January 6, 2021

JF2318: Red Flags to Avoid When Presenting New Deal to Passive Investors| Part 4 of 4| Syndication School with Theo Hicks

In today’s Syndication School episode, Theo Hicks shares the most common red flags that you should recognize before presenting syndication deals to potential passive investors. Not every red flag is a deal-breaker if presented the right way.

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 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. For a lot of these episodes, we’ve given away free resources, free documents; these are PDF how-to guides, PowerPoint presentation templates, and most of them are Excel calculator templates that you can use to help you along your apartment syndication journey. So make sure you check out our previous Syndication School episodes; all of those free documents are available at SyndicationSchool.com.

Today we’re going to conclude the four-part series that focused on some of the things to avoid when you are underwriting and then presenting your new deals to investors. So these are things that you want to proactively address, that your sophisticated passive investors are going to recognize or look for when reviewing a deal. So they might have a checklist of things in their mind, and say “Okay, I’m not investing in deals that have these red flags.” So my goal for this series was to present to you what those red flags are, so that you can avoid them whenever you are underwriting deals and presenting them to investors, or at the very least understand why they’re red flags, and then maybe there’s a reason why you’re doing this, and you can explain that to your investors.

Not every single one of these things is a deal-breaker. Some of them are. A lot of them are just things that investors are going to ask, and so they make you look more professional if you’ve done these things already, that way they don’t have to ask.

So let’s jump into where we left off, which is at number 17 on our list, which is in our category of the pro forma. So the proforma is going to be your income expense projections broken out by line items for each year of the hold period. And then usually, it’s compared to the T-12 and/or the T-3, which is the trailing 12 month of income and expenses, or the trailing 3 months annualized of income and expenses. So when you are putting together your proforma, here are some of the things that you want to think about.

The first that’s gonna be a red flag – and again, this is 17 on the list – is that there are large variances between your projections and the actual T-12 or T-3, and there’s no explanation for why there’s a big difference. So a T-3 and a T-12 column is gonna include the most up-to-date information on the actual income and actual expenses at the property. And then next to that is gonna be your year one projections, year two projections, year three projections, year four projections. So since it’s presented in that fashion, investors are gonna very quickly look down and say “Okay, let’s take a look at the T-12 expenses, and then take a look at the year one expenses… Oh, wait a minute. Why is May’s repairs so much lower in year one? I’m gonna mark that down and ask the syndicator. Why are taxes so much higher? Why is insurance so much higher?” Things like that.

So to proactively address that, have a column to the right of the proforma, or you can have a footnote section at the bottom of the data table of the proforma explaining all of your assumptions for every single line item. So for gross potential rent – why is year one projections way higher than the T-12? Well, see rent comps for this explanation.

Why is concessions zero, whereas they’re paying X dollars per year in concessions? Well, the plan is to burn off concessions, because they’d been giving concessions for whatever reason.

Why is vacancy higher year one, and then not as high in year two and year three? Oh, because we’re doing renovations, and we assumed a higher vacancy rate during renovations. Why is maintenance and repairs so much  higher in the T-12 than on the year one projection? See cap-ex budget for deferred maintenance investment. Things like that. So any line item. There should be an explanation, even if it’s just same as T-12, or same as T-3. Or based off of current expenses, based off of current income. And for any differences, there should be an in-depth explanation as to why that is. If that’s not there, it’s gonna be a red flag for your investors.

Now, more specifically on the proforma would be the real estate tax assumption. So whenever you’d buy a property, you take a look at the T-12 and they’re paying 100k/year in taxes. And that’s based off of the current assessed value of the property. Usually, what happens after you buy a property with a new  purchase price, the taxes are reassessed based on the new purchase price, and then go up, usually, assuming the property was sold for more than it was bought. When that’s the case, taxes are gonna go up, which is why you can’t just set the year one and on tax assumption to the taxes on the broker’s proforma, or the taxes that the current owners are paying. You’re gonna need to determine what the tax rate is in that market, and then create your tax assumptions based off of that and your projected purchase price.

Again, in some cases it might be the same, but especially in the past five years and now, taxes are gonna go up, because of how much values have increased over the past 10+ years. So if you are assuming that the taxes are the exact same, that’s gonna be a red flag to your investors.

The last proforma red flag, which is something that if you’re a Best Ever listener you’re not gonna be doing this, but it’s still possible… And that would be not having a reserves budget. Now, you’re gonna have your upfront reserves budget, which I talked about last week a little bit. This reserves budget is the ongoing reserves budget. Now, most lenders require this anyways, so it’s gonna be included regardless. If you’re getting a loan, you’re gonna have to include a reserves budget, because your lender is gonna require it each month… So just make sure that you’re including this on the proforma, so they know that this is an operating expense. To not include that to make the net operating income look higher, and in reality you’re spending extra tens of thousands of dollars a year to the lender for the reserves budget… So make sure you’re including that in there if you’re securing debt.

