December 17, 2020

JF2298: How a Passive Investor Vets an Apartment Deal Part 3| Vetting The Investment Summary|Actively Passive Investing Show With Theo Hicks & Travis Watts

Today Theo and Travis share their expertise on how to vet the real estate deal by reading the investment summary. They discuss the most common red flags and things to look out for before agreeing to a new deal.

This episode is part 3 of the series “How a Passive Investor Vets an Apartment Deal”, which focuses on the most commonly asked questions about real estate deals. The other parts will cover the topics of vetting the market and the team.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting Thank you for listening and I will talk to you tomorrow. 

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Theo Hicks: Hello, Best Ever listeners, and welcome back to another edition of the actively passive investing show. I’m your host, Theo Hicks, as well as Travis Watts. Travis, how are you doing today?

Travis Watts: Doing great, Theo. Thrilled to be here. As always.

Theo Hicks: Yup. Thanks for joining us. And we’re going to wrap up a three-part series on how to vet a syndication deal. And we’ve done part one and part two on how to vet the actual team, and then how to vet the market in part two, and in part three, we’re going to talk about how to vet an actual deal as it comes in.

I know that the overall series is called How to Vet a Syndication Deal, but obviously, the deal is just one aspect of the vetting process. So we’ve got 10 different things we want to hit on today… Travis, do you have anything to say, or do we just jump right into it?

Travis Watts: Just to point out, again, if anyone listening hasn’t heard episode one and two, tune in to those; there’ll be a little bit of overlap. But this one’s really exciting, because everyone gets excited about the deal itself. And also a lot of investors, myself included, make a lot of mistakes, in my opinion (newer investors, especially) looking too intensely at the deal first, and not enough on the team and the market. So definitely rewatch those if you haven’t, and excited to get started in the deal.

Theo Hicks: Perfect. So point one is the investment summary, and what to look at in any investment summary. Before I dive into this – I just spoke with someone earlier today, and he made a really good point that I think is very relevant to what we’re talking about today. He was saying how he has some passive investors who he’s just shocked by, because maybe he talked to them on the phone once, and he knows that they haven’t necessarily done any research on him, the company, his background… And they will invest hundreds of thousands of dollars with him. And he’s just kind of surprised that somebody would be willing to do that without doing some level of due diligence beforehand. And he’s not talking about why he thinks that is the case, but… I thought that was interesting, because I was like, “Oh, we’re actually about to talk today about how to do due diligence on a deal.” So I know he talked about it in the previous episodes that you don’t want to go too in-depth, and you’re not going to go to the level that the actual syndicator is going, but you also don’t want to just do nothing, and then look at the email, see the returns, and then just invest, right? There’s still extra research you want to do, and that starts before the deal by researching the team, and then what markets they’re investing in. And once they have a deal, it doesn’t stop there; you’re still going to do research on that specific deal. And most of the info you’re going to get is going to come from the investment summary document that they sent you, which is essentially just a presentation that the sponsor puts together that gives you all the info on the deal. And so usually, they’re fairly long… I’ve got one in front of me right now that’s 60 pages long.

So, Travis, you can correct me, but I do recommend reading through the whole document before you’re investing in the deal. The key components in the investment summary… And again, I’m not going to talk about all of this; I’ve actually done syndication school episodes where I go into a ton of detail on the investment summary. [unintelligible [00:06:24].07] a new book coming out as well on passive investing that goes into even more detail on the investment summary. But what you want to think about here is you want to not just look at their returns, but you want to look at the information, and the assumptions, and the data that they are using to come to the conclusion of these terms, right? So you’re not going to see their full underwriting model, but they should tell you what assumptions they are making in order to come to these returns. How much are they increasing rent by? And then what are the rent comps that that is based off of? And then are those actually accurate rental comps? Or are they something that’s way better than what the deal is actually going to be, and so the rent numbers are inflated? What income and expense increases are they using every single year? Are they assuming that the rents are going to increase by 10% every year because in the past five years they’ve increased by 10%? Or are they being conservative and saying, “Oh, it’s going to increase by 2% to 3%”? Those are examples of things that you want to look at.

