle available in which you can actually continuously invest into larger properties and delay the capital gains expenditure that is due to reveal itself at some point. This vehicle is called a 1031 Exchange.

 

According to the United States Internal Revenue Code (26 U.S.C. § 1031), a 1031 Exchange allows a taxpayer to defer the assessment of any capital gains tax and any related federal tax liability on the exchange of certain types of properties. In 1979, federal courts allowed this code to be expanded to not only sell real estate but also to continuously purchase within a specific timeframe with no liability assessed as that time.

 

In addition, these exchanges must be utilized for productive use in business or investment. Prior to 2018, properties listed under the code included stocks and bonds and other types of properties. However, as of today, the 1031 Exchange only includes real property which makes this excellent for investors.

 

1031 Exchange Rules Explained 

 

There are 7 primary 1031 Exchange rules which require a deeper study: 

 

  • Like-kind property 
  • Only for Investment or Business Intentions
  • Greater or Equal Value Replacement Property Rule
  • “Boot” is denied
  • Same taxpayer rule
  • 45 day identification window 
  • 180 day purchase window

 

1031 Exchange Rules Explained 

 

Like-Kind Property

 

According to the IRS, each property must be utilized in trade or business for investment purposes. Keep in mind that property used personally, like personal residences or second homes, will not qualify for the 1031 Exchange opportunity. 

 

However, real property, most commonly known as real estate, does include land and anything attached to the land or anything built upon it, or an exchange of such property held primarily for sale does not meet the requirements for the utilization of a like-kind exchange.

 

Only for Investment or Business Intentions

 

To meet the criteria for a 1031 Exchange, the real estate must be utilized for investment or business purposes only. The investment vehicle must be property that is not considered a primary residence but is used to generate income and profits through appreciation and that can take advantage of certain tax benefits.

 

For example, real property identified for investment purposes can be any property that is held for the production of income, whether it be a rental for leasing option, or if the value increases over time (capital appreciation). In order for it to meet the criteria for the tax deferral, the property must be held strictly for either investment or business use.

 

Greater or Equal Value Replacement Property Rule

 

The greater or equal value replacement property rule identifies a limitless amount of properties as long as their combined value does not exceed 200% of the originating, or previously sold property. In addition, this rule also includes the acquired properties to be valued in the neighborhood of 95% or higher of the property that is being exchanged for.

 

“Boot” is denied

 

The term boot is where money or the even exchange of items considered to be “other property.” If it is determined that a taxpayer does receive boot, that booted exchange or a portion of will become taxable.

 

Rules of Thumb for the Boot Offsetting Provisions:

if the seller receives replacement property of the same or higher value than the net sale price of the property previously sold, and in addition, the seller spans all of the proceeds from the acquisition on the property being replaced, then that exchange does meet the criteria to be totally tax deferral. If the seller follows these guidelines, then there is no consideration of this being considered “cash boot” received and either took on new mortgages in addition to the previously dissolved mortgage or the seller gave the “cash boot” to reconcile any received “mortgage boot.”

 

The Same Taxpayer Rule

 

It is mandatory under the same taxpayer rule that the seller who previously owned the property that was sold must be the exact same person, via tax identity, who takes over ownership of the property being replaced. The question is why? The answer is because if the taxpayer changed their identity, based on tax law, then there would be no continuous action of the tax. Therefore, the proceeds are subject to become taxable.

 

45 Day identification Rule

 

Under the 1031 exchange code, the taxpayer has a 45 day window from the date of the sale of the previously owned property to identify the replacement property. The 45 day window is commonly referred to as an identification period. This process must be done in writing with the authentic signature of the taxpayer.

 

When identifying the replacement property, remember the following suggestions:

  • Any real property as long as it is being considered for business or investment purposes may qualify. The property can be located anywhere in the continental United States. In addition, in 2005 there were certain temporary regulations that were allowed for rental real estate to be purchased in Guam, and the Northern Mariana Islands, and also in the US Virgin Islands.
  • The property must be clearly identified with a physical street address or legal property description, and in some cases, specific unit addresses are mandatory.
  • In the process of identification, the property may be changed or additional real estate can be added by 12 midnight on the first 45th day of your identification window. Keep in mind that there are two rules that must be remembered and they are the 3-Property Rule and 200% Rule. Sometimes, revoking your original identification may be required while you are in the process of making a new one.
  • If there is any property purchased within the window of the 45 day rule then there is no formal identification needed, however, keep in mind to take the identification of other properties in consideration.
  • Purchasing replacement properties from relatives should be given careful scrutiny.

