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Understanding the Personal Financial Statement

Understanding the Personal Financial Statement 

Real Estate investing is a team sport and it’s important to leverage the collective power of the deal team to get a deal done.  Whether the team is looking to finance a multifamily deal or to market themselves to potential brokers and sellers, it’s necessary to provide a thorough and accurate accounting of their individual and collective financial condition.  The easiest way to do this is through the creation of a Personal Financial Statement (PFS). 

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Personal Financial Statement – Defined  

A Personal Financial Statement is a document that contains a detailed accounting of an investor’s assets, liabilities, and income and it’s used to provide evidence of financial strength and/or ability to close on a deal.  In a multifamily transaction, providing a Personal Financial Statement serves two purposes: 

  1. It demonstrates the ability to support a loan if necessary:  In multifamily lending, there are two types of debt, Recourse and Non-Recourse.  If a lender requires that a deal have “recourse” it means that they require the personal guarantee of the principal(s) in the loan transaction.  Providing a guarantee gives the lender the legal means to pursue the personal assets of the loan  “guarantor(s)” should a deal go bad.  In a non-recourse deal, there are no personal guarantees.   

 

To ensure that the guarantors have the personal capability to repay a loan, the lender will ask them to provide a Personal Financial Statement.1  As a general rule of thumb, a lender wants to see post transaction liquidity of at least 10% of the loan amount2 and post transaction net worth of 100% of the loan amount.  If there are multiple guarantors, these rules apply to them collectively. 

 

  1. It inspires Broker/Seller Confidence:  The other purpose of a Personal Financial Statement is to inspire confidence in brokers and sellers that an investor has the financial wherewithal to close on a deal. 
For both of these reasons, it’s a good idea to complete – and maintain – a Personal Financial Statement for yourself and to encourage each of the members of your deal team to do the same.  

Personal Financial Statement Categories – Defined 

As part of this post, and in an effort to add value, we’ve created a Personal Financial Statement template for you to use as part of your approach to brokers and lenders.  To assist in the completion of it, let’s go through each of the categories in the PFS and define what belongs in each of them. 

Sponsor / Guarantor Information 

The “Sponsor / Guarantor Information” section is used to identify each of the loan sponsors and/or guarantors in the deal.  If you’re sponsoring a deal jointly with a spouse, complete the PFS jointly.  If you’re sponsoring a deal collectively with multiple general partners, each sponsor should complete their own PFS.  

The purpose of this section is to give the lender/broker/seller a good idea of who’s involved in the transaction, where they’re from and what sort of employment they have.  To complete it, fill out the name, address, driver’s license, and employment information.   

Assets 

An asset is property owned by a person or company that has value and can be converted to cash to help meet their financial obligations.  Half of the PFS is devoted to detailing sponsor/guarantor assets in the following categories: 

Liquidity 

Liquidity is the most important category on the PFS because: (1) the funds are readily available to support a loan or make a down payment; and (2) values are easily verified through account or brokerage statements.  Traditionally, liquidity consists of the following categories: 

  1. Cash in Banks:  Cash in Banks consists of all cash held in checking, savings, money market, or certificate of deposit accounts at a financial institution.  The value of the cash listed should be supported by account statements.   
  2. Securities Owned:  The Securities Owned category consists of all publicly held marketable securities owned by the sponsor(s)/guarantor(s).  It includes all publicly traded stocks and bonds or anything that can be readily converted to cash in a short period of time.  It does not include privately held securities that don’t have an established market or readily identifiable buyer.  The value listed for securities owned should be supported by brokerage account statements. 
  3. Cash Value of Life Insurance:  If any of the loan sponsor/guarantors own a life insurance policy that has a cash surrender value, it should be listed in this category.  The cash surrender value should be supported by account statements. 

When applying for a loan, the combined, post-transaction liquidity on the loan guarantors should be equal to 10% of the loan amount.  For example, if the loan is for $1,000,000, then the guarantors should be able to demonstrate a combined $100,000 in liquidity after they’ve made the down payment on the property. 

Long Term Assets 

Long term assets are generally considered to be a non-liquid asset that is held for more than one year.  When evaluating a loan request, lenders are generally less interested in long term assets because their value is more difficult to prove and they may be difficult to convert to cash.  Long term assets are categorized into the following groups: 

  1. Retirement Accounts – Vested Balance:  The vested balance for all retirement accounts, such as 401Ks or IRAs, should be listed in this category and supported by account statements.  If you’re unsure what the vested balance of your account is, check with your employer and they’ll provide it. 
  2. Notes and Receivables:  If you’re owed money by another person or entity, it should be listed in this category.  For example, it’s common for a sponsor or guarantor to “loan” money to one of their business entities.  As long as it’s documented with a promissory note, it should be included in this category. 
  3. Primary Residence:  The value of the sponsor/guarantor’s primary residence should be listed in this category.  The value should be based on a verifiable third party estimate such as an appraisal or valuation website, not a “guess”.  A lender will check to confirm the value and you don’t want to be wrong. 
  4. Secondary Residence / Vacation Homes:  If any of the sponsors or applicants own a secondary residence and/or vacation home, it should be listed in this category.  Like the primary residence, the valuation estimate should be verifiable through a 3rd party and supported by recent sales comps. 
  5. Other Real Estate Owned:  If any of the sponsors or guarantors own other types of real estate such as land, ranches, or home lots it should be listed in this category.  Again, the value should be supported by a 3rd party estimate, but in this case it may be harder to come by.  If it is, you should be clear about the methodology used to arrive at the value.   
  6. Real Estate Investments and Partnerships:  This category is particularly relevant for multifamily investors.  It should include the value of all real estate investments such as partnerships, limited partnerships, interests in an LLC, and individually owned properties through an LLC.  As with the other real estate categories, the stated value should be rooted in verifiable fact and the valuation methodology should be clear.  The listed value should include only the portion of the investment owned by the sponsor/guarantor.  For example, if a sponsor owns 20% of a $1,000,000 property, the listed value should be $200,000, not $1,000,000. 
  7. Businesses Owned:  If any of the loan sponsors or guarantors own a non-real estate business or a portion of a business, the estimated value should be listed in this category.  A business can be notoriously difficult to value so be clear about the valuation methodology used. 
  8. Personal Property:  Lastly, any sort of personal property with a substantial value should be included in this category.  It may include things like art, collectibles, automobiles, boats, or furniture.  Because it’s difficult to independently verify the value of these assets, a best estimate should be listed. 

Total assets are calculated as total liquidity plus long term assets.  Next, let’s look at the other half of the PFS. 