So you’ll read it through and they should have outlined for you in the executive summaries and various summaries what assumptions they’re making, and then if you scroll down to their financial analysis section, they should have their proforma and then they should have underneath that exactly what assumptions they made for each of the line items. For example, for concessions – are they just basing them off of the T12, or are they changing them based off of something else? Are they making their expenses based off of the T12? Are they basing them off of their property management company? If something is different than the T12, why did they make that change? Those are kind of the things that you want to think about.

So there’s a lot, but the whole idea here is that you want to identify their assumptions that they’re making, and then making sure that those assumptions aren’t something that are just completely crazy and aggressive, as opposed to being conservative. So the more times you see the word “conservative” in the investment summary, the better.

Travis Watts: I couldn’t agree more. The things that I would add to that — first of all, I love this, because you’re a lot more on the active side, and speaking to a lot of active syndicators themselves. I’m more on the passive side and speaking to passive investors, so it’s great to get the two perspectives.

This is what I would say to anybody who’s active or passive to the theme of our show here – the purpose of the investment summary is to essentially paint the picture of your business plan, what you intend to do, what your assumptions are, to your point, and to answer as many questions as you possibly can, all within a summary.

To that point, I’ve got to say, I’ve seen some bad investment summaries. And what I mean is, I want to go through that, kind of some red flags and what not to do… So you were just mentioning, Theo, that you’ve got one in front of you that’s 60 pages long. That’s a great length; that tells me they’ve got enough information in that summary to pretty much answer most questions that people are going to have. What I’ve seen commonly with new operators is a six-page overview, or a 10-page overview. And what happens is, by the time I’m done looking at the last page, if I even get that far before I fold on the deal, I’m saying “Is there a preferred return?” or, to your point, the assumptions’ there; what about the average income in the area? What about the schools in the area? I have so many questions that you have to hop on a call now, and then you got to go book that and set that up. It’s just inconvenient. And you should have a call obviously with the operator to ask questions or to clarify points, but as an active syndicator yourself or GP, you want to make sure you’re trying to address any concerns and any questions that may pop up… Maybe even put an FAQ at the end of it or something, to where people theoretically should not really have any questions by the end of it.

So the other red flags I look for is either on page one or somewhere near the end, there should be always legal disclaimers. And that’s important. It’s a very litigious society; you want to know that this group is working with adequate attorneys and legal counsel, and that they’re doing things the right way; they’re not just making a PowerPoint and then trying to raise capital. That’s a bad idea.

Other things I look for are multiple points of contact; that’s part of my own criteria. I don’t like to read through a whole summary at the end, where it’s like, “Contact John Smith” and he’s the only point of contact. I understand it might be an investor relations rep, or maybe it’s just a solo GP… But what happens if there is only one point of contact in a deal, and that point of contact is not in contact, or they’re on vacation for weeks at a time? That can be very concerning to investors. So I like to store a few numbers in my phone, if I can’t get a hold of one, I’ll try the other. Just something basic to look at.

The last thing I’ll say is just professionalism goes a long way. This is something I get asked by newer GPs that are just getting started, I get asked a lot about what LPs are looking for, and that kind of stuff. I always start with professionalism. Your website, your company prospectus, these overviews that we’re talking about, make them look professional; if there are typos all over the place, and you’re missing stuff, and it’s six pages long, and it looks like your nephew made it on PowerPoint, I’m usually out like that. If I see something that looks that bad, no one’s taking the time or effort to even put any emphasis on this. I don’t want to partner with somebody like that.

So just something to keep in mind, whether you’re an LP looking at it, you’re thinking, “Gosh, they misspelled their company name.” Or you’re trying to raise capital and wondering why you’re not being very effective. Think about that. So that’s all I have on that first topic.

Theo Hicks: Yeah, I’ll just very quickly add to that. A lot of things Travis talked about are things that indicate how trustworthy this individual is, how on top of their game this individual is. And as you remember, we talked about when vetting the team, one of the main reasons why people choose to invest with someone is going to be because of trust. You look at 20 syndication deals, and the return numbers are the exact same; what’s the differentiating factor? Do I trust the team? Do I trust the person?

And then one other thing I forgot to mention was case studies. Cases are also really good to see in the investment summary, because it proves that they’ve done this before, and you can see how their projections compared to their actual numbers.