 

180 Day Purchase Rule

 

When completing a 1031 exchange, the 180 Day-Purchase Rule mandates that the replacement transaction must be completed within 180 days or six months in total. Regardless, the rule always applies. This means that conveyance of title must be completed by this date. If you ever decide to participate in an apartment syndication, please adhere to this rule.

 

Executing a 1031 Exchange

 

Example 1: Assuming that a taxpayer has decided to invest into a multifamily unit and he has decided to sell it. To the taxpayer’s surprise, the property generated $300,000 in gains, and after closing, the net proceeds were $300,000. With the taxpayer staring at a capital gain tax liability of 200,000 in taxes (federal capital gain tax, depreciation recapture, state capital gain tax, and net investment income tax) after the property sells. Only $100,000 in net equity is available to be reinvested into another property.

 

Example 2: If the same investor chose to complete an exchange, the investor would have had to have identified the new replacement product being a multifamily unit within 45 days and invests the entire 300,000 into the purchase of the replacing property with no capital gains due.

 

For an investor, a 1031 exchange is an excellent opportunity. When you decide to invest in properties, it is natural to migrate to larger units, specifically multifamily properties.

 

As you continue development and growth in this area, you may even want to consider becoming an apartment syndication investor. This will allow you to pool resources from other sources that will facilitate the overall growth of your portfolio and investment profile. Understanding the 1031 Exchange can generate large revenue and save taxes.

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 by Joe Fairless

What is a Fair Commission to Pay an Apartment Broker? – Ask The Expert

One of my apartment syndication consulting clients is under contract to sell one of their apartment deals. They emailed me a few questions about the percentage of the sales prices their broker is asking for as a commission.

The sales price is approximately $42 million, and the broker is asking for a 0.8% commission.

My client asked “do you think this is fair compensation? Do you think we should cap the commission at a certain number? Any additional bonus structure?”

For those who are not in the multifamily investing niche, you may be saying “0.8% commission sounds amazing” since you are likely used to the 3% commission for traditional SFRs and two to four-unit deals. However, since larger apartments are sold for tens of millions of dollars, the approach for paying the broker is different.

We asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart about how to fairly compensate a real estate broker and here is what he said:

The 0.8% commission “sounds a drop high for a deal that size. I always like to incentivize brokers to fight to push for the highest price but also create realistic expectations. If $42 million is the strike price, I would suggest your client tries to negotiate a 0.65% commission up to the strike price. Then, 5% for anything over the strike price. This way, the broker gets a fair commission if he/she hits expectations but can do much better if he/she delivers a great price.”

5% isn’t a typo either.

“In this case, you offer them what would be slightly below market. Market pricing would probably be around 0.75%. If the property sells for $44 million that means the commission would be $330,000 [$44 million X 0.75%]. By offering them a large incentive to get more than the strike price, it makes them fight for every last dollar. For example, if they sell the deal for $44 million, their commission would be $273,000 for the first $42 million plus $100,000 for the additional $2 million. The total commission would be $373,000 which means that the broker can do better as they do a better job getting a higher price.”

So, to answer my client’s question: the compensation structure that is most advantageous to both the seller and the broker is one where the commission percentage on the projected sales price is slightly below market rates and the commission percentage on the amount above the project sales price is significantly above market rates. With this structure, the broker can make more money by grinding for a higher sales price and the seller benefits from a higher sales price.

Do you have a question for an apartment syndication expert? Let us know in the comment section below or by emailing it to info@joefairless.com.

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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 by Joe Fairless

How to Calculate the Preferred Return and IRR for Apartment Syndication Deals – Ask The Expert

One of my consulting clients asked me two questions about calculating the two return factors that are the most relevant to passive investors: preferred return and internal rate of return.

