“What mistakes did you make in your career that I should be on the lookout for as a new passive investor?” Travis Watts answers this listener question by sharing four mistakes he made starting out as a passive investor that you can learn from:
- Location, location, location: You cannot overcome a bad area with good management.
- Understand that management is key.
- Make sure you understand the underwriting.
- Don’t do a deal just for tax reasons or because you see a lucrative fee split structure.
Want a more in-depth look at how to vet a team, a market, or a deal? Then check out our three-part miniseries starting with episode JF2396: Passive Investing Strategies | Actively Passive Investing Show With Theo Hicks & Travis Watts.
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TRANSCRIPTION
Travis Watts: Hello, everybody, and welcome. It’s Travis Watts with another exciting episode of The Actively Passive Show. This week, the topic came from actually a conversation I was having with an investor, and this investor asked me, being that I’m a full-time passive investor, he asked “What mistakes have you made, and what should I look out for?” He just basically, was looking to avoid some newbie mistakes, and I thought that’s an excellent question and I want to do it justice, I wanted to better articulate my point, so I made an episode out of it.
I want to share this information because it’s important you guys to balance the risk conversation with the reward conversation. Of course, everybody’s always out there talking about whatever it is they do, whatever their investment is, how awesome it is, and how great it is, and that’s fine. It’s also important to have the conversation about what risk you’re taking on or what mistakes could easily be made. So with that, I’m just going to walk you through four things I made mistakes on early on and mid-career so to speak, in regard to being a full-time passive investor. So we were talking about multifamily, private placements, syndications, being a limited partner.
So without further ado, let’s dive right into number one. Location, location, location. We all know the saying, we all know the phrase, it is a classic real estate line, but here’s the deal. I made a few investments early on. I say a few—well, yeah, it was a few. It was probably three, total. These were C-class properties, first of all. So the class of property, meaning, A class is new development, new construction, or not that old, very high end, luxury, very high creditworthy tenants, stuff like that. So we’ve moved down two spots on the spectrum down to C. This particular place that’s coming to mind right now didn’t even have a pool, didn’t have a gym. This was just kind of living in the unit and paying the bare minimum rents in an area that we all found out wasn’t such a great area. And I will point out why that is so important.
You cannot overcome a bad area with good management. So at first, this operator was pointing the finger at the property management company. They had hired a third-party property manager, and then things weren’t going well, there was lots of problems, stuff wasn’t getting addressed at the property level. So they fired him, and then the whole quarterly update was how excited they were to bring in this new property management company. Well, guess what? The new property management company couldn’t really do any better. The same problems existed, and when I say these problems, what I’m talking about is there was a shooting on the property. Fortunately, nobody was even injured, but still there was a shooting, so obviously, people don’t want to live in an area like that. There was a stabbing, there was vandalism… They had put up a gate to make it a gated community, and someone ripped the gate apart and broke it. So it wasn’t even functional. There were squatters on the property in the vacant units that hadn’t been leased up. There was just so much stuff, and it all came back to the fact that we had bought a property in a bad area. Just straight up. It was probably a C-minus, D-plus kind of sub-market, and the property itself was probably a C property. So it wasn’t the worst. I think it was built in the ’70s.
But anyway, my point is that of all the deals I’ve done A, B, C – I have never done anything under C – the C properties just notoriously have a lot of problems. That’s just my experience. I’m not saying you’ll have the same experience with a C property; it depends on a lot of factors… But I’m just letting you know.
B class is my sweet spot. I like the 1980s, 1990s, early 2000s built, good markets, good areas, surrounded by good neighborhoods with a high price of single-family homes, high wages in the area, all that kind of stuff, and we’re just taking an older property and we’re improving it. We’re bringing it back to the market standards in the business model.
A class, very rarely have any problems. However, less cash flow associated. So I’ll leave it at that. The mistake I made was investing in bad area. So whether you’re active or passive and you’re looking at a real estate deal, single-family, multifamily, syndication, GP, LP, whatever it is, pay attention to location. Look at school ratings, look at the surrounding neighborhood metrics, look at the jobs in the market, read the stats, look at the crime stats.
Number two is understand that management is key. Now, I just alluded to that you can’t overcome a bad location or area with good management, but in a general sense, the profitability will come from the key management; their ability to advertise and screen for quality tenants, and take care of issues on the property. A lot of deals that are being purchased – not always, but a lot – in the syndication space, and this is probably true with anybody buying, often the management hasn’t done a good job, therefore, they’re not leased up properly, or the rents are well below the market, or maybe it is a mom-and-pop operator and they just refused to ever raise the rents wedge… It’s usually management-related. Or you get on Google, you type in the property and you look at reviews and you just see zero stars and one stars, “Management’s not doing this,” “Management that,” management, management, management.
