JF2297: Red Flags to Avoid When Presenting New Deal to Passive Investors | Part 1 of 3| Syndication School With Theo Hicks
In today’s Syndication School episode, Theo Hicks shares some information on putting together an investment summary and presenting it to passive investors. The three risk points of the deal are the market, the team, and the business plan. In this series, Theo will be talking about the red flags that can show that the deal might not be the best, and how to approach them when writing a deal summary.
To listen to other Syndication School series about the “How To’s” of apartment syndications and to download your FREE document, visit SyndicationSchool.com. Thank you for listening, and I will talk to you tomorrow.
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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: Hello Best Ever listeners and welcome back to another episode of the syndication school series, a free resource focused on the how-to’s of apartment syndications. As always I’m your host Theo Hicks. Each week we air a podcast episode that focuses on a specific aspect of the apartment syndication investment strategy. And for a lot of these episodes, especially the first batch of episodes we released, say first fifty or so episodes, we gave away some free resources, free documents with those. So make sure you go to syndicationschool.com and check out some of those earlier episodes, as well as more recent episodes too, and download all of those free documents we gave away; very helpful when starting and growing your apartment syndication business.
Today we’re going to kick off a series – it’s most likely going to be a three parts series – on some red flags when underwriting an apartment syndication deal. I wrote a very long blog post from the perspective of the limited partners on identifying holes or red flags when reviewing an investment summary document.
The idea is that your passive investors are not going to be experts on real estate investing. And the purpose of you creating the investment summary is to provide them with that data, which you know how to find, in a simple summarized format, so that they don’t have to go out there and do it themselves, right? They can just trust that you pulled the correct information and that you’ve included everything that you need to include on the investment summary, all that the data that they need in order to determine how to invest.
But you might have some passive investors who will simply scroll down to your returns section and say “Okay, they’re offering a 20% IRR, a 15% IRR, and a 10% preferred return… So, yeah, I like the returns, I’m going to invest.” Whereas on the other hand, on the other side of the spectrum, you might have passive investors who read every single word of the investment summary and then send you an email with a bunch of follow up questions they have on where you got these numbers from, why isn’t this included in here, things like that.
So what I wanted to do for this Syndication School series was to talk about the same concept of red flags when underwriting, making an investment summary, but from the perspective of you, the GP, the sponsor, the apartment syndicator, so that you can make sure you’re including all of the relevant information in not only your investment summary, but also in the conference call.
So we’ve done episodes in the past on the new investment offering conference call, how to put together an investment summary, but this is going to expand upon that and go over when you’re reading your investment summary, or when you’re making your investment summary, what to think about, how to proactively address things that a very detailed, meticulous passive investor is going to ask.
I’ve broken these into a couple of categories. So we’ve got market, red flags, business plan red flags, projected return red flags, debt red flags, purchase and sales assumptions red flags, proforma red flags, rental and sales comparable property red flags, and then some other miscellaneous red flags that do not really fall into any of the other categories. And so obviously, some of these are red flags that would come up based off of things you’ve done prior to identifying a deal, so I guess we are going to be covering more than just a deal, but also the market a little bit, as well as the business plan.
Now, keep in mind that the three risk points of the deal are going to be the market, the business plan, and the team. On most, we can maybe talk about a little about the market, but when it comes to the team, we have other episodes on that, on how to make sure you’re setting yourself up for success based off of your background and experience and knowledge, your partner, and the other various team members. But mostly, this is going to focus on “Okay, I’ve identified a deal, I’m making the investing summary… How do I make sure that I can, for one, save time without having to answer a bunch of questions from my passive investors if I left some things out? And two, how can I make sure that not only am I addressing those concerns, but in the eyes of the passive investor they see this opportunity and think that it’s a good deal.”
So let’s start off with the market. Obviously, the market is going to be the geographic location that the subject property is located in. Obviously, the first red flags for your market would be if they don’t meet the criteria we talked about in the previous Syndication School episodes on qualifying the market. The first thing would be the overall population, so are the people in the market going to be your customers? If you’re selling some widget, then you need to figure out who your demographic is that’s going to buy this widget; those are your customers, right? So in this case, your widget is not a widget, but an apartment unit. And in order to determine how many customers you have and if your customer base is growing or shrinking, you need to know what the population stats are historically, and then the projected population stats for that market.
Obviously, the more people that are in the market, the more people that are competing for apartments, and the higher the rents go; the less people competing for apartments, then you as an operator would need to do lower rents or offer concessions to attract the limited customer base. So you want to see a positive net migration, which is more people moving in than are moving out. And if it’s not the case, if it’s stagnant or shrinking then that’s going to be a red flag.
So if you don’t include any information about the population in your investment summary, by default your passive investor is probably going to think that “Well, there’s a reason why they’re not including that, and it’s because the population isn’t growing or it’s shrinking.”
So make sure that number one, you’re investing in a market that’s growing, and then when you are, include that information in your investment summary. Same thing for rental rates, same idea. You want to see an increase historically and forecasted, in rental rates in the average or median rent for the market; and then if it’s decreasing or stagnant, then that’s an issue.
So the rule of thumb here would be you want to see rental rates increasing by 2% to 3% every year in the years prior, maybe the five years leading up, and then 2% to 3% annually in the future is ideal. We’ll talk a little more about those percentages and where are those come in to play in part two or part three, when we talk about the rental comparable properties.
