JF1604: How to Qualify an Apartment Deal Part 1 of 2 | Syndication School with Theo Hicks
When it’s almost time to search for a deal, it’s important to have your criteria set for what kind of property you are searching for. But how exactly do you figure that out? Well tune into this episode where Theo walks us through exactly that! If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series – a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.
Each week we air a podcast series about a specific aspect of the apartment syndication investment strategy, and for the majority of the series we offer a document, a spreadsheet, some sort of resource for you to download for free. All of these documents, as well as the past Syndication School series can be found at SyndicationSchool.com.
This episode is going to be part one of a two-part series entitled “How to qualify an apartment deal.”
In this two-part series we’re gonna go over the three-step financial analysis process. In this part we’re gonna go over step one, and then tomorrow we’ll be going over steps two and three. Now, so far in the Syndication School series we’ve gone to the point where you have raised money, you’ve gotten verbal commitments from passive investors, so you have an idea of how much money you’re able to raise.
Now, the last step before you’re actually ready to go out and start finding deals is to understand how you’re actually going to qualify these deals before you start finding them. The two main reasons why – number one, it’s gonna save you a ton of time if you have criteria set before you start looking at deals… Because if you don’t have any criteria set, then you’re going to be looking at every single deal that comes across your desk, from 100-unit class A luxury apartments to duplexes that [unintelligible [00:03:57].02]
You probably have an idea in mind of the types of properties you wanna look at, but this episode we’re going to help you set specific investment criteria that you’re gonna use to analyze deals. I’ll mention how much time you will likely save during this podcast as well; this is also important, and I believe I’ve talked about this before, but when you are having your conversations with brokers and lenders and property managers and owners and really anyone that you’re talking to about your apartment syndication and also investors, they’re gonna ask you what types of deals you are looking at… And if you don’t have an answer for them, then you’re not going to look very credible. So having one sentence that you can repeat to every single person who asks you what your investment criteria is will make you look more credible in their eyes, rather than saying “Well, I don’t really care. I’m just looking for any deal, in any market, any size deal, any class deal.” You’re not gonna be taken that serious.
Overall, the qualification process for qualifying a deal is where you analyze the current operations, and then you also project out the future operations of an apartment community so that you can make the necessary assumptions in order to determine whether or not an offer is warranted on a property. Now, this process is referred to by many names; you might have heard underwriting, or financial analysis, financial modeling, or something very informal, which is “running the numbers.” Again, this is the process where you’re analyzing the property as it is now, as well as through conversations with your property management company and your expertise, determining how the property will operate once you take over, putting together a budget and a proforma, and then determining what price makes sense based off of your goals and your investors’ goals.
Now, there are many different ways to do this underwriting/financial analysis process. I’m gonna call it “running the numbers” moving forward, so whenever I refer to running the numbers, that’s what I’m talking about. There’s a lot of different ways to actually run the numbers on an apartment deal, and it’s kind of the same way for any real estate investment strategy. For fix and flips, some people follow the 70%, whereas others have a more detailed process. For rentals some people follow the 1% or 2% rule, or they assume that expenses are going to be 50% of the income… So there’s a lot of different ways to run the numbers, but the main point is that you actually do something, you perform some sort of analysis, rather than just going to the property and saying “I’ve got a really good feeling about this deal” and just sending in an offer, or just sending an offer based off of the list price.
What’s worse than that, what’s probably worse than going with your gut is actually trusting the broker’s proforma. When you are looking at deals, if it’s an on-market deal there’s gonna be something called the offering memorandum, which is just a sales package put together by the broker… And in that offering memorandum will be a proforma, which is basically a five-year profit and loss projection for the property based off of how the broker believes the property is gonna operate. And you don’t want to use that data to set an offer price. Again, arguably worse than just going with your gut and your instinct, just because the offering memorandum might be completely accurate, but it also might be completely inaccurate, and the data is misrepresented by the broker because they want to sell the deal. You don’t really know until you run the numbers yourself.
