January 6, 2022

JF2683: How to Evaluate Risk in Multifamily Apartments 2022 | Actively Passive Investing Show with Travis Watts

There are a lot of variables to consider when selecting a deal, which means there is a lot that could go wrong with your potential investments. Today, Travis Watts outlines three risk areas investors should investigate before closing on a multifamily deal.

Want more? We think you’ll like this episode: JF1386: How Do You Remove As Much Risk As Possible In Real Estate Investing? With Chad Doty

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Travis Watts: Hey everybody and welcome back to The Actively Passive Investing Show. I’m your host, Travis watts, and appreciate you guys’ tuning in. We are back in the studio here today recording this episode on how risky is multifamily in 2022, as we enter the new year. A quick little background on this. Risk should always be top of mind as an investor and I think it’s understated, I think it’s an underserved topic in the industry. Today we’re going to talk about risk as it pertains to multifamily, but I’ve got some really good insights to share with you on some due diligence, so I think you’re going to get a lot of value out of this episode. It’s going to be a bit longer than the last couple. Without further ado, let’s just go ahead and dive right in.

The first thing I want to talk about is the business strategy itself. Just saying “Is multifamily risky?” is kind of like saying, “Is real estate risky?” What exactly are we talking about, commercial, retail, single-family, flips, development? There are all kinds of aspects here. Let’s pinpoint what we talked about all the time on the show, which is value-add real estate in the multifamily sector.

The big difference here when we talk about value-add is to understand one key fundamental, and that’s that the value of multifamily apartments is primarily based around the net operating income. That’s the income the property generates after you pay all your expenses, taxes, debts, and things like this. How do you get net operating income to rise? Well, it has a lot to do with rent and rent growth. What are you buying a property at today? What are the current rents? What do you think you can get the rent to? This is all part of the strategy surrounding value-add. Let’s talk about a cap rate. I’ve described the cap rate in a few different versions in previous episodes,; but I’ll give you a new way to look at cap rate. Hopefully, it’s not too confusing. One, a cap rate is simply just a gauge to see how hot the real estate that we’re talking about is.

If you’ve got a two, three, or four cap, that is suggesting a really hot market or a really hot asset, anything that’s trading in that range. If we’re talking an 8%, 9%, 10% cap rate in 2022, we’re talking about a very soft market, an area that maybe folks aren’t really wanting to move to or buy in for whatever reason. Something to keep in mind. But what cap rate also can be, it’s a multiplier.

Think about buying a multifamily asset at a four capitalization rate. Basically, a four cap is like saying this, if we buy a property — this is just generally speaking, example purposes only. Obviously, it’s not a tried and true exact formula here. If we buy a property at a four cap, it’s a 100-unit or whatever, it produces a million dollars per year in net operating income; the four cap suggests a 25X or 25 times multiplier to purchase price. In other words, someone’s going to say, “Okay, you have a property that generates a million bucks a year. The purchase price will be 25 times that.” Just simply put. So what would that be? $25 million for a purchase price, just generally speaking, just hear me out, that’s how it works from a high level. Not an exact science.

The thing with value-add in the thing with stabilized cash flowing projects is as long as you keep the income up and the expenses under control, there’s a lot more predictability in that kind of play. It can be a lot less speculative than doing new development, where you have to say “Construction costs are this today, but it’s actually going to be three years down the road by the time we complete everything. So hopefully, prices are X, Y, and Z in the future, and hopefully, the market does A, B, and C to help us out.” But that’s speculating an awful lot, in a space that, quite frankly, you don’t have much control over, what government policy is, what the Federal Reserve decides to do, and anything else that may pop up in between in terms of inflation, pricing, wages, lack of inventory, etc. This is why I always say that cash flow is king. This is why I’m not such a fan anymore of flipping houses, although I used to do that. It’s also the same reason that I don’t buy stocks as a buy-low-sell-high kind of mentality or strategy. I think it’s very practical and very useful just to accept that market conditions are widely out of our control, good news in the media, bad news in the media.