So moving on to the next point we want to talk about… So when you’re deciding to invest with a syndication deal, you want to understand what the business plan actually is, what they’re going to do. And the reason why you want to know this is because, number one, the types of returns and the risks associated with each of these is going to be different. But also, the assumptions that they make should also be a little bit different for each of these… Which we’ll talk about a little bit more later. But really, the three main categories are going to be the value add, like a new development, or a fully distressed asset class; or also the turnkey. So I guess that’s four. So depending on which one you do, the types of returns can be a little different.

Let’s just take the opposite end of the spectrum – if you’re investing with a syndicator that does turnkey deals, you’re likely not going to get a lot of upside, but you’re going to see a steady cash flow from day one that doesn’t really change. So there’s a little bit less risk in there as well, since they have less assumptions and less moving parts that deal. But also, you’re not going to make as much money. And so is that what you want? Do you want to just have a steady return? Or do you want to have a chance of doubling your equity investment? Well, if you want to double your equity investment, and [00:13:48].01] turnkey, well, it’s probably not going to happen. Whereas if they have a development deal, or a distressed deal, or a value-add deal, then yeah, that’s definitely possible. But there are also many more assumptions that go into it. It’s a little bit riskier, so you want to make sure that you’re looking at those assumptions, like what Travis is going to be talking about in a second – how much money they’re investing into each of the units? What’s the current condition of the property? Is the market conducive for that type of strategy?

So really, the twofold part is number one, is this the type of business plan I want to invest in based off of my desired returns and my risk comfort level? And then number two – okay, if that’s the business plan they’re doing, then are they setting themselves up for success with his deal in regards to the team, in regards to any assumptions that they’re making?

Travis Watts: 100%, yeah. To wrap that up in a nutshell, to me, the thing I extract from what you were just saying, is knowing your risk tolerance. So generally speaking, higher risk, higher return, right? Everybody kind of has heard that in one form or another. So what I mean is new development has a lot of risks that come with it, right? You’ve got to get permits and licensing, and you’ve got to rely on contractors, and the cost of materials, and it takes years to complete sometimes, and you have 0% occupancy for a long time… There’s a lot that can go sideways, be delayed, go wrong. So that’s risky; to me anyway, that’s how I see it.

So if I’m going to invest in a new development deal, I need to understand that I should be expecting potentially a higher return, versus buying something, to your point, turnkey, already stabilized, already occupied, already has a long track record of being rented – there’s less risk in that, because you’re essentially making money on day one. As soon as you close, there’s money rolling in the door. So you’re probably going to have a lower return because of that.

So it’s understanding where you stand in this balance, understanding what those different types are and what you’re comfortable with. So I tend to focus, for anybody who cares, on the value-add stuff, because I like the idea that one, they’re usually stabilized and occupied anyway, and there’s potentially some upside to the deal as we improve it and bring it up to market rent. So I kind of like that combination of the two; that to me lowers my risk.

So not to be too long-winded on that… What I really want to talk about though is how do you know that a deal is conservative? That’s a very common question, because everyone likes to throw out the word conservative, and who doesn’t want to hear that? But what does that mean? And what do you look for?

For example, an average value add deal – it might cost 5,000 to 10,000 per unit in a turn cost, give or take, so you want to be looking at are they within that normal range? Or are they saying they’re going to put 20,000 into a unit, or 2,000 into a unit, and perhaps they don’t have enough budget allocated to do so, and things pop up unexpectedly… So making sure they have an adequate cap-ex budget, capital expenditures.

Also, something I look at more than ever in 2020 with COVID is breakeven occupancy. That’s important, and that, for simple numbers, we’ve talked about it before on the show. But if you have a 100 unit apartment building, and a 70%, breakeven occupancy, you can have 30 tenants not renting or not paying at any given time, and you’re still able to pay your operating expenses. You may have a 0% return, but you’re not losing money. So that’s important to think about and to look at as you think about recessions, and COVID, and things like that, all the government stuff going on right now.