Questions #1: When a syndicator purchases an apartment complex, how can they determine what the preferred monthly return is going to be?

Questions #2: When a syndicator purchases an apartment complex, how can they determine what the profit is going to be that gives them the estimated IRR?

Theo Hicks, who is the key underwriter for my consulting program, provided answers to these two questions and here is what he said.

 

Question #1 – How to Calculate Preferred Return

The preferred return is a threshold return that limited partners are offered prior to the general partners receiving payment. If the preferred return is 8% paid out monthly, for example, the limited partners will receive the first portion of the monthly cash flow up to 8%.

To calculate the preferred return amount, multiply the total equity investment from limited partners by the preferred return percentage. If the preferred return is 8% and limited partners invested $1 million, the annual preferred return is $80,000 (0.08 * $1,000,000). Typically, profits above the preferred return are split between the general partners and limited partners.

The general partner sets the preferred return percentage based on the business plan, the goals of their limited partners, and what other general partners who are implementing similar business plans are offering.

When underwriting a deal, the average annualized cash flow should exceed the preferred return amount offered to investors so that you can distribute the preferred return.

 

Question #2 – How to Calculate Internal Rate of Return (IRR)

To calculate IRR, you need to know the amount and date of all payments to investors. Unlike cash-on-cash return and equity multiples, IRR takes into account the time value of money (i.e., $100 received today is worth more than $100 received in 5 years).

Typically, the IRR calculation includes the ongoing distributions plus profits at sale. If there is a refinance or supplemental loan, those proceeds are included in the IRR calculation.

When underwriting a deal, you set income and expense assumptions based on how the property is currently operating, market rates, and conversations with your expert property management company. The output of your underwriting is the projected ongoing cash flow and sales proceeds. IRR assumes that distributions are paid annually. A more accurate IRR metric is XIRR, which tracks real time distributions.

 

Click here for more Ask The Expert blog posts. If you have a question you would like to have answered by an Expert, comment below.

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 by Joe Fairless

What Are the Pros and Cons of CMBS Loans? – Ask The Expert

Agency loans. Bank loans. HUD loans. Life insurance company loans. CMBS loans.

These are some of the most popular loan programs syndicators use to fund the majority of their apartment deals.

Many real estate investors are familiar with the first loan programs but not as many are familiar with CMBS loans.

CMBS loans (commercial mortgage backed securities), also referred to as Conduit Loans, are a type of commercial real estate loan that is secured by a first-position mortgage on a commercial property. These loans are packaged and sold by Conduit lenders, commercial banks, or syndicates of banks.

We asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart about the pros and cons of the CMBS loan for our “Ask The Expert” series and here is what he said:

 

Although we haven’t secured a CMBS loan, here are the pros and cons you need to know about if you are considering this loan program.

There are two main pros.

First, CMBS loans typically allow for maximum leverage on deals that may typically be viewed as slightly more risky loans by the agencies and balance sheet lenders like banks and insurance companies.

Also, CMBS loans are a good option for deals that one wishes to hold long term as a cash flow investment

There are also two main cons.

First, the major negative to a CMBS loan is the limited flexibility. Once it is sold off as securities in the marketplace, any modification or request needs to be issued though the servicer of the loan who is typically a third party. The servicer makes all decisions off of what exactly the loan documents say, making it very difficult for any changes to be made. Many people find it valuable to be able to talk to the company that issued the loan to work through any changes such as additional capital, changes in the business plan, or trying to sell the property as a loan assumption.

The other con is that the prepayment penalties are typically expensive and you may need to pay defeasance if you decide to prepay.

 

Overall, you can use CMBS loans for riskier deals and deals with a long-term cash flow play. The downsides to consider are limited flexibility to make changes and higher prepayment penalties.

 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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 by Joe Fairless

What Are the Main Apartment Syndication Operating Accounts? – Ask The Expert

As an apartment syndicator, you need bank accounts to deposit your passive investors’ initial equity investment, money for capital expenditures, ongoing revenue, as well as to send out investor distributions, pay operating expenses and debt service, pay contractors, etc.