So instead of buying a stock at $10 a share, then hoping that one day it’s $15 a share, and then hopefully I can sell. It’s an awful lot of hope. But instead, what I would do is I would buy a dividend-producing stock, ideally at a discount as the markets just pulled back 10, 20, 30%, so I have a lesser chance of it going down even further at that point.

But the important component is, it’s not about the price, it’s not about buying it at 10, or 15, or eight, or nine, or seven. What it’s about is the fact that it’s producing positive cash flow, or a dividend in this case, because we’re talking about a stock.

In other words, it’s a lot less speculative if I can take a company that’s been paying a dividend out for 10, 20, 30 years and say, “Well, they’ve never missed a payment. Or at least 90% of the time, they’ve never missed a payment even through the ups and downs and through the recession, so I have a lot more certainty and predictability on whether or not I’m going to actually receive a dividend from this company.” That has a lot more control to it than saying, “I think I’m buying it at $8 or $9 a share and I believe it’s going to go to $13 or $14.” That’s just crystal ball territory that nobody really has. But some people like to think that they do have a crystal ball.

A few episodes ago, I talked about the lost decade. This was from January of the year 2000 to December of the year 2009, that’s just about a decade of time right there. Had you just bought into the stock market, generally speaking, with an S&P 500 index, which is not a cash flow, or a passive income, or dividend kind of play, even though it’s got a small one attached to it – it’s really a buy-low-sell-high mentality. It’s that you’re going to buy the general stock market and then hope that over time it goes up. But the fact is, during the lost decade, you would have bought in January 2000, it would have trickled down with the dot-com bust, and then 9/11 happened, and then we had a recovery, and then we had the great recession where you would have gone down again, and then we had a recovery where you went up again. But the fact is, 10 years go by and you’re left with really nothing. So you kind of got eaten up by inflation, more or less, and you had no cash flow, nothing to put in your pocket month to month. That’s why I’m not such a fan of just buy-low-sell-high and speculating. Not to suggest that you or anybody else shouldn’t do that, I’m just sharing my opinions, my perspective with you, in hopes that it can help you make more informed decisions.

Okay, that is kind of the big-picture philosophy. That’s from a high level that was talking about strategy and business plan. Let’s dive into the three risk areas that I often talk about. On to the market risk. First, I’ll share a quick story with you that I invested in at least two deals –it could have been three at this point– where, quite frankly, the market itself kind of saved the overall business plan and made investors profitable. In other words, I invested in these deals where the operator didn’t do necessarily a good job at all at executing on the business plan doing what they said they were going to do. The deal was just kind of average and so-so, it was basically just a market price deal and nothing too special. But the market itself was booming, and it was a great high growth area. I’ll pinpoint a few things to look for in a market here in a minute. But essentially, we all got out profitably by the market bailing us out, not with the other two components, the operator in the deal itself being a big contributor to our overall success.

Break: [00:08:40][00:10:18]

Travis Watts: There are really three main areas that I look at when I’m vetting out a market from a macro level that I think is really important to consider. One is jobs. That’s how many jobs are there? Who are the employers? Is the market diversified by industry? I’ve spoken a lot about Dallas in the past being that no one industry comprises more than 20% of the job market. I don’t know if that’s still true today, it may be even better stats than that. But the fact is, it’s not a Detroit, Michigan [unintelligible [10:48] recession, where it’s really just one industry lifting the market, and if that one industry goes down, then everybody’s hurt. Then I look at are people moving in or moving out of the market? Not every market, as you know, is created equal. There’s an exit happening in parts of Los Angeles and San Francisco, more people are moving out than moving in, rents are stagnating, and in some cases declining in those areas. How many people are there in general? How many are moving in versus moving out? This is all just public information that you can look up online. You can probably ask the syndicator or the operator for this data if they didn’t provide it to you in the proforma. I also look at what’s the absorption rate in the market. In other words, take a look at average occupancies and things like that. What is the overall absorption rate? You can find this by the way through CBRE, Marcus and Millichap, there’s a lot of, again, public information that you and I have access to that will tell you this data.

