JF2311: Red Flags to Avoid When Presenting New Deal to Passive Investors| Part 3 of 4| Syndication School with Theo Hicks
In today’s Syndication School episode, Theo Hicks shares the information about the purchase and sale red flags that can turn potential passive investors away from your syndication deal.
In this series, Theo lists 26 common red flags that stand in the way of finding investors and closing deals. To learn about the rest of them, make sure to check out the other three parts.
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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Theo Hicks: Hello, Best Ever listeners, and welcome to another edition of the Syndication School series, a free resource focused on the how-to’s of apartment syndications. As always, I am your host, Theo Hicks. Each week we air a podcast episode that focuses on a specific aspect of the apartment syndication investment strategy. For a lot of these episodes there are free documents for you to download, especially for the first batch of episodes we did, where we walked through the entire syndication process in extreme detail, from A to Z; from being a complete noob, to selling your first deal.
So all the documents that were given away in that period are something that can help you on each step along the way in the process. And then every once in a while we give away free documents for episodes where we go into more detail on those steps… But those are all available at SyndicationSchool.com.
So we are in the midst of what was originally a three-part series, and depending on how long we go today, it might be turning into a four-part series, about some of the red flags when you are presenting a deal to your investors/originally underwriting your deal.
So these are things that a sophisticated passive investor is going to very easily recognize when they’re reviewing your deal as a red flag, and will either ask you what’s going on here, to which you should have a good answer, or they just won’t invest at all, and you won’t hear from them, at least for that deal. So these are things that you want to avoid at all costs.
In part one we started out by talking about the market red flags. These would be 1) a stagnant or shrinking population, 2) a stagnant or shrinking rental rates, 3) a low absorption rate, 4) not including an analysis on the neighborhood or the submarket that the property is located in, but only the overall MSA, or the city, or even the state… I don’t think I’ve ever seen someone just say “Hey, I’m investing in this property in Dallas, Texas. Look how great the state of Texas is”, and that’s it. But I’m sure it’s possible.
Number five would be the population demographic doesn’t match the property. And then in part two we began by talking about business plan red flags – the property class doesn’t match the business plan – and then number seven would be that it’s not actually a value-add, or it’s not actually a turnkey, or it’s not actually a distressed or opportunistic type deal. It’s something else.
And then we talked about projected return red flags. So number eight overall would be guaranteeing a return, or guaranteeing anything to your investors… And then number nine would be not performing a sensitivity analysis, which is when you adjust different assumptions you’ve had – the best-case scenario and worst-case scenario – and then present the best case, the worst case, and the baseline scenario to your investors.
And then we concluded part two by talking about debt red flags. So this was number ten, a total loan term that is less than 2x the business plan. So that would essentially be a turnkey when you plan on selling for value-add, and distressed when you plan on being done with all the renovations. Debt two times that length.
Number 11 overall was not buying a cap on an adjustable interest rate loan, and then number 12 would be including the refinance or supplemental loan proceeds in the return projections to your investors.
So parts one and two were the first 12 red flags. We’re going to knock out as many as we can today in part 3, and then as I mentioned in the beginning, potentially go into a part four to conclude.
For now, let’s go on to part 3, but make sure you check out part one and part two, where I go into a lot more detail on those first 12 red flags that I talked about.
To kick off part three, let’s start talking about the purchase and sales assumptions red flags. This is something that [unintelligible [00:07:37].24] but again, we’re looking at this from the perspective of your passive investor – what are the things that you typically present to your passive investors, that you wanna make sure are conservative.
Now, on your end, we’ve talked about at length how to underwrite a deal properly, so we’re gonna go over some of the main assumptions that you make, and what would be considered a red flag or a hole in your underwriting, that a passive investor will definitely identify when reviewing your investment summary, because this information is either included and a red flag, or it’s missing, and is therefore a red flag.
So again, these are the assumptions you make when you’re underwriting a deal for the purchase and for the sale of the property. The first one, potentially the most important one – because this has the biggest impact on the returns – is going to be the exit cap rate. So the red flag would be the exit cap rate equal to or less than the in-place cap rate. So when you’re underwriting the deal, you input all your project assumptions; you input your proforma for every single year, what you think your operating income is going to be, and base off of that you hit the 7%, 8%, 10% preferred return to your investors. And if you’re doing a value-add or opportunistic deal, then once you sell, based off of that forest appreciation, based off of that value added via the increased net operating income, now that new year 5 (or whatever year) net operating income is going to be used to determine what the sales price is going to be.
