JF1386: How Do You Remove As Much Risk As Possible In Real Estate Investing? With Chad Doty

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If you ask Chad, the answer to the proposed question in the title, is to buy B class multifamily properties built between 1982 – early 2000’s. We’ll hear a better explanation and reasons why he believes this is the best way to invest in real estate with the least amount of risk. We also hear some difficult deals he’s had and how he was able to work through it. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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Chad Doty Real Estate Background:

  • CEO of 37th Parallel Properties Investment Group
  • 12 years of multifamily real estate investing experience & 10 years of management consulting experience
  • Close to $300 million in real estate transactions
  • Based in Richmond, VA
  • Say hi to him at https://37parallel.com/
  • Best Ever Book: The Goal

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

With us today, Chad Doty. How are you doing, Chad?

Chad Doty: I am excellent, how are you?

Joe Fairless: I am excellent as well, nice to have you on the show. A little bit about Chad – he is the CEO of 37th Parallel Properties. He’s got 12 years of multifamily real estate investing experience and 10 years of management consulting experience. They’ve closed on approximately 300 million in real estate transactions.

Based in Richmond, Virginia. You can learn more about their company at their website, which is in the show notes page. With that being said, Chad, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?

Chad Doty: Yeah, you bet. Background – I didn’t grow up as a real estate investor. I was a business operations guy. I got dropped into companies to make them run better. But as my wife — I got a call when I was mid-thirties when our son was being born and I was four hours away, and I’m like “Ugh, I’m gonna be a road warrior. I’m getting a call about a son arriving and I need to fix this.” So I wanted to find better solutions where I wasn’t trading time for money, so I took that business skillsets and looked for ways to create passive legacy-level income, and that sort of led down the path of “Okay, let’s do commercial real estate, let’s do multifamily, let’s do B-grade multifamily and let’s focus on the best markets for B-grade multifamily.” It kind of all came from there.

We’re about 14 people, we’ve been in business since 2008-2009, and total transaction volume is around 380 million, and currently still running [unintelligible [00:02:34].11]

Joe Fairless: Did you initially have the B-class properties and the other things that you described at the beginning, or has that evolved to what you purchase now?

Chad Doty: It was from the beginning. What we looked at is — we didn’t grow up in it… It was “Okay, we want the characteristics of as recession-proof as possible, as evergreen as possible… Because nothing is ultimately fully evergreen, nothing is ever risk-proof, but how do you take out as many of risks as you can, and multifamily had the best long-term risk-reward profile of any real estate asset class, and was a hard asset, tax-advantaged, evergreen; it’s food and shelter.  So we picked it based on the data, and since we’re sort of business deconstruction and improvement experts, we were able to go through that process and kind of said “Okay, let’s play here and just get good at it.” So it started from the beginning.

Joe Fairless: And how do you define B-class properties and why did you choose B-class?

Chad Doty: You’ll hear B, you’ll hear workforce… It just all depends on the resident profile you wanna get good at serving, and for us that is the blue collar, light-blue collar; they’re making anywhere from median household income, from 45k to 85k/year. Median household income in the U.S. is like 57k, so you’re serving the meat of the bell curve; it’s the largest group of the U.S. population. That is how we define it, and we’re typically buying assets that are built between 1982 and early 2000… So B- to A-.

Joe Fairless: And why that age?

Chad Doty: Basically, the box is already there, meaning that HVAC systems, the plumbing – all that stuff is today normal. There’s nothing really that’s changed materially in that. You walk in, you’ve got a  living room, you’ve got a kitchen, you’ve got bedrooms and bathroom. But you can buy at 30 cents to 50 cents of construction costs, add another 5k-10k/door and get a really good product. So the rental improvement range is far better in B grade multifamily and the resident base is far more insulated from economic shocks than let’s say tip of the spear A, or credit-restricted C.

Joe Fairless: With properties that were built before 1982 – have you purchased any, and if so, what did you notice with those in particular?