Overall, the three-step financial analysis running the numbers process is going to be step one – and again, these are going to be three questions you’re gonna ask yourself when you are looking at a deal and going through the process. So when a deal comes across your desk, the first question you wanna ask yourself is “Does this deal meet my investment criteria?” If the answer is no, then you can pass on the deal right away. If the answer is yes, then you’re going to formally underwrite the deal. I’ll get into more information on each of these steps, but you’re gonna need to underwrite the deal, and then you’re going to ask the next question after the underwriting is complete, which is “Do the results of my underwriting meet my goals and my passive investors’ return goals?” If the answer is yes to that, then you will submit an offer, put the property under contract… And then once the property is under contract, you’re gonna be performing extra due diligence – and again, I’ll go into what due diligence is actually in tomorrow’s episode… But at that point you’re gonna ask yourself the final question, which is “Does the property still meet my and my investors’ return goals after this due diligence process?” If the answer is yes, then you close on the deal and the financial analysis process is complete.
As I said, in this episode we’re gonna focus on that first question, which is does the deal meet my investment criteria? And then tomorrow, or if you’re listening to this in the future, the episode after this one will be focused on the underwriting and the due diligence. And I’m actually not going to go into extreme detail on the due diligence and the underwriting in tomorrow’s episode, I’m just gonna give a brief overview of the process, just to kind of complete the three-step cycle. Eventually, in future episodes we’ll have a series that’s focused on underwriting and a series that’s focused on the due diligence.
Let’s hop into the investment criteria. Step two is a pretty lengthy process. When you’re first starting out, if you’ve never underwritten a deal before – and this assuming you already actually have a cashflow calculator on hand, which is basically an Excel document with formulas that allows you to input data and it will spit out IRRs, cash-on-cash returns, budgets, proformas, things like that. Now, if you’re just starting out, it might take you a few days to underwrite a deal. I’m not saying it’s gonna take 24-48 hours to write a deal, because obviously you’re not working the whole time, but if you just spend 3, 4, 5 hours a day underwriting a deal, when you’re first starting off it’s probably gonna take you a couple of days, so let’s say 10-15 hours. Then once you get more experienced, maybe it will take you a little bit less time; maybe you can underwrite a deal in an afternoon. But overall, it’s pretty lengthy.
It’s going to be nearly impossible for you to underwrite every single deal that comes across your desk or your computer screen. So if it takes you ten hours to underwrite a deal and you can only dedicate ten hours per week to underwriting deals, then you can only underwrite one deal per week. You wanna make sure that the one deal you’re underwriting per week is something that is worthy of being underwritten; the way to do that is to screen all deals against your investment criteria, which in doing so is a way to quickly eliminate deals from contention before having to go through that 10-hour (or 3-hour, if you’re experienced) underwriting process.
For your investment criteria – and again, different syndicators will have different metrics that they use for their investment criteria, but here are the four metrics, the four parts that Joe uses when he’s screening out deals.
The first is going to be the investment strategy. Essentially, what is going to be your business plan for once you take over the property? Because if your business plan is to just buy the property and hold on to it and not have to do anything, then you’re not going to want to be looking at deals that are in complete disarray, deferred maintenance, not stabilized, and vice-versa.
The three main categories of deals – and again, people might use different names, but what’s most important is the description of these types of categories. The first category we’re gonna call the highly distressed deal. This is gonna be a non-stabilized property, which means that the economic occupancy, so the rate of paying tenants, is less than 85%, but most likely it’s gonna be lower than that; it might be in the 70’s or even in the 60’s. And heck, it could be even lower than that; it could be in the 50’s or 40’s.
And the reason why – it could be many different reasons. It could be due to just poor operations in general, it could be due to tenant issues, it could be due to having outdated interiors, outdated exteriors, outdated amenities, so they’re not attracting enough good tenants… It could be due to mismanagement, it could be due to just deferred maintenance, and people don’t wanna live there because of how many issues there are… A property can be distressed for many, many reasons, so if you are looking at distressed properties, then your business plan would be to take over the property, and you would address the deferred maintenance, you’d install a new management company, you’d probably turn over some of the problem tenants, and overall you’re gonna be bringing that property to stabilization – an occupancy rate of 85% to 90%+, ideally even higher.
At that point, you would either hold on to the property and continue to either make improvements, or just keep it how it is in cashflow, or you would sell the property to someone else who would take it to that next level.
So the pros of this highly distressed investment strategy – really the only major benefit is going to be the upside potential, because you are 1) likely going to be purchasing the asset well below market value because of the deferred maintenance costs and the lower occupancy. Because of that, the rents are likely going to be lower, or at least the income is going to be pretty low. Once you’re able to cure all the issues at the property and get that occupancy rate from 60%-70% all the way up to 95%, you’re creating a ton of value in that property, and that is going to be equity that you’re able to distribute to your investors.