The other thing I look at is debt financing. So let’s say it’s a value add play, and we’re expecting to buy it, renovate it, and sell it within five years. That’s a pretty typical structure in this space. I would like to see a longer debt term. So like 10-year debt, for example, that’s either fixed or capped – you can purchase an interest rate cap – longer than the business plan. Because the last thing you want to do is have your debt come due right as you intend to sell it, and then you can’t sell it; or we’re in a big recession, and now there’s no equity in the deal, so you’re looking at a potential loss, or you need to get a supplemental loan and you can’t, or all kinds of problems can pop up. If you’re using bridge loans and short term debt, there’s a time in place for all of this, but generally speaking, I like longer debt terms than the business plan.

The other thing I look at is the entry versus exit cap rate. For buying at a five cap today, I like to see at least let’s say a five and a half cap, maybe even greater in five years. 10 basis points per year is kind of my general rule of thumb. I’d love to see more of a gap, but then you’re looking at potentially lower returns and projections. But I have seen it. There was a deal I was looking at a couple of weeks ago, buying at a five and exiting at a seven cap. That’s pretty extreme on the underwriting perspective, but it’s also extremely conservative as well.

And for those that aren’t familiar, I’ll tell you this real quick. Cap rates, just essentially, high-level stuff here – if you paid cash for a property, that’s approximately like your cash flow return, using no leverage and no debt. So five caps like a 5% annualized cash flow if you paid cash.

So what I mean by a higher cap is a projection, you don’t ever want that to actually happen. You don’t want a seven cap when you sell and you buy at a five; that means that the value is going down. But it means that they’re projecting that there might be a softening in the market. And even if that were to happen, they still project they can return these types of numbers to the investors, and that’s kind of what you’re trying to balance out.

The last thing I’ll say, and you already touched on it Theo, is rent bumps; being realistic with it. Here we are in 2020 with COVID, and maybe we’re gonna head into a recession… Who knows, right? I don’t have a crystal ball. But if you’re looking at a deal and it’s “We’re going to raise rents 10% a year for seven years straight”, you need to find out why that is, and if that’s even realistic or going to happen. What assumptions are they going on, to your point? Right now what I see a lot is almost a 0% rent growth in year number one, just because of COVID. Nobody knows, so it’s better to again, under-promise over-deliver. So that’s all I got on that.

Theo Hicks: Those are all really good points. I can’t think of anything to add when it comes to a deal being conservative. I think you hit on all the most important points, except for maybe the reserves, because they’re accounting for reserves upfront. Right now it’s a little bit different, because you’re going to have to have six to up to 18 months of principal and interest in reserves between the loans because of COVID. But even if they don’t, making sure they have some sort of upfront operating account fund to cover the unexpected.

The next thing we have on this list is the different classes of property. This kind of ties back into the business plan. So it’s kind of a quick thing you can do, but if the property is a complete disaster, lots of deferred maintenance, and they aren’t investing any money into renovations – if it’s a deed property, but it’s presented as a turnkey deal, probably not a good sign. Vice versa, if it’s that really A-class luxury property, but they claim they’re going to force appreciation by raising rents – probably not going to happen.

So it’s understanding the property type, and the business plan, and making sure they match up. It’s most likely not going to be an issue, but it’s still something that you want to confirm. And you can get a good understanding of this by just reading the executive summary, because they usually say there’s a lot of deferred maintenance, it was owned by an institutional investor… What’s at the current state of the property? Where are we at right now? And then what’s the plan to take the property to where we want it to be? And then do they have the money to get to that point? I think the next point that you’re going to talk about, which is the sensitivity analysis is something that’s even more important than understanding the class of property.

Travis Watts: Exactly. And before I jump into that, real quick, just to piggyback off what you said there about the A-class scenario… It’s funny, I had to laugh, because again, just about — maybe a month ago, I was looking at a deal that was sent to me, and it was totally an A-class property built in 2015, 2016, something like that. And their whole business model was forced appreciation; it’s like, “What do you think you’re going to do to that property to make it so great and bump the rents so much?” And it just isn’t something I would believe in. Again, back to being conservative. Their projections were like “Double your money in five years on an A-class property”. I don’t think so. But hey, everyone’s got an opinion, right?