Liabilities 

A liability is an obligation of the sponsor/guarantor, meaning that it’s money owed to a person or entity.  Liabilities comprise the other half of the Personal Financial Statement and consist of the following categories:  

  1. Loans Against Securities:  On occasion, a sponsor/guarantor may take out a loan against the securities listed in asset category #2.  If this is the case, the balance should be listed in this category and it should be supported by loan statements. 
  2. Loans Against Insurance Policies:  Because insurance policies often have a cash value, sponsors/guarantors may borrow against them to raise investment capital for real estate projects.  If this is the case, list the balance this category and provide supporting documentation in the form of loan statements. 
  3. Loans Against Retirement Accounts:  A common way to finance the equity contribution in a multifamily transaction is to borrow against a retirement account such as an IRA or 401k.  If this is the case, list the outstanding balance this category and provide supporting documentation in the form of  loan statements. 
  4. Loans Against Primary Residence:  If there is a mortgage on the primary residence of the sponsor/guarantor, list the outstanding balance in this category and provide supporting loan statements. 
  5. Loans Against Secondary Residence/Vacation Homes:  If there are loans against a secondary residence or vacation home, list the outstanding balance in this category and provide supporting statements. 
  6. Loans Against Other Real Estate:  If there are loans against any of the “Other Real Estate” assets listed in asset category #8, list the outstanding balance in this category and provide supporting statements. 
  7. Credit Cards Payable:  List all outstanding credit card balances this category.  The balance listed should be current as of the date of the PFS and supported by equally current credit card statements. 
  8. Loans Payable:  If there are any other loans payable that aren’t listed as part of the categories above such as a car or boat loans, list them in this category and provide supporting statements. 

Total liabilities are calculated as the sum of all liability categories. 

Net Worth 

Net worth is calculated as total assets minus total liabilities and it’s one of the key figures that a broker/lender will be looking for.  In a loan transaction, the collective net worth of the loan guarantors should be equal to the loan amount.  But, net worth doesn’t always tell the entire story of the sponsor/guarantor financial profile.  Often there are “contingent” liabilities – that must also be listed – that tend to muddy the net worth picture of the sponsor/guarantor picture. 

Contingent Liabilities  

For multifamily investors, especially those who own multiple properties, the concept of a “contingent liability” is a critically important component in the lender’s analysis of a guarantor/sponsor financial profile.  A contingent liability is defined as an indirect obligation of the borrower/guarantor.  In other words, it’s another loan that is personally guaranteed by the sponsor/guarantor.  They represent “hidden” risk for the lender because a sponsor or guarantor’s liquidity could be materially reduced if they have to step in and support one of those loans.   

Contingent liabilities are very common with real estate investors as they often guarantee multiple loans at once.  As such, lenders pay close attention to contingent liabilities and they should be listed as part of the PFS.  

If you’d like to go one step further, itemize each of the loans guaranteed and place them in one of the following categories for the lender: 

Unrealizable:  Unrealizable contingent liabilities are loan guarantees on high performing properties that show no signs of weakness.  As such, it’s considered highly unlikely that you’d have to step in and support the loan. 

Potentially Unrealizable:  Potentially Unrealizable contingent liabilities are associated with properties that are performing, but may show some signs of weakness such as increasing vacancies or declining rents.  It’s unlikely that you’d have to step in to support the loan, but not impossible. 

Potentially Realizable:  Potentially Realizable contingent liabilities are associated with properties that may show signs of sustained underperformance or vacancy.  It’s possible that you’d have to step in to make partial or full loan payments. 

Realizable:  Realizable contingent liabilities are associated with poorly performing properties that have negative NOI.  It’s likely that the property will go into foreclosure and that you’ll have to either make loan payments from your own pocket or pay the difference between the liquidated value and the loan balance.  If you categorize any of your liabilities as realizable, it’s wise to go a step further and detail a turnaround plan as this is the category that a lender will pay the closest attention to. 

Income / Expenses  

If the purpose of the Assets/Liabilities section is to determine the net worth of the sponsor/guarantor, then the purpose of the Income/Expense section is to demonstrate that they have significant, recurring income that could also be used to support the loan if needed. 

 

 

Complete the income section by listing all sources of income including salary, bonuses, commission, rental income, dividends, capital gains, and partnership income and provide supporting documentation such as W2s, 1099s, or K-1s.  Often, full time real estate investors don’t have a traditional salary.  Instead, they rely on multiple income sources to pay their bills so it’s important to demonstrate substantial income to qualify for a loan or show financial strength to a broker or seller. 

Next, complete the expenses section by listing all recurring expenses including taxes, mortgage payments, association fees, insurance, alimony, child support, tuition, and living expenses. 

Total annual income less total annual expenses equals net annual cash flow for the year.  If you’re applying for a loan and this figure is negative, it’s going to be important to explain why and how the next year will be different (e.g. you’ll realize a significant gain when selling a property). 

Other Information 

Lastly, there is some additional information that a lender, broker, or seller may like to know about the individuals involved in the transaction and this is the section in which to state it.  If you’ve ever been involved in a bankruptcy or audit, it should be noted.  In addition, if there are any outstanding tax obligations, Letters of Credit, or other past due obligations, they should be listed and detailed to give the lender/broker/seller additional color on the situation. 

“…if there are any outstanding tax obligations, Letters of Credit, or other past due obligations, they should be listed and detailed to give the lender/broker/seller additional color on the situation.” 

Summary/Conclusions 

A Personal Financial Statement is a critical document that demonstrates your financial condition to potential lenders and brokers. 

In advance of applying for a loan or submitting an offer, it’s a best practice to complete one, including all supporting documentation, and to provide it to the broker/lender as evidence of your ability to close on a deal or support a loan in the event of a bankruptcy.   

If possible, it’s ideal to pursue non-recourse debt where an individual guarantee isn’t needed.  If it isn’t possible, a Personal Financial Statement should be created and updated annually. 

 

 

Glossary of Key Terms 

Personal Financial Statement:  A Personal Financial Statement is a document that contains a detailed accounting of an investor’s assets and liabilities and it’s used to provide evidence of the investor’s financial strength and/or ability to close on a deal 

Asset:  Property owned by a person or company that has value and can be converted to cash to help meet financial obligations. 

Liability:  An obligation or money owed to another person or entity.  

Net Worth:  An indicator of a sponsor/guarantor’s wealth.  It’s calculated as total assets, minus total liabilities. 

Recourse Debt:  A loan in which a personal guarantee is required of the loan sponsors/guarantors. 