Next is wages. What are your tenants actually earning? Obviously, the common thing that we look at is how much are they earning on average at this property. But also look at the three-mile, five-mile, 10-mile radius of jobs, look at average incomes in the area, and just decide if you’re going to be charging 1500 a month in rent. Is that adequate for your tenant who’s going to be living there, or is that a stretch or a push, and at the very, very highest end of the affordability spectrum for that three, five, and 10-mile radius? I also look at the same topic, are the jobs recession resistant? In other words, at the property or in the surrounding area, do you have medical facilities, doctors, nurses, and things like that? Or is it cruise ships? Are you right next to Cape Canaveral in Orlando or Miami right there at the port? You got to look at what that industry is comprised of and who’s actually working what jobs. Trying to decide, are the wages safe especially in volatile times like today, with viruses going around, with different industries having to shut down, and all these crazy regulations that we have. You need to know that your tenants are going to be able to continuously pay the rent and that you have a diversified employment base among residents at the property.

Moving on to the operator risk. As an investor, the primary metric or statistic that I look at from an operator’s perspective as I’m doing my due diligence is what is their track record? Is this business model that they’re showing me what they usually do? Is it the norm for them? Is that their specialty? Or is it something that they’re experimenting around with and have never done before? In other words, if an operator’s done 40 deals just like this one over and over successfully and they can show me that data, even if a couple of the properties underperformed but in the wide majority they’ve outperformed or performed expectations, that really goes a long way. Versus just saying, “Look, we’re new to the business and we really hope this is all going to work out. We’ve never done it before but give us your money and let’s see what happens.” That’s a big red flag, at least to me, something to consider. I’m not going to go through all the different line items of vetting out an operator here on this episode because we’ve covered it so many times in different episodes. So check out some of the 2020 episodes that we did on how to vet an operator, a market, and a sponsor. I will point out a couple more things for you real quick right here, which is get references both from the operator. Say, “Hey, do you have any investors that can speak to having some experience investing with you.” But also try to branch out of that if you can. Try to get on forums, Google, and attend any kind of real estate meetup groups, try to meet people who are already invested with these groups.

Guys, I can tell you, word of mouth referral is powerful. The way I’ve found a lot of operators that I partner with today is just through word-of-mouth references. It’s not always because I requested a word-of-mouth reference, it’s usually because I’m talking to someone and they said, “Hey, you ever invested with so and so?” “Yeah, I’ve done four or five deals with them and just had a really positive experience.” It usually kind of starts with that. A little bit of interest, then I do my due diligence, I interview them, then I’m on their deal list, and then I ended up partnering if it kind of matches my criteria. And then I would do a gut check analysis. I think this is really critical and It’s very simple to do. I’m just talking about googling the operator, I’m talking about going on to YouTube, Facebook, LinkedIn, and social media sources. I love to look at videos, I love to watch interviews, and I’m just trying to get a gut check of who are these operators as people, in philosophy, in competency. Are they widely known? Are they out there in the industry? Or again, are they just getting started? Or is there no public information on them at all? Some of these items could be a red flag for you so definitely watch out. If something doesn’t align or you just think, “There’s something off about this person. I can’t really pinpoint it but I’m not really comfortable with what they’re saying or how they answered that question.”

Last, but not least, get on the phone with the operators. If you can meet them in person, even better, but if not, get on Zoom, get on a phone call, and ask your questions. This can be very revealing. Again, like I often say, I’m not looking for the “right answer”, I’m looking for an answer that just makes logical sense. I’m just looking to know they’ve thought things through, that they’re competent in what they’re talking about, and I’m just trying to get an overall gut check that my money is going to be in good hands and not “Oh, hey, good question. Hadn’t even really thought about a recession happening. I don’t know. I don’t think that’s going to happen.” That might be a red flag.

Alright, moving on to the last of the three risk points, in my perspective, in my opinion, and that is the deal itself. Again, just my own opinion, that the deal is 25% of your risk, the market is 25% of your risk, the operator is 50% of your risk. The bottom line is that if you have a good operator, someone who’s experienced and who has a track record, they probably know what they’re doing first of all. They’re probably going to find a good deal and a good market, they’re going to know how to vet a good market and how to vet a good deal. They don’t want to spoil their track record, obviously, plus, they’re co-investing in the deal and everything else. You still must do your due diligence. This is kind of one of those trust but verify thing, so let’s dive into that.