Now, the downside is going to be that since the property is highly distressed, it’s not going to cash-flow from day one, and it also might not cash-flow for the first couple of years during that stabilization process. If that’s the case, then you’re going to need to have investors who are content with not receiving a cashflow distribution during that stabilization period.
And also, because the property is highly distressed, there are a ton of variables that you need to take into account when you’re underwriting the deal. Obviously, the more variables there are, the more things that can go wrong.
Overall, the highly distressed investment strategy has a higher upside potential, but with that higher upside potential comes a greater risk, and the highest risk for this strategy – to actually lose all of your investors’ capital. There’s a risk in regards to there not being much ongoing cashflow, but also risks in regard to capital preservation. So that’s one…
On the opposite end of the spectrum would be what I’m gonna call the turnkey investment strategies. This is when you buy an apartment that requires minimal to no work after acquisition; the property is fully updated to market standards, it’s highly stabilized, occupancy rates 95% or higher… It’s most likely going to be a class A property, although I don’t see why you couldn’t buy maybe a fully-stabilized class B property, or class C property, as long as they’re in a class B or class C market.
The business plan for the turnkey investment strategy would be to take over the asset and essentially achieve cashflow from day one, and kind of just ride that out until you either sell the property, or just kind of hold on to it indefinitely and cash out your investors, or whatever the strategy is going to be after that… But the key here is that you’re buying a property that is completely done, and you’re not going to need to do anything to it renovation-wise after you buy that property.
Now, of course, the benefit of this strategy is that it’s the least risky because of the fact that the property has no issues and is highly stabilized. You’re buying a property that’s cash-flowing from day one, so you don’t have that 6-month to 2-year period where you’re in limbo, you’re doing renovations and you’re hoping that your assumptions during your underwriting process and due diligence in regard to rent premiums were correct, and that you’re able to achieve that NOI number that you projected, and then also achieve that cash-on-cash return you offer to your investors.
For this property we’re gonna know day one how much it’s going to cashflow, and most likely how it’s going to cashflow the years after that… So you’re pretty confident in your return projections to your investors.
A downside of this strategy is 1) there is much less upside with this strategy, because it’s gonna be very difficult to force appreciation. The property is highly stabilized; if the units are all at market standards, then there’s not much meat on the bone for you to go in there and do things to increase the rents. Maybe you can go in there and do a couple operational things to shave off some expenses, but at the end of the day it’s gonna be much more difficult to increase income or decrease expenses in order to force appreciation.
Now, that said, the person following this strategy might try to buy a turnkey property and bet on natural appreciation (market appreciation), which as you know violates the first immutable law of real estate investing. Obviously, not everyone that buys these turnkey properties are doing it for that natural appreciation, but since there’s not that upside of forced appreciation, really the only way the property value is going to increase is through that natural appreciation.
Also, on a similar note, obviously the value of apartments are based off of the cap rate, and since this property is turnkey, then you know that they NOI itself is not going to be changing much after you’ve bought the property, and you know the value of the property is based off of the cap rate and NOI… So if the market stays how it is, then the property value won’t change at all. If the market gets better and cap rates go down, then the value will go up; but if the cap rates go up and the market gets worse, then your property value is going down.
That’s not necessarily the case for the other properties, because yeah, sure, the market could do worse and the cap rates could go up, but you’ve increased that NOI since you’ve bought the property, so it could be awash, or it might lose value a little bit, or you might have actually been able to add value to that property even though the cap rates have increased. So there is still risk with that turnkey property, especially when it comes to the actual market conditions that are completely outside of your control.
The third bucket of investment strategies is going to be the value-add, which if you’re a loyal Best Ever listener you know what value-add is. That’s what Joe does, that’s what I am going to do, that’s what our clients do… And that is when you buy a class B, class C property which is essentially already stabilized, so it’s got an occupancy rate of at least 85%, and there’s some sort of opportunity to add value.
Adding value means that you are making improvements to the operations of the property and the physical property through exterior and interior renovations, with the purpose of increasing the income and decreasing the expenses.
So the business plan is to buy the property and add value. The pros of the value-add investment strategy is that it minimizes the downsides and it maximizes the benefits of those turnkey and distressed properties. If you remember, the pros of the distressed investment strategy is the upside potential; with value-add you’re not gonna have as much upside potential, but you’re still going in there and doing things at a property to increase the income and decrease the expenses, so there is still going to be that upside potential.