Theo Hicks: Well, one thing I forgot to say… So what do you mean by A class, to your point there? So it’s based off of when the property was built, but it’s also based off of economic occupancy too, as well as the condition of the property, and the market too, technically. So a D class property could technically be fully occupied. But it could be in a really bad condition in a really bad market, and that’s a D class. Whereas for an A-class property, it’s usually a new construction deal, a luxury, fully rented, rents are kind of maxed out. And then obviously, B and C are something that kind of falls in between. So those are the three different factors that determine the class and property, high level.

Travis Watts: Yeah. Again, property classes are subjective, too. So that’s something you’ve got to watch for if it’s on a proforma or on an overview. Like you’re talking about, you might see them say, “Hey, this is a B plus property.” It’s a C minus. So who really knows the answer? Well, nobody, technically. But to your point, there are things you can look at – what age is it, what the occupancy… And in general, A-class is a new development, new construction, luxury, highest rents, great areas, all that good stuff, right? It’s the best of the best, the cream of the crop. B usually still has some nice amenities, a gym, a pool, a barbecue area, a dog park, these kinds of things, but it’s an older product; maybe it was built in the 80s, or the 90s, or the early 2000s. C, start dropping off all the perks right? Maybe it doesn’t have a pool, maybe it doesn’t have a gym; maybe the gym is super outdated or super small, and maybe the ceilings are real short, maybe it was built in the 50s, 60s, 70s, that kind of stuff. And D, to your point is usually no amenities or very little, and in a bad area, so to speak.

So again, higher risk, higher return. It’s nothing against a D property. If you’ve got a great team that specializes in that niche, they might be able to turn that thing around and make a lot of money. So just know where you stand on the risk scale. And again, for anyone who cares, I tend to focus on the B asset class, for the most part. I have done some Cs. Okay, to your point, stress test, and sensitivity analysis… Every group should have this data; they might call it something different. What this is, is you’re looking at their underwriting and their assumptions on the deal, and they’re stressing it, in the sense of, “Well, hey, what if interest rates spike up and they double because the Fed makes a big move? What if occupancy drops really low? What’s the breakeven occupancy, like we talked about earlier? What if cap rates shift up or down?” So what this is, is usually just a PDF or whatever, that they can send you; sometimes it’s in the overview itself, other times it’s not. I would always ask for it, any deal you’re going to invest in, just to know, more or less, the worst-case scenarios. How would your overall return, either cash flow or IRR, internal rate of return, be affected if, and then it’s like a, b, c, d, e, f, g, right? It’s all these different situations and scenarios. What if people don’t pay? What if things get worse in the economy? This is just showing you how conservative the deal is. It’s probably your best set of data to understand how conservative a deal is. So I would definitely ask for that.

So again, it’s called either a stress test or a sensitivity analysis, or something similar. If you say those terms to a GP as an LP, they’ll know what you’re talking about, and they should be able to show you something to that effect. So that’s all I’ve got on that. That’s pretty important.

Theo Hicks: Very important that you mentioned. A lot of deals I’ve been looking at lately, they’ve been including it in their investment summary a lot more lately, I think because it COVID.

Travis Watts: I agree, I’ve seen that too.

Theo Hicks: So the next thing we want to talk about – we’ve kind of already hit on this, but the operational, the interior or the exterior, and the amenities upgrades. So when you’re dealing with a value-add, or below, so the value-add or the opportunistic, distressed type of deal, and the business plan is to force appreciation, then you’re going to want to have an idea of what they’re doing to force appreciation, and then what the numbers look like in regards to that. So the different ways you can force appreciation are going to be to make physical improvements to the property, or to make operational improvements to the property. So operational improvements are things that you aren’t necessarily adding anything to the property, like physically… Technically, you might be adding like a new property management company or something, but you’re not adding anything to the property, but you’re making some sort of change to the way that property is managed or operated in order to either increase revenue or decrease the expenses. For example, it would be like billing back utilities to the residents, or maybe one of the expenses is abnormally high, like maintenance, because there’s a lot of deferred maintenance; that’s addressed upfront, and so those expenses are going down.

And then for the other upgrades – the interior, the exterior, and amenity upgrades, those are things that are actually physically done to the property. So interior would be upgrading the unit’s exterior, would be improving the outside of the property, like new roofs, parking lots, parking painting, which might not necessarily be able to calculate the exact ROI, “I put a new roof and they we’re going to raise rents by five bucks.” So that one is more on the deferred maintenance side. You’re going to see that the further down you get with opportunistic deals, and sometimes for value-add deals, it might be focusing on some things, but ideally not that many.