That one’s not that big of a deal, because as I said, you’re gonna have to do it if you’re getting debt… But if you’re not getting debt – you’re either buying it all cash or something, or the lender does not require this, make sure you’re still saving some of the cashflow each month into reserves.

Okay, the end is in sight… Next category is rental and sales comparable properties red flags. So whenever you are doing any deal, you’re gonna have sales comps. These are comparable properties that have sold recently, and use that to determine if you’re overpaying for the property or getting a discount… So the sales comp that sets the market rates for buying. And then rental comps are gonna be comparable properties that you use to determine what the market rents are at the subject property.

So some red flags when it comes to these types of properties would be number 20 on your list, which is not actually a comparable property. So in your investment summary you should include your rent comps and your sales comps, or what properties you used to determine your purchase price, in part. Or what properties you used to determine your rental rates. And these properties should actually be comparable.

So when we’re talking about the sales comparables, a comparable property is gonna be a property that is similar to the subject property in its current condition. So not in its value-added condition, when it’s done with your value-add program, but in its current condition what are similar properties, that are in the same condition, that have sold. They should offer similar types of amenities; it’s not gonna be the exact same, but if a comp has a clubhouse and a pool and a fitness center and a Amazon package center, and free parking, and a barbecue area and a dog park, and then the subject property has none of those things, it’s not a sales comp.

This should have been sold within at least the past couple of years; It shouldn’t be a sales comp from ten years ago. So those are the three main criteria for a sales comp. For the rental comp, the comparable property should offer similar types and quality of amenities as the subject property once it’s stabilized and upgraded. So unlike the sales comp, this rental comp should be the final product. So once you’re done doing all of your upgrades to the property, your value-add business plan is completed, what’s that property gonna look like at that point – find properties that look like that. Similarly for the interior; it should be the same as well.

So the quality and types of upgrades to the amenities and the quality and type of unit interiors should be the same, or at least very, very close to being similar. And then the units at this rental comp property should have been renovated and rented within the past few years at most, ideally more recently… Because you don’t want a property that was fully renovated five years ago. You want a newly-renovated property, because you’re is gonna be newly renovated.

And then something else that’s important too would be that the fees that are included in the rent or excluded from the rent are the same. So if you plan on billing back utilities to the residents, the rental comps should also bill back utilities. So these are what make a property a comparable property, and if they do not meet this criteria, it’s a red flag.

Number 21 on our list is going to be that the market leader that your subject property that you’re buying, rental premiums are going to make it the market leader in rents, or the purchase price is going to make it the highest sales price per unit in the entire market. So assuming that you’re using the comparable properties, then in order to determine your rent premiums, you’re going to take the average rent per square foot of the rent comps, and then the price that’s the average sales price per unit, and get an average number. And then for the rent comps and for the sales price, based off of that average number, you’re gonna determine a rental rate assumption, as well as a fair market offer price.

Now, you should not be assuming that you’re going to achieve the same rental rates as the market leader, or rental rates that are above the market leader. Similarly, you should not have the deal under contract for a price per unit that is equal to or above the most expensive property that sold recently. Instead, they should both be closer to the average, or even better, below the average. So the sales price – that means you’ve gotten the deal below market value, and for the rents, it means you’re being very conservative in your assumption. If you are the market leader in rents or you’re the market leader in sales price, that’s a problem; that’s a red flag that your investors are going to be concerned over.

And  then last in this category would be that the comparable property is not actually near the subject property. So we talked about the material characteristics of the property, and we also need to talk about the location where the property is.

For both the sales comps and for the rental comps, they need to be near the property. And then the bigger the market, the closer it needs to be. If you’re in a rural market, in the middle of nowhere, it might be hard to find a comparable property within a mile of your subject property, so that’s fine. Or maybe you’re in a very unique part of a major market, that there aren’t a lot of comps on the water, on a lake, and there aren’t a lot of lakes nearby, so you need to find a property on a lake further away, or maybe even in a similar market across the country… But if you’re in a big market like Dallas, Chicago, or any other major market, it should be very close. It might even be on the same street, but at the very least, it should be in the same neighborhood, and then if not, in the same submarket. But if you’re investing in Dallas, you shouldn’t have one comp that’s in Fort Worth, another one that’s in Garland, Texas, and maybe another one that’s way out in a rural area somewhere. If that’s the case, if they’re all over the place, it’s a red flag.

