JF940: Why VALUE-ADD Multifamily Properties ROCK!
He likes C class and B class value add Multi family deals, and he surely knows how to sniff them out! Here why large multi family properties make sense and what metrics he uses to validate a proper internal rate of return. If you’re looking to level up in real estate, this episode is for you!
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Steve O’Brien Real Estate Background:
– Co-founder and Chief Investment Officer of Arcan Capital
– Responsible for acquisition of over 20 multifamily assets totaling close to $200 million in the last five years
– Placed nearly $100 million in financing with FMNA, FMAC, HUD, bank and insurance company sources
– Prior to Arcan, Mr. O’Brien was with CBRE
– Based in Atlanta, Georgia
– Say hi to him at http://www.arcancapital.com
– Best Ever Book: Outliers by Malcolm Gladwell
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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 podcast. We only talk about the best advice ever, we don’t get into any fluffy stuff.
With us today, Steve O’Brien. How are you doing, Steve?
Steve O’Brien: I’m doing great. How are you?
Joe Fairless: I’m doing well, and I am looking forward to our conversation, because you are a multi-family investor on a large scale, and I’m looking forward to learning as much as I can from you, and I’m sure the Best Ever listeners are, as well. Steve is the co-founder and chief investment officer at Arcan Capital. He is responsible for the acquisition of over 20 multi-family assets totaling close to 200 million dollars in the last five years. He’s placed nearly 100 million in financing through various loan programs and sources, and prior to co-founding this company he was with CBRE. He’s in Atlanta, Georgia.
With that being said, Steve, do you wanna give the Best Ever listeners a little bit more about your background and your focus?
Steve O’Brien: Sure, absolutely. Thanks for having me, Joe, I appreciate it. I got into real estate at CBRE as an analyst. My background goes back to the numbers and the analytics; I started in the debt and equity finance group, so I got introduced to real estate on that side, and got an opportunity to do a ton of underwriting and see a lot of deals with CBRE.
I also got to see that market crash from up close in 2008, which was a great opportunity to learn about what was done right and what was done wrong. After that, my business partner and I got together and started Arcan Capital to invest in multi-family assets in the South-Eastern U.S., and we have a focus on value-add investing.
Joe Fairless: Based on your experience in underwriting through CBRE and your own practical experience, what are some ways that your underwriting has evolved, from when you started to where you are now?
Steve O’Brien: I actually think it’s a constantly evolving process. We do have our own model that’s an Excel model, and I think just about everyone has something that they rely on from a modeling perspective. I think I learned something new on every deal.
One of the interesting things about real estate is that it doesn’t happen overnight. Getting a deal done soup to nuts can take years; it can take a year to close a deal sometimes. I think if you aren’t constantly evolving and changing with the market, you’re gonna end up stale and missing some things. I’d say our model is a living document that we change based on every deal, but we just try and stay true to our foundations.
You can make a model say almost anything you want it to say; it’s about the data you put in it, and making sure your assumptions and results are correct.
Joe Fairless: What are some of the foundations that are always constant?
Steve O’Brien: I’d say the way that we make the calculations, we try to focus on keeping the math consistent and trying to stay away from some of the tricks in the underwriting that you can do, since income’s supposed to always be higher than expenses. If you grow your income and your expenses at the same rate, you’re gonna create a positive wedge. So just recognizing things like that and being aware of where your model can overestimate and underestimate things based on the numbers you put in it… That’s where we try and be the most consistent. Never let yourself get too far out of your fair way and out of your comfort zone from the underwriting.
Joe Fairless: As far as some things we might overestimate or underestimate, specifically based on your experience, what are the things in the past that you have specifically either overestimated or underestimated and you’ve tweaked since then?
Steve O’Brien: I think you always start with the rent growth. In general, when somebody is presenting you with data on a property, a Trailing Twelve, or even if it’s just a Trailing Six, you should be able to come to your conclusion about what the income has been pretty easily, so it’s all about projecting. Especially in the market that we’re in right now, you’ve seen really high rent growth figures in markets throughout the South-East and throughout the country, but I think you can get caught up in really juicing those figures and assuming that five and six percent annual rent growth is going to continue to occur.