And then the amenities upgrades – those are where you take an existing fitness center or an existing clubhouse, and you upgrade it, make it nicer, or you add it. So for these, they should have a section in their investment summary that says what interior upgrades they plan on doing, what exteriors upgrades they plan on doing, and they’ll have a cost for that as well.

The important thing here that I want to stress is that essentially how syndicators are determining what their renovated rents are going to be is based off of these improvements they’re making to the property. So they say “Hey, right now we’re at this condition, and we’re demanding X in rent. The plan is to go in there and do this to the unit, do this to the exteriors, do this to the amenities, and then we’re going to get higher rents.” But the evidence for those higher rents is going to be other properties in the market that have the same level of upgrades.

So when you’re looking at those rent numbers, they should have a section that has the rent comp analysis – you want to make sure the properties are actually rent comps; you want to make sure that they’re not maybe putting in fake granite countertops and black appliances, and their rent comps are granite countertops and stainless steel appliances, because that’s going to demand a higher rent. So that’s one of the main things to look at.

And then secondarily would be – and I kind of already hit on this – making sure that what they’re doing from the interior and exterior perspective matches the business plan. So Travis gave the example of a turnkey, where they’re somehow going to force appreciation. So I’d say “Okay, well, what amenity upgrades are they doing?” And then looking at the rent comp and seeing if that actually matches up. If it’s a value add deal, they probably shouldn’t be spending half their budget on deferred maintenance. If it’s an opportunistic deal, then yeah, they’re going to be spending a little bit more money on these things. But then at the same time, you want to make sure that they’re not using rent comps that are in an A-class area, when their property is going to be a B or C class.

Travis Watts: Those are great thoughts. And again, a story came to mind that I want to share with everybody, because this is a really simple, practical takeaway that everybody can do. So if you’re an LP, you’re looking at a deal, you read through the business plan, you understand what they’re saying… Okay, cool. What I did just like two weeks ago, I went to – I use that all the time – and I looked at all the comps in the area. And it’s a great site because you can just put in a ZIP code, you pull up every single apartment complex in the area, you look at all their different rents, you look at all their different amenities, all the photos, and you can now stack up and decide for yourself if this seems realistic.

And what happened with this particular deal that I was looking at – what I found out, what I discovered is their projections, what they said they were trying to achieve in rent, if they ended up achieving it, would be the highest rents in the entire market within like a 50-mile radius. I don’t like that. I don’t want to be the most expensive place out there. What I like to see more often is they’re buying a property, the rents are 300 below market today, and they’re trying to raise them 200. So they’re not trying to be the most expensive, they’re not trying to go overboard with it; under-promise, over-deliver.

And one last thing to recap everything that you’d said, the name of the game here is increase your net operating income; the primary valuation of multi-family is based off net operating income. So to your point, what Theo is talking about is you can do that two ways – you can cut expenses, so the inefficiencies on the property that currently exist, and/or you can raise the rents and the revenue, find new ways to bring in revenue outside of just traditional rents, too – premium parking, covered carports, self-storage on site, whatever it is. So at the end of the day, from a high level, that’s all we’re trying to do in the value-add space.

So what I want to touch on, which we’ve already kind of touched on, but I want to go into a little more detail, is debt financing. What I talked about earlier was having a 10-year term on a five-year business plan, that kind of stuff. The other thing is, a lot of people assume just because we’re in the environment that we’re in, the interest rates are really low, so that’s just how it is; everybody has a low interest rate. But that’s not the case. I just looked at a deal a couple of days ago. These guys had a 4.89% interest rate; I looked at another deal, very comparable, 2.89%. That’s a big variance. You need to understand why that is, who they’re using as a lender, is that short term debt, is that a bridge loan? It’s important to recognize this stuff. So right now you should be getting really great rates around the 3% range, give or take, in the environment that we’re in. So if you see something almost 5%, you need to ask yourself why that is and what type of financing they’re using.