Chad Doty: ’82 is sort of a soft number. The hard number is really 1979-1980, because then we’re primarily missing all the lead and all the asbestos risk. That said, there are phenomenal assets that are B+, A- assets, trophy assets on the beach, built in the 1950’s, but they’ve gone through some level of remediation. We don’t buy coast market trophy asset stuff, so it lets us avoid that risk… And generally, you’re gonna have better roof slope structures and better envelopes with some of the stuff built after that timeframe, so that’s kind of why we avoid it.

Joe Fairless: What’s been a challenging property that you worked through and what aspects of it was challenging?

Chad Doty: We bought a deal in Houston that backed up to a [unintelligible [00:05:41].16] and maybe a fifth of the property was [unintelligible [00:05:47].04] and we dealt with some issues on Hurricane Harvey. It was insured, we had business interruption insurance and all that… While it’s actually gonna come out better economically in the long-run, dealing with a 500-year storm is no fun.

It’s one of those things where you think you’re fine, but then just nature happens. We don’t buy stuff on the coast, and this one was insulated, but obviously, stuff happens, and 36 of 104 units got downed by Hurricane Harvey. So that’s been a process… Ultimately, because of the insurance profile, we will end up well, but it’s a lot of brain damage having to go through that process.

Joe Fairless: What part of the brain damage component was most challenging?

Chad Doty: Anyone who has never dealt with commercial corporate insurances – there’s all of the reviews and assessments you have to go through, and the adjuster’s job for the insurance side is to delay and/or minimize payment structures as much as they can to manage the insurance base of the carrier. Dealing with that, and especially with the co-insurance in the back-end – it takes so much longer than it needs to, from the outside looking in… So if you haven’t gone through that before, it can be a little bit of a shock. It just takes time and persistence, and just doggedly going through the process.

Luckily, we’ve got a phenomenal asset manager that had multiple years with equity multifamily that was able to take that, but… It’s something that if you’re not prepared for, it can be interesting.

Joe Fairless: You said it takes longer than it should… Approximately how long does it take?

Chad Doty: We would think it would have been a 60 to 75-day process from analysis to claim, and it took closer to six months. You’ve got business interruption insurance that will recover that lost time and money, but you don’t get it till the end… So every extra delay you get pushed back out when you get to restart distributions for your client.

Joe Fairless: And then with 36 of 104 units being flooded in this case, do you have an operating budget that you dip into to just operate the property in the meantime, or do you do capital calls, or how do you approach that?

Chad Doty: We had a reserve balance to deal with it. Every single deal — and that’s a good part of our philosophy, we are more about minimizing risk, batting percentage versus slugging percentage. Every single deal we carry has a six-month mortgage reserve, and we also look to raise the capital improvement stack for the first five years anyway. So we had the reserve load to deal with it and all of our assets carry it; if you don’t have to, you don’t wanna dip into it so far to not recover it later. But we [unintelligible [00:08:26].05]

Joe Fairless: And then with raising the capital improvement stack for the first five years – that leads me to believe that your deals are projected to be longer than five years? Is that the case?

Chad Doty: Yeah, we’re a long-term holder of cash-producing assets. Our investors are looking for a consistent income stream that’s highly tax-advantaged, with equity growth along the way. So for us, you can actually increase your IRR by deferring capital until you need it, but it’s a hassle factor for the client. Okay, we have a capital call based on the commitments to start renovations, and you’ve gotta then tap people, so you’ve gotta herd cards consistently through the deal. This way we raise it all up front. It lowers our return a little bit, but in the long-run it’s a better product, we believe, for our clients.

Joe Fairless: So approximately how long are the holds projected to be?

Chad Doty: We’ll hold as long as it’s performing. From a portfolio perspective right now we’re holding 250 million, but at one time we’ve had north of that, and we’ll prune either when we get an outsized offer that’s well north of projections, or if we see the market slowing down in ways that we don’t think it’ll keep the NOI growth that we need.

Joe Fairless: What’s something that you’ve done to evolve your business from when you started it to today?