At the same time, since you are buying a property that’s already stabilized, like with the turnkey strategy, you are able to achieve some sort of cashflow from day one. So you can send out distributions to your investors the first few months after closing, whereas you can’t really do that for the distressed investment strategy.
Now, another pro is going to be that most likely the majority of the larger big-ticket items of the property are going to be up to date, or at least they’re not going to be in complete disarray, like they are for the highly distressed. What I mean by big-ticket items are the HVAC, the boilers, the roofs, the siding, the plumbing, foundations – anything that’s going to cost you a ton of money to replace is most likely going to either be maybe 5-10 years old, it’s not going to need to be immediately replaced, and even if it is older, it’s not going to be a terrible condition; it’s going to be something that you don’t necessarily have to replace, but you can if you want to.
Now, maybe you might need to go in there and replace roofs, and maybe you need to replace some of the A/C units, but it’s not going to be a property where every single big ticket item needs to be replaced; that’s not going to be that value-add investment strategy.
Another pro is going to be, as I mentioned, that the property is going to be stabilized at closing, so they’re gonna achieve cashflow from day one. As well, there’s going to be that higher upside potential because of the ability of you to force appreciation, which in turn allows you to provide your investors with a large lump sum distribution at sale, which you’re not able to do with the turnkey investment strategy.
Now, the cons of the value-add strategy are gonna be 1) there are going to be more variables to take into account compared to the turnkey, because you are doing those renovations, but it’s way less than the highly distressed, and as long as you are conservatively underwriting deals, which we will explain in future episodes, then you will have a pretty good handle on these variables by the time you’ve gotten to the closing table.
And then lastly – this isn’t necessarily a con, but compared to the highly distressed investment strategy, there is not as high of upside. The highly distressed – you’re buying a property at a 60% occupancy, and you’re increasing that to 95% occupancy, so that 35% increase is gonna add a ton of value to the property, whereas for the value-add you’re going to be bumping the occupancy rate from 85% to 95%, and you’re also going to be increasing those rents, so there is that potential for a very high upside, and maybe an upside even higher than the highly distressed, but on average, it has lower upside potential than the highly distressed, but way higher upside potential compared to the turnkey.
Which investment strategy is going to be ideal for you? Well, it’s going to be based on your and your investors’ return goals, as well as your risk tolerance, as well as the team that you have. If you have investors who are content with tying up their capital for a year or two, with a minimal to no ongoing cashflow, in order to potentially receive a large lump sum profit at sale, plus you have a team with experience repositioning highly distressed apartments, then you could pursue that highly distressed investment strategy.
But if you talk to your investors and they are more interested in a low-risk place to park their money in order to receive a return that beats inflation, but they aren’t necessarily interested or attracted to a large upside at sale, then you can pursue those turnkey properties.
If you have investors who are interested in ongoing cashflow, as well as an upside potential at sale, plus a property that’s going to be a much less risky than the highly distressed investment strategy, then value-add is going to be the way for you. Also, there’s many other factors that you can take into account here, most importantly the current economic conditions, but overall these are the things you wanna think about when selecting your investment strategy.
Once you select an investment strategy, then based off of that investment strategy you will have your first set of investment criteria that you’re gonna use to screen deals. So if you are distressed, then your investment criteria are going to be class C or class D properties, with a less than 85% occupancy rates, that need a lot of work. If turnkey, it’s going to be class A or class B properties, with 85% or higher occupancy, that needs no work after purchase, and if you select the value-add investment strategy, then your investment criteria is going to be class B or class C properties, with an 85% or higher occupancy, with the opportunity to add value. That is part one of your investment criteria.
Parts two are a little more simple than the investment strategy… Part number two is gonna be the location. If you’ve been listening to this syndication series, then in series in number six you would have already selected your top one or two markets to invest in. If you haven’t done that, go back and listen to Syndication School series number six in order to select your top one or two target markets, and that will be your location investment criteria. Any property that’s not in that location, you won’t even be looking at. You only send out for brokerage lists and send out your direct mailing campaigns, and other off market lead generation strategies that you choose, to apartments that are in your target market.
Number three is going to be the year the property is built, which also is going to essentially correspond with your investment strategy. And again, this is actually pretty general, which is why you’re gonna do plus or minus 5-10 years for each of these, just because you might find a value-add opportunity that falls in the distressed age range, but… This is just general advice. Distressed properties are most likely going to be built over 30 years ago; but again, a property could have been built five years ago, that the owner completely ignored, and it could still technically be a highly distressed property.