Non-Recourse Debt:  A loan in which no personal guarantee is required. 

Loan Guarantor:  An individual or group of individuals who personally pledge responsibility for a loan balance in the event of bankruptcy or foreclosure. 

Contingent Liability:  An indirect obligation of the sponsor/guarantor. 

Financing Your Deal: Understanding the Capital Stack

Financing Your Deal:  Understanding the Capital Stack

Financing a deal can be tough.  As an investor, you’ve got to contend with deadlines, competing priorities, investors, and sellers who are all dependent upon your ability to get the deal done.  Adding to the confusion is the availability of a variety of financing sources, each with their own requirements, that can be utilized to get the deal over the line.

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Collectively, these sources are known as the “Capital Stack” and each component may play a role in the financing of a multifamily real estate transaction.  

Note: Real Estate and Multifamily are specialized subjects that contain technical terms. To assist in the understanding of the subject matter contained in this article, we’ve provided a glossary of key terms (in bold) at the end.

“Collectively, these sources are known as the “Capital Stack” and each component may play a role in the financing of a multifamily real estate transaction.”

 

 

 

Capital Stack – Defined

The Capital Stack is the organization of capital used to finance a real estate transaction.  More importantly, the agreements for each component of the stack define who has the rights, and in what order, to the cash flow and profits generated by the asset throughout the investor’s holding period and upon sale.  For most deals, there are 4 common components in the Capital Stack, which is illustrated in the diagram to the right:

  • Senior Debt
  • Mezzanine Debt
  • Preferred Equity
  • Common Equity

Let’s discuss each one in more detail.

 

Senior Debt

Senior debt is most commonly associated with a bank loan and it’s often the primary source of capital in the capital stack.  It usually makes up the largest portion of the financing, usually 65% – 75% of the purchase price, and the holder is first in line to receive periodic debt service payments.

It’s considered the least risky component of the capital stack and, as a result, usually provides the lowest return.  In exchange for accepting a lower interest rate, the senior debt holder is entitled to a first position lien on the property, which gives them the ability (and right) to initiate the foreclosure/liquidation process in the event of a default.  Once the property is sold, they’re also the first to be repaid.

Mezzanine Debt 

On occasion, there may be a gap between a property’s maximum supportable loan amount and purchase price that isn’t filled by the equity raise.  In these instances, the borrower may opt to seek mezzanine debt to plug the hole and close the deal.

Mezzanine debt is a loan, not secured by the property, but by a pledge of the ownership interest in the purchasing entity.  Mezzanine debt holders are second in line for periodic debt service payments and typically enjoy a slightly higher return than senior debt holders to compensate for the elevated risk.

Because the Mezzanine Debt holders don’t have a claim on the underlying property, their ability to initiate the foreclosure process is limited and often only in agreement with the senior debt holders.  Upon sale and/or liquidation, they are second in line to be repaid.

Preferred Equity 

Preferred Equity isn’t a loan, but an investment in the ownership entity.  Preferred equity holders sit below debt holders, but above Common Equity holders in the Capital Stack.  As such, they require higher returns than debt holders and profit participation upon sale (if available).

However, in the event of a foreclosure and the resulting liquidation, Preferred Equity holders are third in line to be repaid and may only receive a fraction of their initial investment back, if anything.

Common Equity 

The last component of the Capital Stack is the Common Equity holders, who also have an equity interest in the ownership entity, but sit behind the Preferred Equity holders.  As such, their position is the riskiest and they require the highest returns.  But, they also benefit the most from a profitable sale.

In the event of a foreclosure and the resulting liquidation, the Common Equity holder is the last to be repaid.

Capital Stack – A Bankruptcy Example

Generally speaking, when the underlying property is performing as expected and each member of the capital stack is receiving their respective payments, everyone’s happy.  However, if the property performs poorly and falls into bankruptcy/foreclosure, the details regarding the rights of each position in the capital stack are critical.  To illustrate this concept, consider this example.

An investor finds a multifamily property, does their research, and makes an offer to purchase it for $3MM. The property supports a loan amount of $1.8MM (Senior Debt), which means the investor needs to find $1.2MM to close the deal.After calling their investors, they’re able to secure $800k in Common Equity and $200k in Preferred Equity. To round out the Capital Stack, they obtain the remaining $200k needed in the form of Mezzanine Debt. See the diagram to the left for a depiction of the resulting Capital Stack.

Now, let’s assume that, after two years of underperformance, the senior debt holder has foreclosed on the property and liquidated it for a sale price of $2MM, which results in a $1MM loss.  The order of the capital stack determines who has to absorb said loss.

With a sale price of $2MM, the Senior Debt holder is repaid first, and in full, leaving $200k in sale proceeds remaining.  Because the Mezzanine Debt holder is in second position and they are owed $200k, they’ll absorb the entirety of the remaining proceeds.  The Preferred and Common Equity holders will be left with nothing and their entire investment will be lost.

 

“Whether you’re investing in a deal led by someone else or leading one on your own, it’s critically important to be aware of the construction of the capital stack and who’s entitled to what.”

NOTE:  The scenario doesn’t account for interest that may accrue on the loan.  It’s intended to demonstrate the order of repayment in a bankruptcy scenario.  Depending on the state in which the bankruptcy was filed, accrued interest may affect the repayment amount for each position in the capital stack.  In addition, the actual repayment terms and rights may differ slightly.

Summary and Conclusion

Whether you’re investing in a deal led by someone else or leading one on your own, it’s critically important to be aware of the construction of the capital stack and who’s entitled to what.

In addition, it’s imperative to understand exactly where your investment falls in the stack and to be compensated appropriately for the level of risk taken.  It may make the difference between getting something and getting nothing in the event of a bankruptcy.

 

 

Glossary of Key Terms 

Capital Stack:  The organization of capital used to finance a real estate transaction.  It defines who has the rights, and in what order, to the cash flow and profits generated by the property throughout the holding period and upon sale.

Holding Period:  An investor’s holding period is defined as the amount of time for which they plan to hold an investment. It’s usually expressed in either months or years.

Senior Debt:  Senior debt is most commonly associated with a bank loan and it’s the base or foundation of the capital stack.  It usually makes up the largest portion of the financing, often 65% – 75% of the purchase price and the holder is first in line to receive periodic debt service payments.  

Mezzanine Debt:  Mezzanine debt is a loan, not secured by the property, but by a pledge of the ownership interest (common equity shareholder).  Mezzanine debt holders are second in line for periodic debt service payments and typically enjoy a slightly higher return than senior debt holders to compensate for the elevated risk. 