Another important factor when analyzing a market is the absorption rate. Another red flag would be a market with a low absorption rate. Like the population and like the rental rates, the absorption rate indicates the supply and demand of a market. So for multi-family, for apartments, the absorption rate is going to be the measure of newly created apartments that have been rented over three months. So for Q1, how many new apartments came online? And then of those apartments that came online, what percentage of those were rented in that 3-month period? So you’re never going to see 100% absorption rate, because that means that every single unit that came online during those three months, including the one that came online the day before in that three-month period was rented. That’s not going to happen.
So when it comes to the absorption rate, there’s two things you want to look at. Number one, you want to look at the absolute absorption rate for the market, and even more ideally, much greater than the national average absorption rate for multi-family. But then just like the rental rates and the population, you also want to take a look at the trends, so you want to take a look at the historical trend, where is the absorption rate going based off of where it’s been. And you want to see an absorption rate that is increasing, which again, indicates that there’s more and more competition, more and more customers to fulfill the supply that’s coming online.
Whenever you see a low absorption rate or a decreasing absorption rate, it may indicate that the market is in or entering into a state of hyper supply. So they’re building too fast, too many new apartments are coming online compared to the demand for apartments, whereas with the opposite case is that they can’t keep up with the demand. Typically, if it’s hard to build new apartment units, you’re going to see a very high absorption rate.
So low absorption rate – pretty big red flag; it might be something that you want to consider including in your investment summary. And of course, there’s other demographic information as well, like unemployment and economic diversity and things like that. So, same thing – any positive aspect of the market, you want to include that in your investment summary. Why did you pick this market? Why do you like this market? Let them know in as much detail as possible.
Now, another thing to consider – this is number four on my list – is not including neighborhood or sub-market-level data. So if you remember, [unintelligible [00:13:15].28] let you know that in the episodes where we talked about analyzing and qualifying the target market, you start off by looking at the overall MSA and city-level data. So you look at Dallas-Fort Worth, Houston, Orlando, and Tampa. It covers a pretty large geographic area, and we kind of want to take a look at what’s the average demographic, economic data, employment data for all of the submarkets in that overall MSA. And then after we pick the top MSA’s, then we say “Okay, well the averages are really high here. So let’s dig into more detail to figure out which neighborhoods are actually exceeding that already high average.” And then those are the neighborhoods and the submarkets that we want to target.
So you don’t want to just stop at the MSA or the city level, you want to take it a step further and go down into the submarket, and then in this really big markets, these really big MSA’s you want to dig into the neighborhood-level detail as well. So for the population trends, for the rental trends, the unemployment, absorption, economic, employment data, you not only highlight, again, the overall MSA, but also the neighborhood and talk about how much better this neighborhood is than the already better total MSA. Because what happens is if you just focus on Dallas-Fort Worth, or Tampa, St. Petersburg, Clearwater, your passive investors aren’t going to know “Well, okay, we’re not buying an apartment that’s a million units, covering the entire state. We’re investing in a particular neighborhood, so what are the demographics there? Is the population growing there or is it decreasing?”
So that savvy passive investor is going to put up an alarm in their mind if you don’t highlight and focus on the actual neighborhood. And to make sure for the absorption rate — they might not have the absorption rate for a neighborhood level, but at least the rental rates, the population, unemployment, things like that, you should find data for the neighborhood first, and then make sure you’re including that information in the investment summary to proactively address that in the minds of your investors. If you don’t, well that’s a red flag.
Now, something else that’s important that we haven’t talked about, and it’s kind of a subset of the population, which is going to be the population age, or the dominant generation in, again, the overall market, but also in the submarket. So, right now we’ve got on the younger end Gen Z, and on the higher-end baby boomers, and in then in between that is Millennials and Generation X. And all four of those generations want and desire different types of rental housing. So when a savvy passive investor is looking at your deal, they’re not just going to see “Okay, well the overall population is growing. That’s great.” Well, no. “I want to know what parts of that population are growing, and which parts of that are actually shrinking.” So they want to know who is this apartment syndicator targeting with their product, who is going to be their end customer.
And then based off of who the end customer is, what is the population trend for that group of people? And then based off of that, “Okay, so they’re targeting Millennials. Millennials are growing. Okay, well is this property going to fit the needs of Millennials? Or fit the needs of the baby boomers?” After, obviously, all the renovations and upgrades are done. So these need to match. The target demographic needs to be growing, and a large chunk of the portion of the total population in a target market.
And the property needs to match their needs. For example, a mismatch would be if I plan on buying a class B property, and then the plan is to add super high tech amenities, making it a really smart type eco-experience, with maybe smaller unit sizes, but very large common areas, a basketball court, and a lot of fitness-related things, and maybe having things for families or something, when a population expected to grow by 10% are baby boomers. That’s not going to be the best match. Whereas if those were Gen Z or Millennials, sure that might be a good match.
So those are actually just five red flags, and I think I still have about 26 red flags. So we’re going to stop there; this will conclude part one, where we talked about the market red flags. In part two we’re going to start off by talking about some business plan red flags, which will include red flags about the projected return you present as well… And then we’ll probably focus on the debt red flags as well. And then we might get into the purchase and sales assumptions red flags. And then we’ll conclude in part three with proforma red flags, rental and sales comparable red flags, and then some other miscellaneous red flags that didn’t fit into any of the other categories.
So that will conclude this episode. Thank you so much for tuning in. Make sure you check out some of the other syndication episodes we have so far, as well as those free documents, at syndicationschool.com. Thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.
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