Alright, the last section is gonna be the other red flags that don’t really fit any of these categories, but they’re still going to be things that you want to avoid when you’re creating your investment summary in particular. Number 23 on the list is that it’s a short investment summary. So your investment summary needs to be long, because it needs to proactively address any potential question that one of your passive investors might ask. The more information you include in your investment summary, the better. The less questions that the passive investor has to ask you, the better for you, because it saves you time, plus it shows that you’re a professional, experienced person that knows what information to include… Which means that your investment summary shouldn’t be ten pages long; it should even be longer than about 20 pages long… But anything less than that is a huge red flag.

24 is going to be not having a Risks and Disclosures section. Since you are raising money, you are working closely with your securities attorney, and in order to make sure you’re going by the book, there are lots of risks and disclosures you need to provide to your passive investors in that private placement memorandum.

Now, the investment summary is technically like a marketing piece, so you don’t need to include [unintelligible [00:16:32].17] but you should. That shows that you’re a professional, that shows that you’re working with your experiences securities attorney, it shows that you’re transparent, which overall builds trust with your investors.

25 may seem minor, but it’s still a pretty big deal, which is typos. So you’re dealing with hundreds of thousands of dollars, millions of dollars of people’s capital. If you can’t review your investment summary to make sure that there aren’t any typos in it, that shows that you don’t pay attention to details, it shows that you’re maybe inexperienced and you lack professionalism, which might be a problem.  Now, if you’ve got one typo in a 100-page document… But if you’ve got typos on every page, it’s a pretty big deal.

And then lastly would be not including any case studies. The case studies, assuming you’ve done deals before, will explain the deals you’ve done, and that should include your return projections, the actual projections, and if they sold or not. That will give your investors an idea of how aggressive you are on your return projections for this current deal, based off of if you’ve exceeded, or met, or under-delivered on previous deals. Plus, it shows that you’ve done this before and this isn’t your first deal.

So assuming you’ve done a deal before, make sure that those deals are included in your investment summary. But hopefully, they’re good deals. If they’re not, make sure you have an explanation as to what happened.

So those are the 26 red flags. I’m gonna quickly go over them, and then we’re going to wrap up this four-part series.

So the number one red flag, stagnant or shrinking population. Number two, stagnant or shrinking rental rates. Number three, low absorption rate. Number four, no neighborhood or submarket-level data. Number five, population demographic doesn’t match the property. So those are all the market-related red flags.

For the business-related red flags, number six, the property doesn’t match the business plan, and number seven – it truly isn’t a value-add deal or it truly isn’t a turnkey, or it truly isn’t a distressed/opportunistic deal.

Next, under projected returns red flags we’ve got 8) you’re guaranteeing a return, and 9) you are not providing a sensitivity analysis.

Under debt, 10) the total loan term is less than two times the business plan. 11) There’s no cap on the adjustable interest rate loan, and 12) you are including the refinance or supplemental loan proceeds in the return projections.

Under the purchase and sales assumptions red flags we’ve got 13) the exit cap rate is equal to or less than the in-place cap rate. 14) there’s a very aggressive revenue growth assumption. 15) you’re using the same vacancy rate during and after renovations, and 16) no contingency cap-ex budget. And 16.a) would be not having an upfront operating reserves budget.

Under proforma red flags, 17) no explanation for variances between the proforma, so your projections, and the T-12 or T-3, what’s actually going on on the property. 18) Real estate tax assumptions is the exact same as the T-12 taxes, and 19) no ongoing reserves budget. Under rental and sales comparable properties, which we’ve talked about today, is they aren’t comparable properties. 21) You’re assuming you’re gonna be the market leader in rents, or you have a property under contract at the market leader’s sales price per unit, and number 22) comparable properties are not nearby the property you’re buying.

And then the other red flags is 23) a short investment summary, 24) no Risks/Disclosure section, 25) typos, and 26) no case studies.

So those are the major red flags, 26, to look out for, to not do when you’re underwriting and creating your investment summary. Now, again, I said earlier, not all these are gonna be complete deal-breakers. One typo is not gonna result in you not doing the deal. Some of these other ones, like maybe not explaining every single item on the proforma… But most of these are major red flags, so make sure you’re avoiding these when you’re underwriting and when you are presenting your deal to your investors.

Thank you for tuning in. Make sure you check out parts 1-3 – this is part 4 – of the 4-part series, where we go over the red flags to look out for, the holes to poke in your underwriting. Besides those episodes, make sure you check out some of the other episodes we have on the how-to’s of apartment syndications. Download our 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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