Today’s ask the expert question is “how many operating accounts are there per property and what are the purpose of each account?”

We asked my business partner Frank Roessler at Ashcroft Capital about the main operating accounts and what they are and here is what he said:

Typically, you will have two accounts. You will have an operating account and either a capital account or a DACA account.

The Operating Account

The first main account is the operating account. This is the account where all the rents and other revenues are deposited and where all of that expenses are paid out of. Since this is the account that holds all the asset’s revenues, it will also be used to pay out investor distributions. When underwriting a deal, one of the cost assumptions is the operating account fund. I’ve received a lot of questions about this assumption. This is an upfront fund to cover the costs of unexpected issues or shortfalls that arise before you’ve accumulated enough revenue in the operating account. Whatever money you raise for the operating account fund will be held in this account.

Capital Account

The second main account is the capital account. If you secure an agency loan or other loan that doesn’t include funds to cover renovations, this account will hold the money you raise from investors to cover capital expenditures. When it is time to pay the contractors for their work, they are paid from this account. Also, this is the account that your investors will wire their investment to.

DACA Account

The other main account you may have is a DACA account. If you secure a bridge loan or other loan that does include the funds to cover renovations, the lender may require you to deposit rents into this account before funneling them to your operating account. The purpose of the DACA account is to control (and stop) income to you, the borrower, if you fall into cash management for not passing the DSCR test.

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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 by Joe Fairless

Should You Offer Nonrefundable Earnest Money on Apartment Deals? – Ask The Expert

When pursuing an on-market apartment deal, one way to create a more attractive letter of intent is to offer earnest money that “goes hard” (i.e., is nonrefundable) either day 1, after a specific task – like an inspection – completed, or after a certain period of time.

When you are pursuing apartment opportunities worth tens of millions of dollars, the earnest money required will be hundreds of thousands of dollars. So, nonrefundable earnest money can be a risky strategy. If you end up closing on the deal, great. However, if you need to cancel the contract because something unexpected arises during the due diligence period, you will not receive your earnest money back.

Fortunately, you’re reading this “Ask The Expert” blog post, where we asked Ashcroft Capital’s Director of Acquisitions Scott Lebenhart “what specific things should someone do from a due diligence standpoint to be comfortable putting nonrefundable earnest money down from day 1?”

Here is what he said:

“In order to be willing to put up a non-refundable deposit Day 1, our confidence level in the deal needs to be extremely high. We spend a lot of time on due diligence in order to reach this high level of confidence prior to posting the deposit. During the underwriting and bidding process of a deal, a lot of effort is spent to understand the opportunity, evaluate the market, and create the business plan. This entails doing an extensive market analysis, touring competitive properties, and discussing loan options with potential lenders. However, once we are close to being awarded a deal where we know that we will need to put up non-refundable deposits Day 1, we take this diligence to the next level. Our goal at this point is to be as confident as we could be that we will discover no big surprises during our formal due diligence period. In order to do this, we typically perform the following tasks:

 

1 – Speak with a Contractor

We will have a contractor (or person with a strong capital background) inspect the property in order to confirm our capital assumptions. A seller will rarely allow us to do physical inspections of the property with roofers, electricians, plumbers, etc. until we are under contract because of liability issues, however, there have been cases where we were able to do this. Ideally, we would want to do a full, detailed inspection prior to putting up the non-refundable deposits but that usually is not the case. We therefore request as much documentation as we can so we can understand what work has been done and what needs to be done. Some items that we like to request include work order logs, historical capex budgets, and future budgets.

 

2 – Speak with Property Management Company

We have detailed conversations with our management company in order to ensure that they are in agreement of our business plan and assumptions on income and expenses.

 

3 – Speak with Lenders

We have more detailed conversations with potential lenders including sharing our proforma and capital budget with them to ensure that we will be able to achieve our projected loan.

 

4 – Speak with Consultants

We engage our tax and insurance consultants to confirm our assumptions.

 

5 – Speak with Attorney

We discuss any items of concern with our attorneys relating the zoning, title, or any other matters.