And the last thing is a fixed rate or having a cap. I touched on this lightly before. A fixed rate would just obviously mean if you’re locking in a rate at 3%, it’s going to be 3% throughout the entire hold period of the project; it’s not going to move. That’s important, because if it does fluctuate up and down, now you need to be going back to that sensitivity analysis and stress test and figure out what that means for your overall investment.

What a lot of groups will do though is it’s like an insurance policy – they buy an interest rate cap. So if interest rates are at 3%, right now, they might buy a four and a half percent cap. So that’s the max that it’s going to go up. So you just need to know what the cap is, if they even have a cap, those kinds of things. So just questions to ask the sponsors that may or may not be in the overview, but that’s important data to know. So that’s all I’ve got on that one.

Theo Hicks: And then one other thing to add would be the refinance or supplemental loan – we always want to know if they expect to do that, and then if that’s included in the returns. It shouldn’t affect the overall annualized cash on cash that you’re going to get it earlier or at the sale… But it’s just good to know. If you look at the return, it says you’re going to get a 50% return in year two, and you go in there with the expectation that something happens and they don’t do the refinance, then you might be a little disappointed. So I think a good practice would be to not model that in and assume you’re not going to refinance. They mention this in the investment summary, “Hey, we might do refinance. We have the opportunity to do refinance. We’re not putting it in the returns.” So it’s just kind of icing on the cake there.

Travis Watts: Yup, couldn’t agree more. Sometimes that can be a form of aggressive underwriting, to say “Oh, our average cash flow projection is going to be 20%.” You’re thinking “What the heck?” Well, they’re factoring in an immediate refinance, and they’re averaging a poor cash flow with a huge, high number. But to your point, it may not even happen, and then what? You’re left with 6% cashflow. That’s not what you signed up for, so to speak. Alright, that’s all I got.

Theo Hicks: The last thing I wanted to talk about would be looking at the actual proforma. So what the proforma is – it’s going to be a line item breakdown of all of the income line items, so gross potential rents, and loss of leases, and then some of the losses, like concessions and bad debt, and vacancy, and the other income. And then below that, it’ll have all the operating expenses. So maintenance and repairs, contract services, payroll, utilities, things like that. So that’s what’s on the far column. And then next to that it should have how the current operator is performing. So they might just have a T12, or they might just have a T3. So a T12 would be the total for the previous 12 months. A T3 would be the total of the previous three months, annualized out for 12 months. And so they’ll take the last three months and basically multiplied by four.

And then next to that they should have what they expect to do each of the years. So year one, year two, year three, dot, dot, dot, until the last year they plan on selling. Now, there’s a lot of information here… So the main thing to look at is to compare the T12 and the T3 numbers to what they say they’re going to do. If you see a massive change, and there isn’t a note anywhere on why they did that, you’re going to want to understand what’s going on there. So if for example the current maintenance and repairs are $150,000 per year, and then the year one maintenance and repairs is $50,000 per year, that’s a pretty massive decrease. And if there’s not a note and explanation as to why that’s happening, well, that’s a red flag; that’s something you’re going to want to know. So kind of the same thing applies to all the different line items; just take a look at them really quickly and say, “Okay, gross potential income. How does that compare to how they did over the past 12 months? Okay. Vacancy, the same thing. Oka. Concessions, same thing.” And then now, what’s interesting is that if you’re looking at a T12, right now, it’s including all of 2020, whereas the first three months were normal operations, and then the next nine months were COVID. So if you’re looking at a deal, you want to know what that T12 is over, right? If it’s 2019 numbers, then that’s completely different than how the property is currently operating. So in that case, the T3 might be a little bit more accurate than the T12.

A T3 is going to give an indication of where the deal is at more recently. Now, the T3 could also be potentially misleading, because think about it from the seller’s perspective, right? Okay, I’m selling my deal; the higher the net operating income, which is the income minus expenses, the more money I can get. So I might do some things in order to inflate the value of the property. So the T3 might be way stronger than the T12. So that’s something that the active investors are looking at. But overall, just compare how they say the property is going to operate, and if there are any differences or major differences, there should be an explanation for that.