Preferred Equity: Preferred Equity isn’t a loan, but an investment in the ownership entity of the property.  Preferred equity holders sit below debt holders, but above Common Equity holders.  As such, they require higher returns and participate in the profits upon sale.

Common Equity:  Common Equity represents an interest in the ownership entity, but they sit behind the preferred equity holders.  As such, they require the highest returns of anyone in the Capital Stack and typically stand to benefit the most from a profitable project.  

Interest Rate:  The percentage of a loan’s principal balance charged by the lender for the use of it’s money.

Lien:  A right to keep possession of property belonging to another person until a debt owed by that person is paid.

Foreclosure:  The action of taking possession of a mortgaged property when the mortgagor fails to keep up their loan payments.

Default:  Failure to fulfill an obligation, especially to repay a loan.  The conditions of a default are defined in the Loan Agreement.

 
 
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Measuring Returns: IRR vs. Equity Multiple

Measuring Returns: IRR vs. Equity Multiple

Whether you’ve received a deal from a broker or a potential partner, it’s always a good idea to approach their advertised return metrics with a healthy dose of skepticism, not because they’re bad actors, but because return metrics can be manipulated to make a deal look better than it really is. read more

For multifamily deals, two of the most widely used return metrics are known as the Internal Rate of Return (IRR) and the Equity Multiple.  While both are used to indicate the potential success of an investment, it can be slightly misleading to look at any one of them in isolation (which is how they’re sometimes advertised).  If one deal promises a 17% IRR, it may sound great, but in isolation, it doesn’t say what the absolute return is.  Or, if another deal advertises a 1.7X Equity Multiple, it might be good, but it may not account for how long it takes to get there.

To understand how these metrics work, let’s look at each one individually and discuss why it’s important to look at both of them when evaluating a deal.  

Internal Rate of Return

The Internal Rate of Return is defined as the rate earned on each dollar, for each period of time it’s invested in.  It’s often used as a proxy for the interest rate and mathematically, it’s calculated as the discount rate that sets the Net Present Value of all future cash flows (positive or negative) equal to zero.

As a tool for measuring returns, IRR’s primary benefit is that it accounts for the Time Value of Money, which is the concept that a dollar today is worth more than a dollar in the future due to its ability to earn interest.  As such, strong returns early in the project or projects with a shorter time horizon tend to skew IRR higher.

The other major benefit to using IRR as a return metric is that it allows for the comparison of one investment to another as long as they have the same Holding Period.  This includes comparing two multifamily investments to each other or, comparing a multifamily investment to the returns associated with a traditional investment like stocks or bonds.  

But, on the flip side, if you’re trying to compare a multifamily investment with a Holding Period of 10 years to a bond with a 30 year maturity, IRR is useless.  Additionally, IRR doesn’t measure the absolute return on an investment.  A $100M investment that returns $105M in one month (return of $100M in principal and $5M in earnings) has an IRR of ~80%, which seems fantastic, but in reality the investor has only made $5M.  To measure the absolute return, the Equity Multiple is a better tool.

 

Equity Multiple

Like IRR, the Equity Multiple is used to measure investment returns and it represents the percentage of an investor’s funds that will be returned by the end of the investment.  It’s calculated as an investment’s total cash flows divided by the original investment.  For example, a project that returns $150M on an investment of $100M has an Equity Multiple of 1.5X. 

The Equity Multiple’s primary strength is it that it does measure absolute returns, which is why it’s  complementary to IRR.  For example, if an individual invested $100M and the investment returns $150M, the equity multiple of 1.5X indicates that the investor has earned $50,000 on their original investment.

However, there’s no indication of how long it took to earn that $50M.  It may have taken 2 years or it may have taken 20 years, either way the Equity Multiple is still 1.5X.  Another reason that the Equity Multiple is complementary to IRR.

So, Which is Better to Use?

The truth is, neither is better, they each serve a different purpose.  Equity Multiple and IRR should be used together to measure the success of a project because those purposes are complementary to each other.  IRR accounts for the time it takes to earn the return while the Equity Multiple indicates how much an investment returns on an absolute basis.  To illustrate this point, consider the following example of two projects that produce similar cash flows:

 

This example has been purposely structured to demonstrate a key point.  Both investments return the same series of cash flows, but in a different order.  Investment #1 returns $250M in year one while Investment #2 returns $250M in year four.  Knowing that the IRR involves the Time Value of Money, which investment do you think has the higher IRR?

If you guessed Investment #1, you’re correct!  It has an IRR of ~7.84% while Investment #2 has an IRR of 7.37%. It’s because the $250M year occurs earlier in the holding period.  Remember, the Time Value of Money concept skews the IRR higher when the larger returns occur earlier in the holding period (because they have time to compound).

Because the cash flows are the same for each Investment, the Equity Multiple is also going to be the same at 1.37X.  So, given the same Equity Multiple, Investment #1 is the better project because it has a higher IRR.  

But, the Equity Multiple isn’t always the same, which can make the comparison between two investments slightly more difficult.  To illustrate this point, let’s look at another example of two investment opportunities:

 

 

n this second example, Investment #1 has an IRR of 11.32% while Investment #2 has an IRR of 10.10%.  Based on the first example, it’d be natural to think that Investment #1 is the better project because it has a higher IRR, right?  Not necessarily.  

The Equity Multiple for Investment #1 is 1.5X while the Equity Multiple for Investment #2 is 1.53X.  So, despite the lower IRR, Investment #2 is the better project because it actually returns more money on an absolute basis.  

Summary & Conclusions

The point is this.  If you’re evaluating a deal and you’ve been provided with only one set of return metrics, it’s a best practice to perform your own Due Diligence.  At a minimum, you should evaluate IRR and the Equity Multiple for every deal and, in many cases, other metrics such as Cash on Cash Return are important.

IRR works well to compare investments with similar holding periods because it incorporates the Time Value of Money concept.  However, it does a poor job of defining an investment’s absolute return.

On the flip side, the Equity Multiple does a great job of measuring the absolute return, but a poor job of accounting for how long it takes to achieve said return.

To complete a thorough evaluation, these metrics should be used together and compared against alternative options or return requirements to determine if a project is worth pursuing.

Glossary of Key Terms 

Internal Rate of Return (IRR):  The rate of return earned on each dollar, for each period of time that it’s invested in.  It’s calculated as the rate that sets the Net Present Value of an investment’s cash flows (positive or negative) equal to zero. 