 

During the course of our formal due diligence, we always find a few unforeseen items but we work to make sure the impact of these findings are minimal. In order to avoid something from affecting the projected returns of a deal, we create conservative assumptions that can withstand the potential findings. In our capital assumptions we will always have a “miscellaneous” or “contingency” bucket of money to account for anything we discover and we leave cushion on our income and expense assumptions. When we need to put up a non-refundable deposit, our overall goal is to limit the number of surprises.”

In regards to point number 1, Scott says “If the management company has a person dedicated to capital, I would recommend having them do a visual inspection of the property. If not, or if you want to add another layer of diligence, we typically have a contractor walk the property. A contractor will typically be able to give you more accurate pricing on any capital needs.”

In regards to point number 5, Scott says, “When we put up non-refundable deposits, they are always subject to receiving clean title and a clean environmental report. This is generally a market standard so I would fight for this in any agreement. That being said, a title search is very easy to get so we usually do request an updated title report prior to submitting our deposit to make sure there is nothing alarming that we would find out anyway. No need to waste time and money if there is a title defect that can’t be cured.”

 

Overall, when you need or want to put up nonrefundable earnest money, the goal is to limit the number of surprises that come up during the due diligence period. To do so, understand the current state of the property in as much detail as possible, confirm your business plan and underwriting assumptions with your expert property management company, confirm your debt assumptions with your lender, confirm you tax and insurance assumptions with tax and insurance consultants, and address any legal issues with your attorney prior to submitting a letter of intent.

 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

 

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 by Joe Fairless

What Are The Typical Fees Charged by Apartment Property Managers? – Ask The Expert

“Ask The Expert” is back, where experienced real estate and apartment professionals answer your specific questions about real estate investing strategies.

If you have a question you would like to ask a real estate expert, let us know in the comments section below.

Make sure you check out our other “Ask The Expert” blog posts here, which cover fixed rate vs. interest-only loans, interest-only vs. paying down the principal, and when to stop underwriting a deal.

This week’s question is about the fees paid to a property manager for managing your value-add renovations and ongoing management of your asset.

The vast majority of multifamily investors either hire a third-party company to manage the day-to-day operations of their apartment deals or they have an in-house property management arm in their company. The exception would be investors who pursue smaller multifamily deals (under 50 units), in which case they may decide to be owner-operators (i.e., own and manage the deal themselves).

For this particular post, we are going to focus on large multifamily investors (200+ unit projects) who hire third-party property management companies to manage their deals.

That said, the questions we asked the expert are: (1) Do property management companies charge extra fees to oversee the capital improvements and, if so, what are the typical fees, and (2) what is the typical fee for managing 200+ unit apartment deals?

The expert we asked these questions to was Scott Lebenhart, who is the Director of Acquisitions at Ashcroft Capital, and here is what he said:

 

(1) Construction Management Fees

Yes. If you are implementing capital improvements after acquisitions, property management companies will typically manage the entire process. In return for their efforts, they will charge a construction management fee.

Construction management fees are typically on a sliding scale. As the project costs increase, the construction management fees decrease. For example, a fee structure could be:

Total Construction Cost Less Than $25,000: 0%

Total Construction Cost Between $25,000 and $100,000: 5%

Total Construction Cost Between $100,000 and $250,000: 4%

Total Construction Cost Greater Than $250,000: 3%

The fees will be a percentage of the total construction costs. For this fee structure example, if your total capital expenditure costs are $150,000, your property management company will charge $6,000 to manage the projects.

 

(2) Property Management Fees

For 200+ apartments, the typical property management fee is 3% of the total collected income.

 

Closing Thoughts

Before hiring a property management company, you’ll want to determine whether they will manage your capital expenditure projects and, if so, what are the costs. If you plan on performing any level of renovations on your deals, I would strongly advise that you hire a property management company who provides the construction management services. The construction cost ranges and fees will vary from manager-to-manager and market-to-market, so make sure you know the costs upfront so that you can account for them when underwriting deals.

Same goes for the ongoing property management fee. 3% is typical, but they may charge a higher (or even lower) fee. Not only do you want to know what the fee is but also what is included in that fee. Some property management companies will charge 3% with all services included whereas others might charge additional fees for new leases, turnover, etc.