Back when, even before this – I was talking about single family real quick – I had a property and, come on, guys, quite frankly, I was a bad property manager; and when I say that, I mean, I didn’t know what I was doing. So I was making mistakes. It wasn’t like I was mean to people or doing things that were illegal. I’m just saying, I wasn’t effective. I would rent to a tenant, and let’s say they worked at my company. So, they were more of like an acquaintance or a co-worker, and they were going to rent my property. Sometimes I would just forego the screening process. “Ah, I know you. You work where I work. It’s all good.” Well, huge mistakes came from that.
I had a couple tenants that would always pay their rent right at the deadline, if not a day or two late. I wouldn’t be an enforcer of the late fee. It’s like, “Ah, it’s the 6th or 7th; at least you paid it, we’re all good,” and then notoriously, they would do that then every month thereafter, knowing they’re not going to get penalized. So why not pay it on the 8th instead of the first, because there’s no repercussion. Bad idea!
There was one property I had that was so bad, I hired a property management company to take it over, I was fully transparent about the issues and the tenants and what was happening to this point and why I had hired them in the first place, we signed the contract, we moved forward, about 2.5, 3 months later the property manager quit. They quit on me, because the tenants were so bad; and I take full responsibility for me putting them in there in the first place. But I’m just telling you, if you don’t have good management, you will not have a good performing asset.
So when you’re looking at these pro formas, and these overviews, I rarely hear a lot said about the management. It’s all about the deal, the deal, the deal, the deal, this structure, and it’s made of brick, and it’s in this neighborhood, and it was this many units. Talk to me about the management; ask questions about the management.
If you’re going to invest with a firm that’s what we call vertically integrated, meaning that they manage their own properties, just take a look at their track record or their current performance on the existing properties that they’ve acquired – totally cool to be vertically integrated. Lots of great reasons to do that. But if it’s a brand new group, and they’ve never managed properties, and they’re like, “Oh yeah, we’re vertically integrated. We’re just going to wing it and try to manage our own stuff,” probably a bad idea. You probably would want to start with a more experienced group to come into the picture, help you out, learn from them, and then possibly go vertically integrated later.
Again, not telling anyone to do that specifically, but be aware as an investor of who the property manager is, whether it’s third-party or in-house, and what their experience is in managing that kind of asset.
Travis Watts: Number three mistake that I made is not understanding the underwriting. And here’s the thing – not all of us are underwriters, not everyone wants to go stare at Excel sheets and find the misnomers… And one word of caution upfront, don’t get caught in analysis by paralysis. So many people do this. I’ve done this… Where you’re just digging and digging and digging and thinking and thinking and thinking, to the point where you miss out on the deal altogether, right? It fully subscribes or you don’t have a chance to even participate.
So, here’s my philosophy. You and I, and anyone listening – we’re never going to know 100% of everything to make a decision to move forward. So if I can know, maybe 60%, 70%, ideally more like 70% of the details and the data and the underwriting, at that point, I’m comfortable myself moving forward with a deal. I’ll learn the rest along the way, and I’ll never get to 100 anyway.
But here’s the mistake I see most commonly made is – look, you and I and anyone else can make underwriting look good on paper; just the difference in saying, “Well, we were going to take a 70% loan-to-value mortgage on the property, but let’s move it up to 80%.” Well, now the numbers look a lot better, don’t they? But now we’re possibly overleveraging the property.
Another thing I’ve seen is a group’s going to come in and buy something at say a 5 cap, and then they’re going to underwrite to sell it at a 4 cap. So they’re going to go very aggressive with the exit strategy, when in reality, that’s in none of our hands, okay? The way cap rates are fluctuating and interest rates – that’s not going to be in our control. So I like to see the opposite – you’re buying at a five cap, you’re going to exit at potentially a six. You don’t actually want that to happen. A higher cap rate means a lower purchase price. So that’s not a good thing. That means the market has softened up. There’s many ways and reasons that could happen. But what I’m telling you is when you’re looking at the pro forma, ask the question, if it’s not already preemptively stated in the overview, what cap rate are you buying at? And what cap rate do you anticipate selling at? In my opinion, as an investor, I’m always looking for a higher exit cap rate, not a lower one, for underwriting purposes, so that I know this is conservatively underwritten.
Another thing when it comes to underwriting that I see is aggressive rent pushes. And yes, we’re seeing it now and over the last maybe 6-12 months we’ve seen a big uptick in rent; some markets are 12%, 13% 14% year over year rent increases, which is incredible… But guess what? It’s also not the norm. So, if I see that — just making this up, for example, purposes, but let’s say Tampa, Florida. That’s one of the really hot markets right now. Let’s say, it’s got a 10% year-over-year rent growth, at least for the last 12 months. Well, what you don’t want to see in the underwriting is a new deal being purchased in Tampa, and they say, “Yeah, we’re going to get 10% year over year rent increases for the next 5-7 years.” No.