When an operator is doing a deal, I don’t care what operator we are talking about, they want to show you the highlights of the deal and they want to highlight all the best features. They want to show you all the pros, they want to talk about how great everything is, but they’re probably unlikely to show you any negativity or any stats that really don’t justify their business plan. As I’m looking at proformas, I’m tuning into webinars, and I’m thinking about maybe investing in this deal, I’m kind of making notes of what wasn’t covered. I kind of start off as they’re talking, I wonder what’s the cap rate here? What’s the reversion cap rate? How conservative are they underwriting the T12? Are they giving me a sensitivity analysis? These questions, and as I go through, I read, and I listen, I’m marking off my list the answers. What I’m left with, I’m kind of circling, then I’m going to set up a call, I’m going to ask those “difficult questions.” I encourage everybody listening to ask difficult questions as part of critical due diligence. The last thing you want to do is to invest $100,000 and then find out three months later, something wasn’t disclosed or that you didn’t understand something fully, and now you’re locked in for five to seven years.

I’ll share with you guys a really quick story, this was a few years back. There was a deal that I’m listening to the webinar, I’m browsing through the proforma, and everything looks good. The numbers look good, it seems very conservative, the deal seems solid, just seems like an overall great opportunity so I’m really leaning towards investing. After the presentation’s done, I hop on Google Maps, and I just take a little drive-by of this property. What I find is that directly to the left of this property is a really old, rundown mobile home park. Now, nothing wrong with mobile home parks, in fact, I used to live in a mobile home park growing up and I invest in mobile home parks today. But this particular mobile home park was really, really rundown. I mean, it was in terrible shape. The only thing that divided this park from this apartment community was a six to seven-foot concrete brick wall between the parking areas. I thought “Oh my gosh. That wasn’t even talked about in the webinar. That wasn’t even shown on the pictures.” Here they are, showing all the interiors and what they’re going to do for unit renovations, and not even talking about the elephant in the room, so to speak, which is right to the left of the property. Long story short, I decided not to invest in that deal. But this is the kind of due diligence that I’m talking about.

Break: [00:19:23][00:22:19]

Travis Watts: …marketing, it can really hurt your drive-by traffic. You can do all the curb appeal enhancements as you want, new plants, new signage, new lighting, but people aren’t going to miss that as they drive out every single day, in and out of that property, what’s just to the left. Look at school ratings, absolutely. That’s often not talked about on a lot of webinars that I see, it’s that trust but verify. If they make a generalization like “Yeah, great schools, lots of families here.” Just go do your homework, get on Zillow, it’s really easy to go look that kind of stuff up. Look up crime stats, public information, do the drive-by as I mentioned on Google Maps. If you can, the best way is to visit properties in person. I always learned so much about it, and it’s just the common-sense factors, the gut check. When you’re pulling in, what’s the feel, and what’s the appeal? As you talk with the property management company, what’s your general feedback? How does the clubhouse look? Just stuff like that. Are people being responsive on the property? Is there graffiti all over the sign? Are there broken lights all over the place? It really tells you a lot about the area that you’re not really going to see in a proforma.

The goal and doing your due diligence, again, is trust but verify. You’re trying to seek out what’s not being talked about in the webinar or the presentation. Again, just jot down your questions. “Hey, what about that neighboring property XYZ? Is that going to be an issue or do you foresee any problems with that? What gives this particular property that competitive edge compared to the one that’s right next door that seems to be doing great? Is there anything that this property has to offer that they don’t?” Maybe two or three swimming pools instead of one, maybe a better gym, or maybe it’s some of the value-add plans that they’re going to be implementing that’s going to far exceed what neighboring properties have to offer. All that stuff is really great info to have. If you find a bad review on a school, “Hey, I noticed that the school next door is rated at three out of 10. Do you know anything about that? Or is that kind of a red flag for you guys in any way? How do you think that plays into the resale of this property or the value that it has today?”