Travis Watts: Yup, couldn’t agree more. I know we’re going a little long on time for our typical show time, but I did want to say this last, because this is something really nobody’s talking about, that I think is extremely important, that I want to talk about… Which is the exit strategy of the type of asset that you’re buying. So I like to invest in units of, let’s say 200 to 600-unit range… The reason being, you have a lot of exit strategy potential. So you might sell to an institutional player, like a pension fund, or a REIT, or mutual fund, or something like this. You might sell to another syndication group; you might sell to an individual investor, or a family office, just a very wealthy individual or family. So you have a lot of exit strategies.

Versus if I own an eight-plex, well no institutional capital is interested in my project, no syndication group is interested in my project. So really, I’m only selling to other individual investors, therefore my buying pool is very small. So that’s important to recognize, unit count, when you’re considering this stuff. Most individual investors are buying 100 units or less, usually, much less; I’d probably say 50 or less. Syndication groups are going to be 75 units to whatever, I don’t know, 400 units; I’m just using simple numbers. Institutional capital might be 200 plus, that kind of stuff. So it’s important to understand, because even though you’re buying a good deal, what if you can’t offload it? What if you intend to sell it at a certain price, but there are just no buyers that are interested at that time? So you want to maximize your chances to achieve the business plan returns.

Now, the reason you’re not going to find that stuff in an overview or a prospectus is because you don’t want to limit your market, you can’t guess what the future holds, you don’t know who’s going to buy the property, so it’s kind of a moot point to list in there these kinds of things, not knowing who’s going to actually make the purchase. But it is important as a passive investor to recognize that, “Hey, this asset may be very appealing to institutional players out there…” Many of which, by the way, for those that may not know, a lot of their business models are turnkey, to your point earlier; they’re looking for things that are either new construction, newly built or newly renovated, even though they’re pre-existing and older units. But they don’t have deferred maintenance, they’re high in occupancy, the rents are up to the market level… They just want to sit on it. It’s a cash flow play, they’re chasing yield, right? They’re not in the business of value-add; they don’t want to get in there with construction crews and turn things around. They just want to buy something for the yield, because you’re not finding that through CDs, and money market, and bonds, and treasuries. Everybody’s chasing yield. So that’s a whole different place. Sometimes they’re even paying cash for these properties, just to get the cap rate yield. 5%, believe it or not, in today’s world is pretty lucrative to a lot of institutional players that can’t find that anywhere else.

So it’s something to think about as part of your own personal criteria, what types of deals that you invest in. That’s why I chose that unit range.

Theo Hicks: That’s a really good point, and I guess one last thing [unintelligible [00:39:45].20] but one last thing that makes a deal more attractive, especially now because interest rates are so low – so if the debt is assumable. So what assumable means is that at the sale a buyer, assuming they qualify, can assume the existing debt. So deals right now are probably not; many people probably aren’t assuming those loans. But as Travis mentioned, interest rates are historically low right now. And if, say, you’re planning to sell five years from now, and you’ve got a 10-year debt or 12-year debt at a 2.75% interest rate, and interest rates happen to go up to like 5% or 6%, and you don’t have an assumable loan, then you’re not going to be able to get as much money for that deal, or you might not be able to sell it at all. Because, again, since the debt percentage is that much higher, the people buying might not be able to get the cash flow they need to justify the purchase price.

Whereas if you can sell them the deal at that 2.75% interest rate, you’ll attract a lot more attention, [unintelligible [00:40:41].07] more money, or increase the chances of selling the actual deal. So it’s definitely not a deal-breaker, but it’s just that much more beneficial to have assumable debt, especially right now, because of how low the interest rates are.

Travis Watts: That’s a great point. It’s the same concept as buying the interest rate capped; in case interest rates go up, you’re locked in at a certain point. It’s the reverse of that – you’re locking in a low interest rate for someone else to assume. So it’s a great point, and thanks for mentioning that.

Theo Hicks: Awesome. This was the world’s longest actively passive investing show ever. But I really enjoyed it, and I think we got a lot of solid info out. So Travis, thanks for sticking with me throughout this episode. Best Ever listeners, also thank you for sticking with us. Let us know if you like this length, I’d be curious. Because it’s probably double what we usually do. But I know some people like longer episodes, where we go into more detail. So let me know at if you enjoyed the length; or if you’re mad at us, email me too and let me know.

So Travis, thanks again for joining me today, I really appreciate it. Best Ever listeners, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everybody.

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