The reality is it’s always gonna come back to the mean, so we try and be very careful — if we can’t justify a rent increase or we can’t verify exactly what the current market rent is, we’ll go back to the data and say “Where did they sign a lease last month? Where are they getting rents today and what are the comps getting?” From our value-add perspective, we’re always trying to go into a property and improve something, so that we’re not simply relying on market timing.
When we get into the property, if I replace all the appliances, if I replace this, if I replace the light fixtures, how much rent is really on the table? Because if it’s only $50 and I assume it’s $100, then that can really ruin your deal. So it all starts with rent growth and rent assumptions.
Joe Fairless: How do you gather that data and information to accurately project the rent as much as you can, knowing that you don’t have a crystal ball?
Steve O’Brien: Well, I think you do your best with analysis. There are a lot of companies out there like REIS or CoStar that provide you with that sort of data. At the same time, we think real estate is really a local business, so we’ll focus heavily on the comps. You get to know the area and determine who your real comps are and determine where they’re going.
Just because rents are going up in Atlanta or in Charlotte doesn’t mean that in your particular market you’re going to get that same rental increase. You may have several brand new properties being built right down the street, or you may have a property that’s really old that got torn down that’s going to increase your demand. So we try to focus on the micro-market and make sure that we get as much data as we can on the comps and the specific properties that are competing, and how they relate to our property.
Joe Fairless: How do you determine who are the real comps? Because I’m sure brokers present comps to you and then you look at that, but then I’m positive that you also do your own assessment of who the comps are. So what do you look for to make sure that the property that you’re underwriting is being compared against the real comps?
Steve O’Brien: Actually, that’s a great question, and I love what you said with the real comps… As you mentioned, and having been at CBRE and starting there, I can tell you the way the brokers look at comps is they’re looking for things that support their analysis, and I think that’s what everybody’s doing, but as an investor you need to have more of an open mind, and I think you need to be willing to look for things that don’t support your hypothesis, so that you’re willing to walk away from something that’s not a good fit.
The nice part about multi-family is it’s pretty open from a data perspective, and if you call a property, you’d be surprised at how much data they’re willing to give you. We will tour properties, we will call and say we’re doing a market survey, and in general, multi-families are a fairly tight-knit community. You’ll find some properties that may not be a hundred percent honest with you about occupancy and rental rates, but in general, if you drive around the properties and you get a feel for what type of property your property is, you can compare it not dissimilar from how an appraiser might – age and quality…
Then you can call them and say, “Hey, what are you getting for a two-bedroom? What are you getting for a one-bedroom?” and it’ll become pretty clear to your whether the numbers that you were given, whether it’s by a broker or even by an appraiser are realistic.
That’s one of the great parts about multi-families – in general, there is an incentive for everyone to share this information… So you can get it, you just have to ask for it.
Joe Fairless: As far as what you’ve just said, age and quality – can you elaborate on that? The reason I’m asking is let’s pretend a multi-family investor just got a deal sent over to her, and she is looking at the deal and she’s like “Okay, now I need to know where are the rent comps.” It’s an off-market deal, but she has access to databases as well as her car, so she can drive around. How does she initially qualify the rent comps? What are the specific factors?
Let’s say this property was built in 1980 and it’s in a B class area. How does she go about actually finding the rent comps?
Steve O’Brien: I think that there’s a big, broad process that you can go through, but we have some very specific categories that you probably wanna focus on. Number one is distance. The reality is something that’s ten miles away probably isn’t one of your real comps. Now, in some of your very small markets, maybe one of the advantages you see is that there are only two comps within ten miles. But in general, I’d say proximity is a very important factor, and age is a very important factor.
Constructions, just like almost anything else, as the time goes on, things change. As we’ve all seen, if you go look at deals that are built in the ’60s and ’70s, they can be very different from deals that are built in the ’80s and ’90s. One of the things that we try and focus on from a value-add perspective is identifying similar age, similar construction quality, whether it’s two-storeys versus one storey.
One of the new buzzwords in multi-family is ceiling height. Nine-foot ceilings is a big deal right now for newer products, because a lot of the older products have eight-foot ceilings. It’s up to you to determine whether something can be a comp if it’s a nine-foot [unintelligible [00:11:58].00]. I think you can, and you can make adjustments up and down, because that’s what your clients are gonna do. Residents are gonna go back and forth and they’re gonna put a value on specific things.