I know I kind of alluded to this earlier, but a stress test or a sensitivity analysis is basically something that the underwriting team generally does. They say, “Well, if interest rates go up, this is kind of the effect to the investors.” Or “If occupancy falls down from 95 to 85, this is the effect that would have on the cash flow to our LP investors.” That’s just something you probably are going to have to ask for separately. It’s usually not included in your standard webinar presentation or something like that. Certainly not in a PPM, private placement memorandum. So make sure that you’re asking for stuff like this if the numbers are really critical to you, or if you feel like maybe they’re not being so conservative with the underwriting. This will tell you a lot about a property. A lot of times, I’ll see really great looking proformas but then I won’t see things like them disclosing, “Hey, we’re buying this at a four cap,” and that’s all they say about it. They don’t tell you about stabilization upon the cap rate, they don’t tell you about their projected exit cap rate. We’ve talked about this a lot, but for buying a property at a four cap, I like to see a five cap in the future projected.

Now, I don’t actually want to see that happen. That means the softening of the market, which means a lesser purchase price generally speaking, but it’s a way to be conservative when you’re underwriting and something to look for. If they do a presentation and just say, “Hey, we’re buying it at a four cap, end of the story,” I’ll always ask the question, “What about the exit cap? What do you think that might be in the future?” If they say, “Four and a half, five, five and a half, six,” that’s being conservative. If they say, “Oh, the same. Four or lower. Three, two, one,” red flag for me. It’s just showing that they’re being very aggressive. It’s kind of like predicting interest rates. Do you want someone to predict the interest rates are going to keep going down, down, down forever until we go negative interest rates? Is that being conservative or is it more conservative to say, “Well, interest rates might be going up at some point in the future. Hopefully, they don’t. But if they do, we’ve already factored that into this business plan.”

The last thing I want to point out here about the deal itself is, again, under the philosophy of “trust but verify,” go to places like apartments.com and actually look for yourself at the comps. I know they usually will show you comps and the overview, but they’re handpicking the comps that they want to show you, the operator, so it’s better to do your own due diligence. If the business model is, “Hey, we’re buying this property. It’s got a lot of two bed two baths, they’re currently rented at $1,100 a month, they’re not renovated units, and the comps are 1400 per month in the area.” If that’s what said, if that’s what the business plan is, hop on apartments.com, go look at actual comps in the area, in the three, five, 10-mile radius, look at two bedroom two baths, and see if they’re actually renting at 1400 or greater for a very comparable property. It is not a comp to suggest “Hey, we’re buying a 1975 property and we’re going to raise rents to 1400 when a brand-new built A-class luxury apartment community is renting at 1400 a month two bed two baths.” That’s not a comp even though it’s the same square footage, two bed two baths, I tell you.

Obviously, a prospective renter is not going to go rent the 1975 unit if they can go rent a 2022 built unit for the same price. You really got to read between the lines there and think how conservative is this. Maybe the other older properties are renting at 1400 or 1500 or 1600, in which case, that’s a very conservative assumption. But maybe they’re only running at 1200 and maybe they’ve already been renovated. That’s a big red flag. If you’ve got renovated units running at 1200 and this business plan is to raise rents to 1400, you may not get it. That means you may not get the overall projections and that means all the numbers kind of go out the wayside. Do your own homework. That’s what I wanted to cover in this episode is some of the risk points going into 2022. We have to be more diligent than ever, as investors we need to be doing our own homework.

You can always reach out to me if you have further questions, travis@ashcroftcapital.com, joefairless.com, social media, I’m always happy to help with any questions you have. I appreciate you guys so much as always for reaching out. Well, let’s connect on LinkedIn, let’s connect on Bigger Pockets. Let’s connect on Facebook, on Instagram, @passiveinvestortips. I’m always here to be a resource for you guys. Thanks so much and we will see you next week in another episode of The Actively Passive Show. I’m Travis Watts. Have a Best Ever week.

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