Maybe you project to have a 50% return at sale. But if you change it change the cap rate just a little bit, that 50% return might be a 40% return, or a 30% return, or a 20% return. Or a negative percent return, depending on how high the cap rate is and how high the net operating income is.
So when you buy the property upfront, the in-place cap rate is set based off of the purchase price, and then the in-place net operating income. Or sometimes it’ll be based off of the purchase price, and then the stabilized net operating income. So essentially, what cap rate are you buying the property at?
If it’s a really distressed deal, sometimes the in-place cap rate will be based on what the market cap rate is for similar deals that recently sold, based on the final product. So if you plan on renovating up to a class A, then you wanna look at other class A product at that time to see what cap rate they’re trading at. That’s the in-place cap rate – the cap rate you buy the property at.
Now, on the backend you want to estimate to the best of your ability an exit cap rate. That is the cap rate in this future time, that will be used to determine the value of the property. Now, the red flag here being that you assume that the in-place cap rate is the exact same as the exit cap rate. Or you assume that the exit cap rate is less than the in-place cap rate, which is even worse… But just assuming that, in the first scenario, the market is the same at sale as at purchase; the second scenario, where the exit cap rate is less than in-place cap rate, you’re assuming that the market is better at sale than at purchase, which is totally possible.
It’s totally possible that you buy during a recession or you buy at a time where cap rates are really high, and then five years later the cap rate is actually lower. So not only do you get the value from the increase in net operating income, but you also get the increase in value from the reduction in the cap rate, because there’s an inverse relationship between the value and the cap rate.
But what if the cap rate doesn’t go down? What if the cap rate goes up? Well, then the return projections that you provided to your investors are gonna be way off in the wrong way. As opposed to saying “Okay, right now cap rates are 5%, and it’s possible the market keeps chugging along, or it’s possible that things get better… But to be safe, we’re assuming that the market is actually going to be worse at sale.” So a rule of thumb would be 0.1% every year. So if the in-place cap rate is 5%, you’re selling at year five, then you’re assuming an exit cap rate of 5.5%. Some people will go even higher than that, some people have a different way of calculating it, but in general, that’s a rule of thumb, 0.1% every year. That way, if the cap rate is still 5%, or 4.75%, or 4,5%, then your returns are off, but they’re underestimated, as opposed to overestimating your returns.
So a huge red flag is when you’re underwriting, you’re assuming that the exit cap rate is going to be better than the in-place cap rate. And then it’s also a red flag – still big, but not alarm bells going off as DefCon20 would be if the exit cap rate is equal to the in-place cap rate. So that’s number 13.
Number 14 is another assumption that you make, which is the revenue growth. This is separate than if you’re doing a value-add, or a distressed play, where you are renovating the property, and then renovating the interiors, and then you are raising rates based off of that. I’m talking about the natural revenue growth that you’re underwriting into the deal based off of the various rental forecast predictions and inflation.
Traditionally, apartment syndicators will assume a natural revenue growth of 2%-3% every year, and the same thing for the expenses. Now, sometimes you might come across a deal where you’re reading the OM, and the broker is telling you that “Oh, we’re assuming a 5% revenue growth every single year, because the past five years rents have grown by 10% every year. So we’re being conservative in saying 5%.” Well, just because you see that, as a syndicator that should be a red flag; when you’re [unintelligible [00:13:05].13] similarly a passive investor who is reviewing your deal will see that as a red flag.
So if you say that rents have grown by 10% every year for the past five years, and they’re projected to grow by 10% every year for the next five years, and you’re being conservative and assuming a 5% revenue growth every single year, you’re not being conservative. You don’t want to be aggressive with your revenue growth, for similar reasons as exit cap rate – what if those projections are wrong, and it grows by 3% instead of 5%? Then your returns are way off in the wrong direction, as opposed to if it actually ends up being 5% and you assumed 2% or 3% – well, there you go. Icing on the cake for your investors.
So make sure you’re being smart with these revenue growth assumptions and you’re not basing them off of forecasts or basing them off of the standard 2% to 3%.