A 2000-built property can be a comp with a 1980 property, it just depends on the other things that they offer. What are the amenities? Pool, fitness, tennis courts, fitness center… So it’s basically creating a list of property information and comparing that side-by-side, no different than when you’re going online and you’re trying to compare different software programs, and you’ve got the checks by all the different things this software program does versus the other. We do it in a very similar way.
Then, of course, you can get as detailed as possible. You can compare the size of pools, you can compare the number of parking spaces, and covered parking vs. garage. So you can really take it down to a very micro-level, but when you’re looking for your comps, I think you need to stay a little bit more broad as far as age and construction quality and location.
Joe Fairless: Generally, what have you found is the right distance to look for from the subject property?
Steve O’Brien: Everybody’s different. I think that if you were just gonna pick a number, I would say that it’s within a couple of miles. The problem becomes — it depends on your density, and every market is different. I think the answer to that question is based on where you are. It can be a great benefit that you draw a radius outside from your property location, and in that two-mile radius you only have one comp – that could be a great thing. It could also be a bad thing. It can be a sign that there’s not a lot of demand in your area.
I think it’s more about understanding your area, but we try to look in denser areas within a mile radius. In larger areas, we would typically draw the line around a five-mile radius, because in general if someone is looking to live in an area, it’s our opinion that five miles is about as far as they’re going to live once they’ve made a decision of “Hey, this is the spot. This is where I wanna be.” You probably aren’t gonna go too much further than five miles, but you may have to expand that to get enough comps… And who knows what enough is? Is it 4-5, or is it 10? I think everybody has to determine that on their own.
Joe Fairless: I’d love to hear you elaborate a little bit more about your example that you said where a 2000-built property can be a comp with a 1980 property, depending on the amenities. Can you elaborate on that?
Steve O’Brien: Absolutely. I think in general there are certainly some construction changes between a mid-1980s product and the 2000s. Materials get better, but I think you also hear people say that they don’t build them like they used to. So I can have a 1980s pool (that was built in the 1980s), but some of the new pools, they call them resort-style pools – it’s a little bit bigger, a little more deck space, maybe you’ve got grills out there… So it’s about taking that single item — the tennis courts… What conditions are the tennis courts in? I can take a tennis court, and for a relatively small amount of money, I can make it look and feel almost brand new. But if I have a 2000 deal and no one’s touched that tennis court for 16 years, my 1980s tennis court could be better than the 2000.
So I think it’s about identifying what those specific amenities are, and comparing them side-by-side. I think fitness centers are one of the big ones, because in the 1980s fitness centers weren’t really a thing; that was at properties. Now it’s a major component of a lot of the new deals that you’ll see. Large fitness centers that you don’t even need a gym membership anymore. If you go back and look at a 1980s deal and you have a little thousand-square-foot room that they’ve put some equipment in and they call it their fitness center, then that’s not really fair to compare to some of these big 5000-square-foot with free weights, ellipticals and all the different machines. Just because they both have a fitness center doesn’t mean that it’s fair to compare them apples to apples.
I think that’s what I mean by amenities – it’s something other than simply the living quarters and the units themselves. Dogwash stations, dog parks, car wash stations… We’ve seen some of the new deals – particularly student housing, which is a little outside of the multi-family logs, but some of the new student housing deals are a maze of full-club houses with flat screen TVs and video game systems and pool tables…
Not everything is created equal, so it’s not just as easy as saying, “Yes, we both have a pool.” I think you have to take a closer look at that pool and you have to take a closer look at those tennis courts, instead of just assuming that the 2000 deal was better. That’s probably a safe guess, but that’s why you gotta go put your eyes on it.
Joe Fairless: What year properties do you wanna buy now?
Steve O’Brien: I’d say right now we really like somewhere between 1980 and 2005. The reason we like that is because we like to add value to things, and it’s hard to add value to something that was built six years ago. You can, and there are some markets where it certainly happened, where the growth has been so much that you’re going from Formica countertop and black appliances to granite countertops and stainless appliances, because you can get substantially more rent for those upgrades. But in general, we like to focus on deals where we can make [unintelligible [00:17:19].20] transformations.