 

Would you like to Ask the Expert a question? Let us know in the comment section below! 

 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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 by Joe Fairless

When Should I Stop Underwriting an Apartment Deal? – Ask The Expert

We are back with the third installment of our “Ask The Expert” series, where experience real estate professionals answer your questions about apartment syndications and other investment strategies.

If you have a question you would like answered by a real estate expert, let us know in the comment section of this blog post.

The first two “Ask the Expert” posts were about multifamily loans. In particular, about the pros and cons of fixed rate and floating rate loans and the pros and cons of securing an interest-only loan and paying down the principal.

This week’s question is about how to approach multifamily deals that have “whisper prices”.

A whisper price is the price that either the seller or the broker wants or believes the value of the property to be.

The question we asked the expert is: “at what point do you pass on a deal when you cannot hit your return projections using the current whisper price? Do you continue underwriting with a price that is lower than the whisper price? What is the cutoff point? 20% below the whisper price? 10%? In other words, how do you know when to stop and not look into a deal anymore?”

The expert we asked this question to is Scott Lebenhart, who is the Director of Acquisitions at Ashcroft Capital, and here is what he said:

 

We often find that brokers and sellers set their expectations too high when creating a “whisper price”. On the other hand, we have seen deals that far surpass the whisper pricing. While it’s important to understand the expectations of the seller, we tend to put the whisper pricing aside until we have completed our initial review of the deal.

The initial review consists of, first, looking at the property from a high level. Is this a property we want to own? Do we like the location? Is the quality of the asset what we look for? Does it fit the profile of deals we are trying to buy (in our case, value add deals)? If the deal passes these questions, then we start our initial underwriting the deal. After the initial underwriting, we get a general idea of what we feel the property is worth to us in order to hit our desired returns. We then compare this to the whisper price to get a gauge of how close or far we are from the seller’s expectations. If we are significantly off on pricing, we usually have a conversation with the broker or seller and give them our initial feedback to explain that pricing seems a bit aggressive to us. This will typically elicit a response and the broker/seller will provide their feedback that maybe other potential buyers have the same reaction or perhaps that other buyers think the whisper price is reasonable. Depending on this response, this will typically dictate how much additional time we will spend on the deal. If it is a deal that is good fit for us and a property that we want to own, we will continue to make an effort to put our best foot forward. This includes doing some more detailed underwriting such as calling rent comps, discussing the budget with our property management company, speaking to potential lenders, etc.

After completing either just our initial underwriting or performing a more detailed analysis of the property, we will submit a Letter of Intent (LOI) at a price that we are comfortable at or we have another conversation with the broker/seller about where other LOIs have been submitted. Usually, a bid process with have more than one round of bidding, so after this first round we get a general idea of where the “market” is valuing this property as opposed to the “whisper” price. If our value is in line with the other groups bidding on the property, then we will continue to pursue the transaction with the hope of buying it.

 

In summary, you should always take the whisper price with a grain of salt. The buyers are the ones who tell the seller and the brokers how much the property is actually worth, because they are the ones who are underwriting the deal and formulating a business plan. If a deal doesn’t pencil in at the whisper prices, let the seller and brokers know. Maybe they’ve received similar feedback from other buyers. Submit an LOI at your price and if your offer price is in line with other buyers, continuing pursuing the opportunity.

 

Would you like to Ask the Expert a question? Let us know in the comment section below! 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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Two Common Real Estate Scenarios: Communication and Protection
 by Joe Fairless

Two Common Real Estate Scenarios: Communication and Protection

In this blog post, we’re going to be looking at two niche real estate scenarios that can happen to just about any investors.

The first scenario involves dealing with older potential clients and original buildings. If you’ve been in this situation before, you know that it can be quite a delicate process getting older owners to sell.

Communication Issues

Imagine this: You just found a potentially amazing off-market apartment building deal. It has 150 units and a $4 billion portfolio. It was purchased back in 1978, just over the 39-year expiration of the depreciation tax benefits law. The owner is in his late 80’s and purchased these buildings when they were first built at the time. You give him a call and ask him if he has any interest in selling, but he has trouble hearing you. He hands the phone to his caregiver, who abruptly says no and hangs up. What solution is there?