Chad Doty: We’re always fine-tuning our asset management. We try to be very closed-loop about it when we make a choice – how did that end up with the returns? How did that compare to projections? How do we get better next time? We’re constantly going through that Kaizen process, that constant, never-ending improvement. So that’s evolved just step by step with every deal, and as cap rates compress and as interest rates nudge up, some of our biggest evolutions have been in our capital structuring and how we raise, and converting from friends and family 506(b) offerings that can’t advertise to 506(c) accredited only, can advertise, with having a [unintelligible [00:10:22].16] and being able to really push the envelope. We went from buying 25 million in assets three years ago to 50 million, and now this year we’re gonna do 100 million.

Joe Fairless: And with that growth, I’m sure that you get the question – if not frequently, then a good amount – the market is coming up for a correction, so why are you buying right now? What’s your response to that?

Chad Doty: It’s a great question. When you say “the market”, there’s no national real estate market, right? It’s all local. That said, interest rates are national… So part of it is, but not all of it. So it really is “What’s the demographic story of where you’re going to play, and what happens when the economics turn?” And if you look at buying now, you can still get good pricing. It’s compressed, but if you can still create value in those deals, you’re still getting double-digit returns with consistent cashflow in the assets if you know what you’re doing… So why not buy?

Is there less of a spike on the going in price? Sure. But philosophically, everyone’s heard the term that “You’re making money when you buy”, and we think that’s a half-truth, or it’s proven not that way to us. You don’ really make your money when you buy; you establish a baseline profit to market averages. You actually make your money when you operate and you sell. And if you can operate well, you can make money in any market cycle.

Joe Fairless: Yeah, I completely agree. You mentioned earlier you all have made decisions and you’re constantly focused on never-ending improvement, and you look at the cause and effect of what resulted in a profit or loss, or what allowed you to make more or less money… What are some tactical things for some of the best ever listeners who are apartment owners on perhaps a smaller scale? Maybe they’ve got a 100-unit or a 150-unit… What are some tactical things that you’ve seen with your portfolio that they could implement to help their apartments perform better?

Chad Doty: We were slow adapters of revenue management, LRO, and using it to ride with the market, and in every single deal we implemented it on, it improved our revenue pretty much within the first two months… And they’re good enough now where even smaller players can get access to it. So we were slow adapters to that, because you think that the resident doesn’t like not knowing what the pricing is gonna be on a day-to-day basis, but the market is moving there anyway. So get out of your way and look at best practices of companies bigger than you and don’t be afraid to adopt them regardless of your size, because your resident base doesn’t know you’re a small player compared to [unintelligible [00:12:59].24] or Greystar or whoever; they just know they might wanna live there, so understand the experience of other players and model those. You don’t need to reinvent the wheel. This is not a cutting-edge business; it’s primarily a blocking and tackling service business.

Joe Fairless: How much does LRO cost?

Chad Doty: It can vary between $3 and $5 a door per month. But if you get 10 to 20 or north of that, it pays for itself pretty much instantly.

Joe Fairless: It sounds like you do value-add deals… Does it make sense during the first 12 months to have that in place, or is that in place after you do the renovations?

Chad Doty: You absolutely put it in place, because what you’re doing is you’re not improving all the assets at once; what you’re doing is you create a model. There’s a million ways to do this. The way we do it is you first understand what spec you wanna hit in terms of the unit amenities of the asset and where you expect to peg that rent, compared to your comps within 3-5 miles. That’s just math and observation and data collection.

Then when you go to put your model together, that model then will be “Okay, I wanna own this part” and then you’ve gotta test how that model sells with a combination of LRO in the marketplace. Then you’ll start to renovate against that spec and adjust. So you wanna have LRO on while you’re starting your first wave of renovations, to let you understand how you’re doing.

Joe Fairless: You mentioned earlier identifying what the large companies are doing and then doing aspects of what they do or modeling after what they do, and that’s why I’m glad we’re interviewing you right now, so what are some additional things that you all do that could be modeled by an owner who had on a smaller scale properties, but are still apartment investors?