We like to take before pictures and after pictures, and have a real wow factor, and you need some age in order to do that. It’s hard to create a wow factor for properties that are much newer than 2000-2004. But you can go into some properties that age, in 1984, and it feels like a generation ago, and it was. I’m sure you’ve seen them too, the old cabinets that you’ll see in some of those 1980s deals, when everybody liked the original wood grain look. Now everybody likes the bright-starred white kitchen.
Things change, and I’m sure in 15 years they’ll go back and look at deals and say, “Oh man, that was built in the 2000 teens”, because of this style and that style. So we like to create that transformation, and you need a little age in order to do that.
Joe Fairless: And then real quick, clearly you can have some wow factor if you buy a 1960 property and you do the renovation, so why 1980 versus 1960 or 1970?
Steve O’Brien: I think we see a lot of similarities between the construction – not all of it, but you can sometimes find a 1985 deal, garden style apartment that’s built very similarly to how they would build it today. That’s what you’re looking for to really create that transformation and to increase the age of the asset, or the perceived age of the asset… It’s “Can I make this look new?” A lot of the ’60s and ’70s deals (especially the ’70s) you get some of that modern architecture, and it’s hard to bring that property out of the ’70s, to make it look like it’s no longer a ’70s feel.
The same is true for some of the ’60s properties as well, where there are just changes that you can’t make. Meanwhile, in the ’80s, with vinyl siding, or T1-11 wood, or cedar siding, it’s pretty easy in the scheme of things to rip that off and put on the new hardie siding or cement board siding and give it a fresh, new look and make it look like it was built in the last 10 or 15 years.
That’s why we try to stay away from a little bit older products. There are also a ton of other issues you can run into with aluminum wiring, asbestos, all sorts of environmental potential concerns that frankly people didn’t know about in the ’60s and ’70s. Now that you know that, it can be a real pain to deal with those issues if you can avoid them.
Joe Fairless: Let me pose a hypothetical scenario to you. You just got a lead from one of your friends in the business, and he said “Hey, I’ve got this portfolio of 1960s properties, 300 units. They’re in a B+ area that’s trending towards an A.” What do you do in that scenario?
Steve O’Brien: Well, I think rule number one for us you have to go see the real estate. That’s rule number one, because there are a ton of deals that if you don’t go put your eyes on them, you don’t get the real assessment for what they are. I would go to those properties and then I would start asking some of those bigger picture questions – are there any environmental concerns? Copper wiring, polybutylene plumbing, asbestos – those different materials from the past, that can cause problems.
But some of the coolest deals around now are currently [unintelligible [00:20:50].29] deals that were formerly old warehouse and mill space, and they’ve been completely remediated and they’ve been completely remediated and they’re beautiful deals, with no environmental concerns.
I think rule number one is if something sounds interesting to me and it’s a good area, I’m gonna go see the property. Then I’m gonna start asking the big miss questions, the things that can really hurt a deal, and try and check off those big problems off my list, so that I can focus on the little problems.
Joe Fairless: You mentioned some of those questions – environmental concerns, the wiring… Just off the top of your head, what are some other questions that you would ask that would the big ones that might kill the deal?
Steve O’Brien: It’s all the major systems, especially for the older deals. Does it have central air or is it a wall unit? Because that’s something that is really hard to get around, not having central air, and you just need to know that; it doesn’t necessarily make the deal a bad deal, you just need to understand that part of it.
I would say roofs, the age of the siding, wiring, plumbing and electrical systems in general. If the wiring is just old and needs to be replaced, that’s a very expensive problem. Same thing for plumbing. It’s really hard to get into the walls of a property. To the extent that you can verify that those things either have been remediated or are in very good shape, you can really avoid a big miss.
Missing on one unit that turns out to be down is a relatively small miss on a reasonably sized property, but if it turns out that you have to rewire your whole property, or you need to put new roofs on your entire property, that’s gonna cost you something substantial, and that’s gonna really change your return.
Joe Fairless: Steve, what’s your best real estate investing advice ever?