For turnkey, it’s most likely going to be built within the last ten years, and for value-add it’s most likely going to be built 10-30 years ago. Whichever investment strategy you choose, take the current date and subtract 30 years for distressed, subtract 10 years for turnkey, and subtract 10-30 years for value-add. Do plus or minus 5-10 years on the upper and lower ends, and those are going to be the ages of properties you look at.
Right now it’s 2019, so if I was going to be a turnkey investor, then I’d only look at properties that were built in the 2000’s, for example. That’s number three.
Number four is going to be the number of units. If you remember actually the last Syndication School series, number nine, where we discussed how to raise capital from passive investors, you should be already on your way to getting verbal commitments from people in your network, and pursuing all of the various different money-raising strategies we discussed in those episodes. Based on that, you should have an understanding of how much money you’re capable of raising… And I believe we’ve talked about this before, but when you’re buying apartments, expect to have to raise about 30%-35% of the project costs. So since you know how much money you can raise, you know how much money you need to raise for a deal, then you can use those two numbers to determine what’s the maximum amount of apartments you’re capable of buying.
Then once you have that number, you can determine what the average cost per unit is for recent sales of properties that meet your investment criteria. That’s going to be value-add, distressed, or turnkey. Then the location, as well as the year built, which is information you can get from your broker, or you can do that by looking up recent sales yourself. All of those will get you to the point where you can determine how many units you’re capable of purchasing.
It might have been confusing, so here’s an example… Because for me, that all made sense in my head, but here’s an example. Let’s say you determine how much money you can raise, and then based off of that 35% of the project cost, you determine — you’re capable of raising 1.155 million dollars; 35% down means you can buy a property worth 3.3 million dollars. Then let’s say you talk to your broker and you determine that based off of your value-add investment strategy those properties are going for approximately 50k/unit in your market. So 3.3 million dollars divided by 50k/unit is going to be 66 units. The average is 50k/unit; you can essentially round up to 100 units. So my investment criteria would be 100 units. I could look at properties that are up to 100 units, but no more.
Those are the four pieces of your investment criteria. One was your investment strategy, two was the location, your target market, three – what is going to be the age ranges of properties they look at, as well as the number of units.
Now, again, one of the main reasons why we did this was to save ourselves time… And if you remember back to the Syndication School series about the company presentation, you remember the 100/30/10/1 process, which means for every 100 deals, 30 will meet your investment criteria and get underwritten; of those 30, 10 will meet your actual return goals, and of those ten which you send offers on, one will be accepted and closed on.
In other words, for where we’re at right now, for every 100 deals you look at, only 30 are being worthy of being underwritten. So if you don’t have this investment criteria, that means you’re underwriting 100 deals, and only 30 make sense… Whereas now you are going to eliminate those 70 deals that don’t make sense and just underwrite those 30 deals that meet your investment criteria.
Now, once you become an expert underwriter, underwriting should take you around three hours to do per deal. So since you’re limiting 70 deals, that means you’re saving 210 hours worth of time, which is over five 40-hour workweeks. So just by following the simple four-part exercise and setting investment criteria, which is going to be your investment strategy (value-add, distressed or turnkey), it’s going to be an occupancy level – if it’s value add it’s gonna be greater than 85%, if it’s distressed it’s gonna be less than 85%, and if it’s turnkey it’s gonna be greater than 95%. Also, obviously, for distressed it’s gonna need a whole lot of deferred maintenance, for turnkey it’s gonna need no work, and for value-add it’s going to have value-add opportunities.
You’re also gonna have your location, so your one or two top target markets. You’re going to have an age range, and you’re gonna have a number of units. Using all of those, you’re gonna be able to filter out 70 deals and save yourself five 40-hour workweeks of time.
That concludes this part of the episode, where we introduced the three-step financial analysis process, and then we focused on step one, which was about your investment criteria and defining your investment criteria.
At this point, you can actually start to find deals, which is most likely what we’re gonna talk about in next week’s series, but I didn’t wanna finish off the three-step financial analysis process and talk a little bit about underwriting and due diligence, which we will talk about tomorrow, in part two.
In order to listen to other Syndication School series about the how-to’s of apartment syndications, as well as to download your free documents that are on there for past series, make sure you visit SyndicationSchool.com.
Thank you for listening, and I will talk to you tomorrow.