Chad Doty: I think when we started I did a 6-unit building and a 12-unit building, then partnered up with another guy, and then we did 112, and then we’ve been at that level since ’09. When we first started though, we would abdicate – and I say abdicate as a negative term – construction management and renovation management to the property management firm. Most people at this scale will self-manage and it’ll be a job, or they’ll have third-party property management and then you’re asset-managing them… But there’s actually three roles in every deal; there’s asset management, which is controlling strategy, property management (day-to-day blocking and tackling) and construction management, which is what are you doing with the value-add piece, with the bulk renovations, the contracts that manage the asset… And most property managers are not very good at construction and contract management. So find ways to outsource that sooner rather than later, or partner up or take it yourself, because you’ll get more bang for your buck, and you’ll get more of what you want.

Because getting in the day-to-day of how they lease and how they rent – they know that stuff better than you. But the construction management side/renovation side, more times than not they don’t.

Joe Fairless: From a team standpoint, you mentioned you had 14 employees? Is that correct?

Chad Doty: Correct.

Joe Fairless: How do you structure your team?

Chad Doty: We basically have acquisitions and asset management, which is driven by my business partner and co-owner; that’s got three staff. Then we have sales and marketing, which is basically lead gen and education, and then whenever we have a new deal, the raise process with those deals. That’s three people. Then we have basically shared services, which is client communications, office manager, fractional controller, and a few other admin folks.

Joe Fairless: If you were to start another company from scratch, but does the same thing, how would you prioritize the hiring for which comes first?

Chad Doty: It depends… There’s a book called The Goal by Eliyahu Goldratt; it’s about bottleneck management and the best thing you can do is just to optimize throughput as you solve for the weak link. So it all depends on what you don’t have.

When we started — I’m an operations guy; I wasn’t a rainmaker capital development guy… So we sell by being good at what we do. Our weak link early was capital development, but as you start to get a track record and people start calling you, then capital development gets lighter and you’ll need to scale your acquisitions. So I don’t think the answer is one or the other, it’s “What is your gap?” and solve for that gap. Most business ownership is just solving for a weak link.

Joe Fairless: That’s really interesting. Based on your experience as an entrepreneur and real estate investor, what is your best real estate investing advice ever?

Chad Doty: I touched on it briefly, but there’s a fantastic book – an old book, my dad gave it to me; I’m mid-forties – called Winning the Loser’s Game, and it’s about tennis pros. The best tennis pros don’t hit the most aces, they make the fewest mistakes. Same thing with Jack Nicholas – it’s not that he [unintelligible [00:17:49].23] He never really made any errors. Same thing in investing – there are people who might make 300% on a deal, but then they have a deal that does nothing or gives back.

Find a way to minimize your risk in every single action that you take, so that the process you build around that business is wrapped around that risk mitigation. It makes thing so much easier, because then you can be aggressively conservative, meaning that you will aggressively buy every conservative deal you can. That puts success on autopilot, because then you’re not really worrying so much about “What about this, what about that?” You’ve taken care of that in the way you architect deals, and then the rest of it really is how do you then get bigger? What’s the next weak link you have? That has served us really well.

Joe Fairless: From an underwriting standpoint, what do you make sure is in place to have that risk mitigated as much as possible?

Chad Doty: The risk mitigation starts before underwriting. For us, it’s the two things that we need before we even think about the deal – we have to have an MSA submarket neighborhood that we know in our bones we’d put our grandma’s last $100,000 in. So there’s population growth, components of population growth, employment growth, components of employment… There’s easily 25 metrics we go through and say “Okay, is this the kind of market that will serve our client?” Then we find the best property management in that type of client service business, so B-grade operator vs A-grade operator. Then and only then we look at deals. Because if you’ve done that, you’ve taken out the two biggest risk rocks, really.

Then when you go to underwrite, then we’re looking for — a big thing we look at is breakeven occupancy. This is something that Ray Alcorn introduced me to. He lives in Blacksburg, VA, I live in Richmond, and I’m sure it’s been out there before, but he has a fantastic book on it… And it basically is “How vacant can a building be and still make money?” We basically sensitivity-test all of our assets going in, and we’ve gotta be able to buy a deal that can take double market vacancy for a year and still make money. So if market vacancy is seven, double that as 14; we have to have a breakeven occupancy of 86%, meaning the building could be 14% vacant for a year and we still make money.