Steve O’Brien: My best real estate investing advice ever is to use debt to your advantage. I think there’s a reason they call it leverage, and a lot of people jump into loans… It’s a great idea to structure those the right way, and it can save you a lot of time and pain in the long run.
Joe Fairless: I’d like to do a follow-up conversation with you about debt and leverage if you’re open to that. Would you be open to that?
Steve O’Brien: Sure.
Joe Fairless: Cool. We’ll have you on the show one more time so you can talk about that specifically. Are you ready for the best ever lightning round?
Steve O’Brien: Absolutely.
Joe Fairless: Alright. First, a quick word from our Best Ever partners.
Joe Fairless: Best ever book you’ve read?
Steve O’Brien: Outliers by Malcolm Gladwell.
Joe Fairless: Yes, that’s a good one. One of my favorites. Best ever personal growth experience and what did you learn from it?
Steve O’Brien: I would say it was the market crash in 2008. I’m sure you get that a lot. While you’re going through it it’s really painful, and I think though you learn more in the down markets than you do the up markets. That was a great opportunity to experience a lot of pain, but almost everything that I do in my underwriting comes from the failures I saw during that time. I learned a lot of what to avoid during that time.
Joe Fairless: And what specifically do you do now in your underwriting that you weren’t doing before?
Steve O’Brien: I think it’s some of the stuff that we talked about earlier – the rent growth figures, and just the understanding… I mean, it’s amazing to go back and think that during that time no one ever thought values would go down. Just remember that that’s possible. I think justifying all of your numbers, as opposed to just penciling in a figure – “Oh, rent will go up this much” or “Sure, I can get that figure”… It’s really actually finding some data to back it up.
Joe Fairless: What’s your favorite data source?
Steve O’Brien: We use CoStar, but there’s so much news available on the internet, that whether it’s the local business journal or Bureau of Labor Statistics… There’s a ton of data out there. In fact, there’s probably too much data, so that’s why we like to focus on CoStar and one particular source, so that we’re at least consistent. Because it doesn’t feel right to just pick and choose “Today I’m gonna use this, and tomorrow I’m gonna use that” just to prove your point.
We like to pick one and stick with it, and that choice for us has been CoStar, but there are a lot of great companies out there like REIS and other analysis sources that people use and trust.
Joe Fairless: Best ever deal you’ve done?
Steve O’Brien: Definitely the deal we did in suburban Atlanta. It was actually a duplex community, and the property was being run more like a single-family neighborhood than a multi-family property. It was in big distress, so we came in and purchased the property all cash, because it was a mess, so it wasn’t financeable. To give an example, it was in such bad condition after the foreclosure that there were residents who instead of reporting a termite infestation would just put posters up over the holes in the wall, and wouldn’t even report it because they didn’t think anybody would fix anything. So we really had to sell the vision on that one of what we could turn it into, the transformation we could make.
We were able to do it four years later; it’s worth about three times what we paid for it, and we were able to finance out all of our capital, and it’s been a great deal. We basically turned it from a single-family neighborhood into a multi-family property.
Joe Fairless: What’s the biggest mistake you’ve made on a deal?
Steve O’Brien: It’s actually on my own personal house. I bought a house at the absolute worst time in 2006. I always laugh about it, because I’m a real estate person and I still bought a house in 2006, at the absolute worst time. Just going back and thinking about it, it’s funny… I think we all ignored a lot of the signs that some of this stuff didn’t make sense and we all paid the price, but hopefully we came on the other side better for it.
Joe Fairless: What’s the best place the Best Ever listeners can get in touch with you?
Steve O’Brien: The best place is our website, www.arcancapital.com.
Joe Fairless: Sweet. Steve, very informative and educational conversation – I know for myself, as well as some Best Ever listeners. Thank you for being on the show, spending some time with us talking about how your underwriting process is constantly evolving, and how to find the real rent comps when we’re looking at opportunities, and the three ways to find those rent comps: distance, age and construction quality, while taking a close look at the amenities, because as you said, a 2000 property could be a rent comp for a 1980s property. We really have to look into some of the specifics.
Thanks for being on the show, I hope you have a best ever day, and we’ll talk to you soon.
Steve O’Brien: Great, thanks so much for having me.
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