When you see big spikes, like we see right now, there’s usually a leveling off, sometimes even a slight sinking; I’m not saying that will happen. I’m just saying that can happen; you’re not likely to see 10% a year or year after year for the next decade.
So what I’m looking for is either very little rent growth in year number one as they do renovations, or maybe just a conservative 2% or 3% a year rent growth in the projections. Again, you don’t really want that to happen. You want a higher number than that, and hopefully, you get it, but you’ve got to be conservative too, because if you’re basing your overall return, which is most people are investing based on the overall return projections, you want to know these are conservatively underwritten, or else that’s not going to happen.
And the last thing I’ll say about underwriting is take a look at the capital expenditures budget. If you can, try to get a line by line, and ask questions about it. Why is the landscaping $300,000 per year? Why is it $8,000 per unit? And then look at the breakdown – how much of that is flooring, countertops, cabinetry, appliances. If you feel like they’re being a bit skimpy, like given the inflation right now and the supply chain issues, maybe those appliances are going to be on backorder, or they’re going to cost 30% more than they did last year. Just take that into consideration.
‘Same with property tax and insurance. I’ve seen huge volatile swings in these prices, where it’s underwritten as a 5% a year increase to the insurance or the property tax, but it ends up being 25%. These things can throw off the overall numbers to the investors.
And if the operator has it, I always ask for a sensitivity analysis or what some people call a stress test, and that just shows that they’ve put this projected pro forma through hypothetical stress testing. So in other words, what if interest rates are 4% today, but they go to 6% over the next few years? What if our occupancy today is 95%, but it falls down to 80%? Then what, and what it shows you often is what happens to the overall investor returns should these things occur… So that can be very informative to help you decide how conservative they’re being on these numbers.
Travis Watts: Alright, number four. A lot of people are out there talking about tax advantages of real estate, multifamily, and a lot of people are out there promoting their fee structures, saying “Oh, we have super low fees versus our competitors or whatever.” Number four is don’t do a deal just for the tax reasons or just because you see a lucrative fee split structure. Here’s the way I look at it – yes, tax advantages are excellent in my experience in real estate in general, and having a nice fee structure can be nice as well. But if the deal you’re investing in is aggressively underwritten, or the operator can’t actually execute the business plan anyway, what use are the tax advantages or the low fee split structure if you end up with 4% or 5% return in the end, when you hope to get more like a 15 or 20? It’s definitely a secondary consideration.
I see some people getting caught up in those and saying, “I would never invest with this group over here, because of their fee structure”, and that’s fine to have that opinion… But you guys – I think I mentioned this on a previous episode… I’m in a deal – this is not a multifamily deal, this is a different private placement – and the operator is getting about 66% of the profits and the limited partners are getting about 33% of the profits. Just rough numbers there; but for years, I’ve still been getting overall a double-digit return, on an annualized basis. So, I’m okay with the quote unquote “unfavorable fee structure” because to me in the end, that deal’s still helping me accomplish my goals. So that’s the way that I frame it. That’s the way I look at it.
So the difference between the 80/20 split, or 70/30, or 50/50 and I’m looking more at the office operator, their track record, their ability to actually execute the deal… And generally speaking, if you’re going to invest with a group that has a longer track record and more experience, they probably aren’t going to have as low of a fee split structure compared to maybe a brand new group that’s just getting started, who’s trying to be competitive and gain investors.
So with all of that in mind – I told you this would be a shorter episode, I just want to conclude by saying that Theo Hicks and I recorded last year, it’s about a year ago, you can check it out on YouTube or joefairless.com, how a passive investor vets a team, a market, and a deal. So we did a three-part mini-series. I think each episode is roughly 30 minutes long, so it’s an hour and a half of content, where we go in much more detail about how to actually vet the team, the market and the deal.
I highly recommend that you guys check out that three-part mini-series if you haven’t already, because I could talk all day long, about risk and reward and experience and all this kind of stuff, but every week, I’ve got to pull it back, I’ve got to tone it down, I’ve got to just give you some key elements and hopefully inspire you to do some more research on your own so that you can conduct proper due diligence before you invest.
Thank you guys so much, as always, for being here. I truly appreciate you. I truly appreciate you tuning in to these informative little rants that I that I do. My passion is to help other people like yourselves understand the risks, the rewards, the pros, the cons to real estate investing. It’s made such a profound impact in my life that I want to share that and I want to help other people. So reach out anytime, joefairless.com, travis@ashcroftcapital.com. If I can ever be a resource for you guys, I’m all over LinkedIn, social media, Facebook, whatever, happy to do so.
Have a best ever week, we’ll see you next time on the Actively Passive Show.
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