Equity Multiple:  A measure of an investment’s absolute return.  It’s calculated as the total cash flows received from an investment (positive or negative) divided by the total amount invested.  For example, an Equity Multiple of 1.0 means that an investor is getting back the same amount of money that they put in.   

Net Present Value:   The present value of a series of cash flows is the current value of a future stream of income given an expected rate of return.  Thus, the Net Present Value is the difference between the present value of future cash inflows and future cash outflows.

Time Value of Money:  A financial concept which dictates that a dollar available today is worth more than a dollar available in the future, due to its ability to earn interest.  It’s the fundamental concept behind IRR.

Holding Period:  An investor’s holding period is defined as the amount of time for which they plan to hold an investment.  It’s usually expressed in either months or years. 

Due Diligence:  The research that an investor performs on a potential deal.  For the purposes of this article, initial due diligence is performed on a series of investment opportunities to determine which one is best to proceed with. 

Cash on Cash Return:  Another measure of an investment’s return.  It’s usually applied to income producing assets (like Multifamily) and it’s expressed as the ratio of the investment’s before tax cash flow divided by the amount of cash invested.

Get Your Deal Approved – Understanding How a Lender Underwrites a Multifamily Loan Request

Get Your Deal Approved – Understanding How a Lender Underwrites a Multifamily Loan Request

Despite the fact that the approval criteria are remarkably similar, retail banks and lenders are frustratingly inconsistent with their multifamily loan approval decisions.  One bank may look at a deal and want nothing to do with it, while another may be happy to lend the money. Naturally, this begs the question, why?
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To answer that question, we’re going to review 4 key elements of the loan underwriting process and provide actionable advice that’ll put you in the best position to get your multifamily deal approved.  Let’s start with the key players involved in the transaction.

Note: Real Estate and Multifamily are specialized subjects that contain technical terms. To assist in the understanding of the subject matter contained in this article, we’ve provided a glossary of key terms (in bold) at the end.

Understanding the Key Players

From the point of initial contact, your loan request will pass through several hands before a decision is made; however, only a few of those individuals have critical input into the approval decision.

As a borrower, the first, and sometimes only, person that you’re likely to encounter is the Relationship Manager.  Their job is to bring in new deals and shepard them through the approval process.  They act as your advocate and the most experienced among them know how to “play the game” to get their deals approved.  Remember though, they’re sales people and sometimes they can be overly optimistic about your deal’s chances so it’s best to take their words with a grain of salt.

The Loan Underwriter is the individual responsible for taking the property documentation from the Relationship Manager and “running the numbers” to determine if the cash flow generated by the property is sufficient to repay the proposed loan.  They’ll write up their findings in an approval document and forward it to the Credit Officer.

The Credit Officer is the decision maker.  Typically, they’re a senior executive, have a deep understanding of the bank’s Credit Policy and the trust of the board to independently make loan approval decisions.  Depending on the size of your request, the loan may have to go through several credit officers before final approval.

 

As a borrower, it’s unlikely that you’ll have any interaction with the Credit Officer, but they’re the most important person in the approval process.  To improve your chances of getting an approval, get to know the Relationship Manager and Underwriter and establish an open dialogue so they can ask you direct questions about the deal.

Understanding the Credit Policy

Whether you’re working with a traditional bank or specialty lender, everyone’s going to be making approval decisions based on a written Credit Policy.  Below is an example of a major bank’s multifamily lending policy:

There are three things about this credit policy example worth highlighting:

  1. The policy serves as the basis for a Credit Officer’s decision and the best Relationship Managers will know the policy inside and out and guide you towards a structure that fits within the approval framework.  Conversely, if there’s no hope of shaping the deal to the approval framework, they’ll be honest and send you elsewhere.
  2. There aren’t a lot of specifics with regard to the approval policy.  The key aspects such as LTV, DSC, and Term are explicitly defined, but the rest of the terms are subject to interpretation.  The “In the Box” column highlights the bank’s preferences, which can change at any given moment.  In fact it’s the “In the Box” criteria that are responsible for much of the inconsistency between lenders.

When working with your Relationship Manager, ask them what their Credit Policy approval criteria look like.  If your deal doesn’t fit, don’t waste your time.

Credit Approval Framework – The 5 C’s of Credit 

Let’s assume your deal makes it through the initial screen and the loan package ends up on the Underwriter’s desk.  To evaluate the deal, they’re going to use a specific framework, colloquially known as “The 5 Cs.” Let’s look at each one individually and what they mean for your deal:

Character

As the borrower, your character is a critical component in the transaction.  Are you trustworthy? Do you have a good reputation? Have you successfully repaid loans as agreed in the past?  To determine your character, the lender will look at things like credit reports, overdraft activity, and market reputation to ensure you’re a trustworthy borrower.

[1] It may not be called “In the Box” with all institutions, but each lender will have some level of stated policy and preferred loan parameters, which are subject to change.

Master the Character component by working hard to get to know your Relationship Manager so that you can demonstrate your trustworthiness.  If you have any hiccups in your past such as a bankruptcy or foreclosure, be open about them and be prepared to explain how this request is different.

Capacity

The Capacity of the property to repay the proposed loan may be the most critical element of the deal and it comes down to one simple question, does the property proforma generate enough cash to repay the proposed loan?  To determine the capacity of the deal, the Underwriter will look at a wide array of financial metrics including rents, expenses, reserves, vacancy assumptions, comparable rents, historical performance, and future expectations.  They’ll take all of these metrics and create their own repayment model, which may or may not differ significantly from your own.

Master the capacity component by using your understanding of the bank’s credit policy to create a realistic proforma that the bank will accept.  Be clear about each line item and how you derived the value. Be conservative in your assumptions and detailed in your analysis. Present your findings in an easy to understand format and be prepared to answer any questions the underwriter may have.

Capital 

How much of your own capital are you injecting into the deal?  As a borrower and investor, you’re highly incentivized to use as little of your money as you can get away with.  However, the bank wants to know that you’re invested in the deal and that you aren’t going to walk away if things get rough.

Master the capital component by clearly explaining where your equity contribution is coming from and why you’re committed to the deal for the long haul.  NOTE:  There’s an important difference between your money and investor money that you’ve pooled for an equity contribution.  If you’re leading the group, demonstrate to the bank that you’re personally invested in the deal.

Conditions

This is a little more macroeconomic than deal specific, but the bank is going to carefully consider multifamily market conditions at the time the loan request is made.  To assess this, they’ll look at things like rental trends, occupancy rates, job creation, migration patterns, income levels, competition and wage growth.