What one should do in this situation is to get curious. Start asking yourself some questions, then draft a letter to them. This is how you can learn more about their situation while introducing yourself to them. This is your chance to say, “I’m not sure where you’re at in this stage of owning these properties, but I can tell you that you might be worried about tax liability when you sell them. I have experience purchasing these types of buildings and I’d be happy to talk about some solutions any challenges you might be having.”

Penning a handwritten letter shows care and integrity. Keep in mind that many people of a certain age are struggling to keep up with the constant innovations and growth in the tech and digital world. A handwritten letter could be a breath of fresh air and a means to communicate that potential sellers may appreciate.

Protection From Embezzlement

Now, think of this scenario: You’re embarking on a general partnership in the real estate industry. It is your first time committing to such a project, and you’ve heard horror stories from colleagues involving embezzlement, fraud, and massive loss of funds. The general partner controls the business plan as well as the financial account connected to the project. You’re wondering how you can protect yourself from them embezzling funds from the operational account, and what auditing protocol you can use to protect yourself as a passive investor from theft.

There are several ways to approach this, but we can look at the most tried and true method.

You can have some checks and balances before the deal is done, which won’t be very much. After the deal is closed, though, you can do a lot more. For this scenario, we’ll look mostly at what a beginner real estate investor can do preemptively to stay safe in a general partnership.

There is no money for a potentially untrustworthy or shady general partner to take before the deal, but you can do some due diligence prior to a deal. If a shady partner is going to steal money from the entity itself, then they would have to do it afterward. This is because that is when the money is physically in the bank account.

Before the deal closes, there are a few things you should do. First off, you should absolutely take the time to look at the overall structure of the deal to make sure that there is at least an 8% preferred return. Make sure that the general partner is getting paid an asset management fee if and only if they are actually performing. If they’re proving themselves and they’re returning the preferred return, they can get that asset management fee. Otherwise, they get nothing.

Obviously, these are things that aren’t going to outright prevent someone from stealing money in a general partnership. When it comes down to it, they’re just small things you can do to ensure that the deal itself is set up in the mutual favor of you and your general partner, so that you have an alignment of interest.

Those are some things you can do before the deal. Another thing you should absolutely be doing before signing on anything with a general partner is to check those references. You can absolutely not go into a general partnership blind with no knowledge of who you’re working with. Even if the hearsay is overwhelmingly positive, you absolutely need to still check in with the partner’s references. By doing so, you’re going to get a really good picture of what the partner is all about.

Call their references and listen to what they have to say. We’re talking about past partners, firms, project managers, any business colleagues or people who have worked with this particular partner. Even if you get glowing reviews, you should then Google your partner. Those are things you’re probably already doing, but it really can’t be optional if you’re a baby real estate investor. You can be seen as an easy target because you don’t necessarily know the signs and symptoms of a parasite real estate partner. When you Google them, look for the partner’s name or firm title. And don’t be afraid to dig deep.

This doesn’t directly answer the question of how to make sure they’re not embezzling money, and we’re aware of that. However, there is some prep work that needs to be done on the front end to mitigate the risk of getting in with a group that is known for criminal activity. Sometimes that front end research is really all you need to check out.

What do you think about these two scenarios in real estate? Have you experienced either situation in your career? Tell us your real estate story in the comments below!

Image courtesy of Pixabay

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 by Joe Fairless

Fixed Interest Rate or Floating Interest Rate Loan? – Ask The Expert

Welcome to the second installment of the “Ask the Expert” series, where we ask an expert real estate professional your questions about different investment strategies.

If you have a specific question you’d like to ask an expert, let us know in the comment section below.

Today’s question is about the two types of interest rates.

When securing a loan, the two types of interest rates offered are fixed rate and floating rate.

A fixed interest rate is locked in and will not change during the life of the loan. A floating (or adjustable interest rate) may go up or down depending on the market.

The question is: what are the pros and cons the fixed interest rate vs. the floating interest rate loans?