Number 15 is going to be about the vacancy rate assumptions. This is assuming you’re doing a value-add or a distressed business plan; a red flag would be having a vacancy rate that’s the exact same the entire time. So year one, year two, year three, year four, year five, 5% vacancy rate, regardless of what you’re doing to that property. [unintelligible [00:14:16].03] that’s not actually the case, because when you’re doing a value-add deal, you go in there and just by taking over the property, and you start doing your exterior renovations right away, some of the residents are going to get the hint that “Okay, this new owner’s in here, they’re making the property look nicer… They’re probably at some point gonna do this to the units too, and I’m probably not gonna be able to afford that new rent, so I’m gonna move out. I’m gonna month-to-month lease, and I’m going to give my notice, or I’m going to just skip and just disappear, or somewhere in between. Or at the end I’m just gonna leave and not renew.”
So from that you’re going to get some skips, and some people leaving, so that’s going to increase vacancy… And then once units begin to be turned over, as opposed to just going in there and maybe slapping on a new coat of paint and redoing the carpet and putting a new renter in there, which might take a week or two, you need to go in there and renovate the entire unit. So it’s gonna be vacant longer.
So because of those reasons, you may even force vacancy up, where you go in there and everyone who’s on a month-to-month lease, you’re giving them a notice to vacate. So because of all these different reasons, when you’re doing a value-add business plan you want to assume a higher vacancy rate during at least the first year, maybe even into the second year.
And even if the current vacancy at purchase is 5% or 3%, it doesn’t matter. If you plan on going in there and doing renovations, expect tenants to leave, and expect units to be vacant longer. So you need to account for that in your underwriting.
So if you have in your investment summary that you plan on renovating 100% of the unit in two years, and the vacancy is gonna be 5% during those two years, as well as 5% afterwards, that’s a problem… Because you need to be assuming a higher vacancy rate – 8%, 10%, maybe even higher, depending on the market occupancy during your renovations. That way, if renovations go faster, if no one skips, if everyone’s willing to stay and just have their units renovated while they live there, and the vacancy ends up being 5% or lower, that’s great. But again, if it’s not, then you’ve already accounted for that in your returns to your investors.
The last assumption we’re gonna talk about would be your cap-ex budget. So even if you’re doing a turnkey deal, there’s gonna be some cap-ex expense. For the turnkey it might be very minor; maybe you repair a couple of small things, or maybe you’re just going to rebrand into something new, or whatever…
So there’s usually gonna be a cap-ex budget for everything, and then obviously for value-add it will be even bigger, and for distressed it will be the biggest. So this is important for all business plans, but probably the most important when you’re doing any sort of renovations.
So this budget is going to include – let’s just take a value-add, for example. It’s going to take all the costs to update the units, to replace whatever you’re replacing, to add the new stuff, and then the labor costs. Similarly for the exteriors, or any deferred maintenance – you’re gonna have the materials and labor costs. Any amenity upgrades – materials and labor costs.
You don’t wanna stop there though. You wanna also have a contingency for if something goes wrong. Again, the heavier the value-add, the more important this contingency budget is, because you’re not going to 1) know every single thing that’s wrong with the property before you buy it. 2) You’re not gonna have the actual quotes from contractors until after you buy that property. So you can get estimates from contractors, you can have an estimate based off of previous deals, but at the end of the day it’s still a pretty big unknown. So give yourself a 10%-15% buffer, which means that you have a 10% to 15% contingency budget, so that you say “Okay, I plan on spending a million dollars on all these different things, but I don’t really know exactly how much this contractor is gonna charge, and maybe they’re breaking into a few walls and they might find issues back there… I’m gonna have an extra 150k just in case.” If it’s not used, that money goes back to your investors anyways. But if you need it, then it’s there to use.
So a big red flag is if you don’t have a contingency budget included in your budget. 10% to 15% is pretty normal… And again, this is on top of any operating reserves that cover any sort of shortfalls at the beginning of the business plan because of vacancies, and lower rents, people leaving, and things like that.
So I think we’re gonna stop there. We’ve kind of talked about that one a lot. We’re going to complete in part four the remaining red flags. We’ve got ten red flags to go. So we’re going to talk about red flags on your proforma, and then red flags in the rental and sales comparables.
So we’re kind of going in order of how these variety of things appear when you’re underwriting, as well as in the investment summary.
So that concludes this episode. Make sure you check out parts one and two, where again, we talked about the red flags as it relates to markets, business plans, and the projected returns, and the debt. Today we talked about the purchase and sales assumptions used when underwriting, and the next episode, part four, we’re gonna talk about the proforma, the rental/sales comparable properties, and then other red flags that couldn’t really fit into any of these categories.
Until then, check out our other episodes, download the free documents… Have a best ever day, and we will talk to you tomorrow.
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