Master the conditions element by demonstrating to the bank a clear understanding of why the macroeconomic environment and sub-market conditions are favorable for your proposed purchase.  Source your data and provide plenty of charts and graphs to support your argument.

Collateral 

Lastly, the bank is going to perform detailed analysis on the proposed to collateral in an effort to answer one question, if you default on the loan and the bank has to liquidate the property, can they do it for enough to repay the outstanding loan balance?  To determine this they’ll commission a 3rd party appraisal and take a close look at the intangibles that can make the property attractive to potential buyers. These include things like location, ingress/egress, parking, amenities, security, condition, recent renovations, landscaping, unit mix, and unit layout.

To master the collateral component, put together a document package on your proposed loan that outlines all possible details on the property, including each of the elements mentioned above.  In addition, do the research on your competition and come to the lender with a point of view on where your property stacks up against others in the sub-market.

Non-deal related considerations

In some cases, you may present the bank with a deal that meets credit policy, is “in the box” and covers all of the 5-Cs that still gets declined.  How? There are two non-deal considerations completely out of your control to be aware of.  

If you’re working with a retail bank, they have to abide by regulatory limits on the composition of their loan portfolio and they may not have any room left in their “multifamily bucket” at the time of your application.  It has nothing to do with you or your deal, but it could still sink your chances. Be sure to ask your Relationship Manager at the outset if they currently have “appetite” for multifamily deals.

In addition, each lender subscribes to reports, newsletters, and economic forecasts that shape their view of the multifamily market.  If the lender you’re working with has a negative outlook on the multifamily asset class in general, there may not be much you can do to change their mind, no matter how good the deal is.

If your deal gets declined, be sure to ask why.  If it’s for one of these two reasons, don’t waste your time appealing the decision.  Look for another lender to work with.

Conclusions 

Remember, at the end of the day you’re dealing with people who have different opinions and institutions that have different policies and regulatory requirements.  Both of these factors are at the root of the seemingly inconsistent decision making.

To put yourself in the best position to get the deal approved, invest the time to get to know Relationship Managers from multiple lenders, quiz them on their policy and “in the box” requirements, and push them to be honest.  When it comes time to underwrite the deal, remember the “5-Cs” and present the lender with a loan package that is detailed, thorough, presentable, and reasonable.  

Glossary of Key Terms 

Relationship Manager:  A lender’s Relationship Manager is their sales person.  Their primary job is to originate loans where the borrower and collateral have an acceptable level of risk.  If working with a retail bank, it’s also the Relationship Manager’s job to originate new deposit accounts.   

Loan Underwriter:  The Loan Underwriter works in the lender’s credit department and their job is to analyze potential loan transactions, document their risks, and make an initial approval/denial recommendation.   

Credit Officer:  The Credit Officer is a critical role in the loan origination process as they’re the individual who has the ultimate approval/denial authority.  Their job is to examine the underwriter’s analysis and decide whether or not to approve a loan request.  

NOTE:  A lender may have several credit officers with varying levels of approval authority.  The bigger the deal, the more likely that it’ll have to go through multiple Credit Officers before final approval. 

Credit Policy:   A lender’s Credit Policy is a written document that defines the terms and conditions under which the lender is willing to extend credit.  When contemplating their approval/denial decision, it’s the Credit Officers job to do so in compliance with the written Credit Policy.

Loan To Value (LTV):  The Loan to Value ratio is the percentage of a property’s appraised value that a financial institution is willing to lend.  It’s calculated as the loan amount divided by the property’s value.

Loan to Cost (LTC):  The Loan to Cost ratio is the percentage of a property’s cost that a financial institution is willing to lend.  It’s calculated as the loan amount divided by the property’s cost. It’s typically used in construction lending where the cost represents the budgeted cost to construct the property.

Debt Service Coverage Ratio (DSCR):  The Debt Service Coverage ratio is a metric used to indicate how a property’s cash flow relates to the annual loan payments.  It’s calculated as the Net Operating Income divided by the annual loan payments.

Net Operating Income (NOI):  Net Operating Income is a measure of a property’s cash flow.  It’s calculated as a property’s revenue minus operating expenses.

Amortization:  Amortization is a tool used to spread a loan’s payments over time.  In multifamily lending, it’s expressed as the number of years required to reduce the loan balance to $0, given a defined payment.

Loan Term:  The Loan Term is defined as the number of months for which loan payments may be made.  If a loan is “Fully Amortizing” than the Term and Amortization are the same and the loan balance will be $0 at the end of the term.  Iin multifamily lending, it’s common for the Term and Amortization to be different to allow for lower payments (and positive cash flow).  But, it also means that there’s a balance at the end of the Term.

Vacancy:  In multifamily lending, Vacancy is defined as the percentage of unoccupied units and it’s calculated by dividing the number of vacant units by the total number of units in the property.  For example, if a property had 100 units and 5 of them are vacant, then the vacancy is 5%.

Recourse:  If a loan has “recourse,” it means that it requires the personal guarantee of the loan sponsor(s).  If a loan is “non-recourse” than no guarantee is required.

Reserves:  Reserves are monies set aside for future maintenance costs.  In multifamily lending, it’s common for a lender to require $250 per unit, per year in reserves.

Measuring Returns: Understanding How IRR Works

Measuring Returns: Understanding How IRR Works

When considering an investment in a multifamily property, one of the first questions that an investor may ask themselves is, “If I invest in this property, what is the return I can expect on my investment?”
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IRR is designed to measure the compound annual rate of return an investor can expect on their investment…

For a multifamily property, there are a variety of ways to measure returns, but one of the most commonly accepted and most misunderstood is called the Internal Rate of Return or IRR.  IRR is designed to measure the compound annual rate of return an investor can expect on their investment and we’re going to discuss it in detail in this article.
Note: Real Estate and Multifamily are specialized subjects that contain technical terms. To assist in the understanding of the subject matter contained in this article, we’ve provided a glossary of key terms (in bold) at the end.

Calculating IRR

IRR is the rate earned on each dollar invested for each time period it’s invested in.  That second part of the definition is a critical one, “…for each time period it’s invested in.”   There’s a time component to IRR that can’t be ignored because it accounts for the compounding of returns.  IRR is often used as a proxy for the interest rate and mathematically speaking it’s calculated as the rate of return that sets the Net Present Value of all future cash flows (positive of negative) equal to zero.