We asked this question to Scott Lebenhart, the Director of Acquisitions at AshcroftCapital, and here is what he had to say:

 

“Different lenders offer different options in terms of floating rates vs fixed rates. A lot of this depends on where the lenders are getting their money from and how they need to price it in order to get the returns they are looking for. Many of the longer term lenders (such as Fannie and Freddie) offer fixed rate debt since they tie their loans to treasuries. Since these lenders have priced their loan with the expectation for the loan to be in place for a long period, there is usually a high prepayment penalty if we wanted to sell or refinance the loan early. Most of the shorter term lenders will offer floating rates tied to the 1 month [LIBOR]. Since the loan is tied to a shorter term security, the floating rate loan offers a lot of flexibility to sell or refinance the loan without a large prepayment. 

The pros and cons of this is really property specific. At a high level, they are both good options, however we typically chose a floating or fixed rate to match the business plan of our deals. For deals that we plan on drastically improving overtime, a floating rate loan makes the most sense since it provides ultimate flexibility to sell or refinance the deal once we complete our business plan. For deals that we will be improving (but not as drastically), we have found that longer term fixed rate debt is a better option. Although it is difficult to refinance the fixed rate debt early in the hold, we are able to get supplemental loans to capture some of the value that we have created through our business plan.”

 

In summary, the floating interest rate is ideal when you are adding a lot of value and require flexibility. If you expect to sell or refinance your deal, you can do so without paying a high prepayment penalty. The major potential con of the floating interest rate loan is that it can change during the business plan. If interest rates go up, your interest rate will go up as well.

The fixed interest rate is ideal when you are adding some value and don’t expect to sell or refinance after completing a value-add business plan. As long as you have the ability to secure a supplemental loan (click here to learn how to secure a supplemental loan), you can recapture some of the value created without selling or refinancing. The other pro is the locked in interest rate, meaning you won’t be negatively affected by rising interest rates. The potential con is your inability to sell or refinancing without paying a prepayment penalty, with is why fixed interest rate loans are better for longer hold periods.

Would you like to Ask the Expert a question? Let us know in the comment section below!

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

 

 

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 by Joe Fairless

Interest-Only Loan or Paying Down the Principal? – Ask The Expert

“Ask the Expert” are quick hitting blog posts where an experienced real estate professional answers your questions. If you have a specific question you want answered by an expert, let us know in the comments section below.

Today’s question is about interest-only payments.

As the name implies, when an investor secures a loan with interest-only payments, the monthly debt service is equal to the interest on the principal loan amount. For example, on a $10 million loan at an interest rate of 5% amortized over 30 years, the interest-only payment is $41,666.67. Whereas the debt service on a non-interest-only loan would be $54,486.03 (principal + interest).

The question is: is paying down the principal (i.e., monthly debt service equal to principal plus interest) a more conservative approach than only paying the interest on the principal, especially in the case of a market correction?

We asked this question to Scott Lebenhart, the Director of Acquisitions at Ashcroft Capital, and here is what he said:

 

“It’s not that it’s more conservative one way or another, however, for an investment, it is usually the preference to get cash back sooner than later. The time value of the additional cash flow received throughout the hold helps increase returns rather than receiving a larger distribution at the sale. Additionally, in the event that there is a catastrophic macro level event where a property loses significant value and [the investor is] unable to pay back the loan when it becomes due, it would be more impactful … to have received the additional cash flow along the way.”

 

Back to our $10 million loan example – the difference between the interest-only payment and the principal plus interest payment is $12,819.36. Technically, all payments above the interest payment decreases the loan balance. So, rather than receiving that additional payment during the business plan, you will receive it at sale.  Due to the time value of money, that $12,819.36 is worth more now than it would be worth in the future (say once the property is sold in 5 years). In the event of a massive reduction in property value, you’ll be happier if you were able to receive those additional cash flow payments, especially if the value of the property is lower than the loan balance that you would have otherwise paid down.

 

Would you like to Ask the Expert a question? Let us know in the comment section below!

 

Are you an accredited investor who is interested in learning more about passively investing in apartment communities? Click here for the only comprehensive resource for passive apartment investors.

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Joe Fairless