All the markets we’re in have never hit a double market vacancy event historically, and the largest real estate downturn since the Great Depression was ’08-’09. So it’s a great safety metric that has served us well.

Joe Fairless: As it relates to that breakeven occupancy, if you are in a market that unfortunately does dip significantly to double market vacancy – once in hopefully a lifetime, or hopefully never, but if it happens once in a lifetime, it happens… Would the approach be to lower rents and give concessions to keep the occupancy high, or would you let the vacancy take place and keep the rents for the current units at their rate?

Chad Doty: That’s a great question… It depends. First of all, the LRO – and this is a benefit of doing it – will be sensitive to a concessionary market, it’ll be sensitive to flattening rents, it’ll be sensitive to declining rents, so you’re gonna get some good feedback on that.

We generally believe that just from an underwriting perspective – and I think we’re preferred with Freddie and Fannie; we’ve got 220-odd million dollars of debt with them in our history… They’re gonna get nervous if you dip below 92% occupancy. But if you’ve got rents — still, they wanna have that current flow. So I think your lender community and your investor community — because in your whole period, occupancy is gonna make you more cashflow, but when you’re gonna sell, it’s going to be your average rental rate and market occupancy. Some people think “Hey, I’ve got a 97% occupancy building” – you don’t get valuation on that when you sell it; you get valuation on market occupancy and whatever your lease rate is on your rent roll. So if you’re holding, optimize for occupancy. If you’re looking to move the asset, you’re optimizing for rent rate.

Joe Fairless: We’re gonna do a lightning round. Are you ready for the Best Ever Lightning Round?

Chad Doty: Bring it.

Joe Fairless: Alright, let’s do it. First, a quick word from our Best Ever partners.

Break: [[00:22:01].09] to [[00:22:43].25]

Joe Fairless: Best ever book you’ve read?

Chad Doty: The Goal, Eliyahu M. Goldratt.

Joe Fairless: Best ever deal you’ve done?

Chad Doty: We bought a deal in Louisville, Kentucky that had a 1031 component from a deal in College Station, that we then bought another deal in Dallas, Texas, and we were able to jump cashflow for the client by 25% on each level. It was a fantastic deal, and a series of deals that we cascaded through.

Joe Fairless: Over what period of time?

Chad Doty: Six years.

Joe Fairless: Do you remember roughly the purchase prices of each of those three, just so we can get a visualization?

Chad Doty: Sure. The first deal was 4.3 million, the second deal was 10.5 million and sold for 14.6 in only 2.5 years, and then the other one was 26 million.

Joe Fairless: And is that a current property, or did you exit out?

Chad Doty: No, it’s a current property, and it’s probably worth high twenties, low thirties right now, and we’ve had it for 2.5 years.

Joe Fairless: What’s a mistake you’ve made on a transaction?

Chad Doty: I bought a deal that was a 1978 and had asbestos; we wanted to do washers and dryers in the deal and we couldn’t without a massive renovation budget, because of the remediation costs. It was still profitable, but it dinged our ability to grow rents at a faster pace… So that’s one.

Joe Fairless: Best ever way you like to give back?

Chad Doty: Kid’s causes. We give a lot to the Children’s Hospital here in Richmond, as well as FeedMore, which does a lot for child hunger in Virginia. So we’re very kid/local the way we run it.

Joe Fairless: And how can the Best Ever listeners get in touch with you and learn more about what you’re doing?

Chad Doty: 37parallel.com is our website, and then we have a booklet called “Evidence-based investing.” It’s basically how we came to believe this to be a solid space. If you go to 37parallel.com/bestrealestate, people can get their hands on that.

Joe Fairless: Chad, thank you so much for being on the show. Thanks for talking about your approach, why you’re focused on class B properties, pros and cons on that, as well as the type of investment group that you all are and what your philosophy is, some tactical things that can be helpful, like the different LRO that you discussed, as well as scaling the company for any apartment investors who are looking to scale their apartment investing business.

Thanks for being on the show. I hope you have a best ever day, and we’ll talk to you soon.

Chad Doty: Thanks, Joe.

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