To illustrate this concept, consider the following series of cash flows.  Assume a purchase price of $1MM, annual net cash flows of $50,000 and a sale for $1.2MM at the end of a 6 year holding period (year 6 also has $50,000 cash flow).  It looks like this:

To calculate the IRR, it’s easiest to put the cash flows in a spreadsheet and use the function for IRR to calculate the answer.  Doing so returns the discount rate at which the NPV of this series of cash flows is equal to $0. It’s ~7.7%.

To check this, use the same series of cash flows with the NPV function.  For the discount rate, use the answer to the IRR function and, if you’re right, the answer should be $0

Pros of Using IRR as a Tool for Measurement

As a tool for measuring the return on your property, there are several advantages to using IRR.

IRR is a good metric to account for the time value of money, which is the concept that a dollar received today is worth more than a dollar received in the future, due to its earning potential.  This is where the time component comes in.

In addition, IRR is a simple metric that can be used to compare investments of a similar time horizon.  For example, if you’re trying to decide between three different properties with the same holding period, IRR is a good way to compare the return potential for each.  This isn’t just limited to comparing real estate investments, IRR can also be used to compare non-traditional investments (like real estate) to traditional ones like stocks or bonds, as long as the time horizon is the same.

While IRR is useful, it isn’t perfect.  When using IRR, there are a few limitations to be aware of.

Cons of using IRR as a tool for Measurement

Remember the importance of time in the IRR equation?  It contributes to one of the major flaws with IRR, it can’t be used to compare projects with different holding periods.  If you’re comparing a real estate investment with a 5 year holding period to a bond investment with a 10 year holding period, IRR is useless.

Further, IRR doesn’t measure the absolute return on an investment.  For example, a $100M investment that returns $105M in 1 month works out to an IRR of ~80%, which seems great.  But, the absolute return is just $5M, which isn’t as good.

Lastly, IRR doesn’t consider the cost of capital.  Rationally, you only want to consider projects with an IRR that exceeds your cost of capital.  If the project has an IRR of 10%, but your cost of capital is 15%, then the deal probably isn’t worthwhile.

For these reasons and others, IRR is best used as one of several metrics to compare investment opportunities.  To illustrate this idea, let’s look at an example.

Example

Year 0 cash flow represents a purchase price of $1MM.  Because it’s an outflow, it’s shown as a negative number.  Years 1-4 show a series of cash inflows based on the proforma and sale occurs in year 5.

To calculate the Net Present Value of this opportunity, a discount rate is required.  The discount rate that results in a Net Present Value of $0 is the internal rate of return.

Rather than go through the complicated math of the calculation, it’s easiest to use the IRR function in a spreadsheet to calculate the answer.  The input would look like this:

=IRR(Cash Flow 0, Cash Flow 1, Cash Flow 2, Cash Flow 3, Cash Flow 4, Cash Flow 5)

The result is 14.78%.  If the IRR exceeds the cost of capital by an acceptable margin than it’s an indication that the project may be worth pursuing.  But remember, the IRR only makes sense if the income and expenses on the proforma are reasonable and accurate.

In addition, it’s only one data point in the investment evaluation process.  It shouldn’t be used in isolation.

Conclusion

When evaluating investment returns, IRR is a key metric that can be used to measure the success of an investment.  It’s useful in a variety of different scenarios, but has limitations. For this reason and others, it shouldn’t be used to evaluate an investment in isolation.  It should be used as a part of a suite of metrics that tell the entire story of the opportunity.

Glossary of Key Terms

Internal Rate of Return (IRR):  The rate of return earned on each dollar, for each period of time that it’s invested in. It’s calculated as the rate that sets the Net Present Value of an investment’s cash flows (positive or negative) equal to zero.

 

Net Present Value (NPV):  The present value of a series of cash flows is the current value of a future stream of income given an expected rate of return. Thus, the Net Present Value is the difference between the present value of future cash inflows and future cash outflows.

 

Holding Period:  An investor’s holding period is defined as the amount of time for which they plan to hold an investment. It’s usually expressed in either months or years.

 

Time Value of Money:  A financial concept which dictates that a dollar available today is worth more than a dollar available in the future, due to its ability to earn interest. It’s the fundamental concept behind IRR.

 

Cost of Capital:  For a multifamily syndicator or lead partner, the cost of capital describes the total blended rate required to acquire funds for the project.  If only debt is used, it may be equivalent to the interest rate on the debt. However, if some combination of debt and equity is used, it would be the blended cost of both.  

 

 

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The Power of Mastermind Groups in Multifamily Real Estate Investment

The Power of Mastermind Groups in Multifamily Real Estate Investment

Multifamily real estate investment is a dynamic and challenging business. We have to be quick on our feet if we’re going to keep up with the market, beat out the competition, and build a business that’ll provide us with a lifetime of reliable cash flow.
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The question: how do we consistently get ourselves to perform at the highest level?

Napolean Hill was one of the greatest self-help authors of all time, and for decades he talked about the power of teaming up with others to push us beyond our limits.

 

The idea was simple: when two people get together, a third mind is created: a Master Mind.

 

The creativity and productivity unleashed by that Master Mind give us more than any of us could ever come up with on our own.

 

My Experience with Masterminding

When the market crashed in 2008, I lost $50 million in equity.

I was nearly knocked out. And as I struggled to figure out how to pick up the pieces and press forward, I noticed that most of my peers didn’t seem all that motivated to carry on. They were in the same boat I was.  I wanted to put my business back together, but I couldn’t find much support.

It was about that time that I learned about Tony Robbins’ Platinum Partnership—a premium group dedicated to people who were truly serious about personal success.

By premium, I mean premium. The annual cost for membership ran well into six digits. For someone who’d just been creamed by the downturn, that price tag was intimidating. But the investment was more than worth it.

In Tony’s group, I met some of the heaviest hitters out there—names you’d surely recognize from the pages of Forbes and Business Insider. Those individuals brought me the wisdom and insight I needed to figure out my way forward.

More than that, they connected me with opportunities. Through one of my fellow Platinum Partners, I was invited to join the Digital Marketer’s War Room and mastermind with even more of the biggest names in business and marketing.

As a direct result of my involvement in both groups, I’ve made millions of dollars. Even better, I’ve gained friends for lif

The Specific Benefits of Masterminding

 

You don’t have to shell out big bucks to benefit from a mastermind group. The best groups are often those you piece together with a handful of colleagues.

When you do form or join a group, here’s what you can expect to happen:  

Synergy

As I mentioned above, Hill’s basic argument for masterminding was synergy. Two heads aren’t just better than one; they come together to form a third.

 That third mind will take you further than either of you could’ve gone on your own.

In his 1930 book, The Magic Ladder of Success, Hill likens it to connecting multiple batteries in a single circuit. With each additional power source, you step up the amount of energy overall. Mind chemistry, he said, works the same way.

How might that work in multifamily real estate investment?

To give one of many examples, imagine you’re investing in Pittsburgh, and a buddy is working in Grand Rapids. You’re both struggling to beef up your off-market deal flow.

So, you start getting together regularly to mastermind strategies. Not only do you bring together the stuff you’ve already been doing, but you begin pinging new ideas off one another. Before you know it, you’ve each got 5 new, killer ways to market directly to sellers and it’s all thanks to the “Master Mind” that emerged in your meeting.

This is the kind of synergy that happens all the time in my coaching and mastermind groups.

Motivation & Accountability

Charlie “Tremendous” Jones once said, “You will be the same person in five years as you are today except for the people you meet and the books you read.”

That’s absolutely right.

The quality of your life will always be directly proportionate to the quality of your peer group. Whether your peers expect a lot of you or a little, you will rise or fall to meet their expectations. That’s what I learned when I looked at the people around me in 2008.

Surround yourself with people who doubt their own ability to succeed, and you’ll live down to their expectations. But if you put together a mastermind of investors you admire, you’ll soon find yourself rising to the level of competence in the room.

More than that, masterminding comes with a commitment to one another.

If you’re looking for ways to build your multifamily business, your fellow masterminders won’t just help you come up with new ideas. They’ll hold your feet to the fire and make sure you actually implement them.

 

Proximity

One of the most valuable lessons I learned in my experience with mastermind groups was that “proximity is power”.

I’ve sat around a conference table and been schooled by the best in the business. I’ve jumped on conference calls and received wisdom that literally brought millions in revenue. I’ve had some of the most successful people in the world hook me up with exactly who and what I needed to break through to the next level.

That’s what masterminding can do for you.

You may not be well-established. You may not be a millionaire. You may not have access to the heavy hitters who can make or break a large-scale investment operation.

But the degrees of separation between you and the people who can launch your business into the stratosphere are fewer than you think. As I learned, a well-placed connection or two in your mastermind group can change your life and business.

 

Conclusion

Can’t find a group? Then form one yourself. Connect with a few investors you admire, set up a monthly lunch, and get to work on improving one another’s businesses. As you start to see results, invite in a few more successful businesspeople you admire. Focus on adding value to others, and they’ll return it tenfold.

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Ten Ways to Increase Revenue in an Apartment Investment

Ten Ways to Increase Revenue in an Apartment Investment.

There are numerous methods and ways to increase revenue at an apartment complex. read more

And, if you as an investor truly want to maximize your profit (Either as an ongoing entity, or upon disposition) you should consistently be seeking out ways to increase income at your properties.

In this article, I will discuss ten things you as an apartment owner/manager can do to grow the income at your property.

Some of these are very simple, some are more difficult and have more inherent risk. 

However, one thing all of these things must have is that they make economic sense.  In other words, the “cost” of the undertaking must be less than the “benefit”.

So, before undertaking any such program, a thorough cost/benefit analysis must be performed, and if the program does not provide a clear economic benefit, it should be avoided. I like to see a maximum of a 3-4 year payback on any capital improvements.

 

Let’s start with the more difficult undertakings first.

When you purchased your investment, did it also include any additional vacant land?  If so, you may want to investigate adding additional units to the property.  Adding units is obviously a highly complex process, but it can also be very lucrative, especially is strong, high-demand markets.  If you do not have any experience with apartment development/construction, you should be certain that you understand the development process fully before moving forward.  With development comes development risk, and entering into this arena “blindly” can be economically disastrous.

Another development/construction idea to consider is adding enclosed garage spaces or carports to the property.  If local zoning allows, these structures can usually be developed within existing parking areas.

A third method to increase revenue is through a Ratio Utility Billing System also known commonly as RUBS.  This is a system that allows an apartment owner to allocate utility costs, primarily water, to the tenants.  RUBS is often utilized in situations where there are space or cost constraints that do not allow for sub-metered units, and calculates a resident’s utility bill based upon a number of factors including; occupancy, unit size, bedroom/bath count and number of water fixtures.  While implementation of the system is relatively easy, the difficulty lies in dealing with tenants who will suddenly be burdened with an increase in monthly housing costs

 

Let’s now turn to some of the easier things that can be done to increase revenue at your property.

 

Does your property have a common laundry facility?  If so, are the individual washer/dryer units owned by the property or are they leased?  If leased, you should be aware of when the contract expires, and at the end of the lease term, you should seriously consider terminating it and purchasing your own commercial units.  These units are usually not too expensive, and they typically pay for themselves in six to twelve months.  After that, it’s all profit for you, less any costs to maintain or repair the units.   I can speak from experience that these units are usually “cash cows”, and can add a significant amount to your property income.

Another simple undertaking is allowing for short-term rentals of six or even three months.  While turnover costs will be more frequent, you can offset that by charging higher rents and requiring larger security deposits.  Short-term renters typically understand that these higher costs are justified in exchange for a “non-typical” lease.

The next two mechanisms that can be enacted are somewhat related.  Providing fully furnished units can be an excellent way to generate additional revenue.  In most areas there are several companies that provide furniture and furnishings on a leased basis, and the costs are typically reasonable.  Furnished units can command sizeable premiums, and they can be rented to short-term renters (see above) or corporate users who will use them to house employees who are either temporary, or transitional.  In many instances, corporate users will rent the units on a long term basis and use them on an as needed basis.

Furnished units can also be rented on a very short term basis (weekly or even shorter) through various internet based facilitators like Air BNB.  Of course, turnover costs and potential property damage issues are increased under this scenario, but fully furnished units can usually be rented at very large premiums that should more than offset the increased costs.  Each market is different, but again, a cost/benefit analysis should provide enough information to decide if this is a profitable endeavor.

Do you allow pets at your property?  If not, perhaps this is something that should be considered.  Obviously, the types of pets that will be allowed (species, breed, size, etc.) will need to well thought out, and clear rules regarding pet ownership will need to be enacted.  But it is typical for pet-friendly properties to charge an up-front pet fee, an increased security deposit as well as an additional monthly rent premium.

Furnished units can also be rented on a very short term basis (weekly or even shorter) through various internet based facilitators like Air B & B.  Of course, turnover costs and potential property damage issues are increased under this scenario, but fully furnished units can usually be rented at very large premiums that should more than offset the increased costs.  Each market is different, but again, a cost/benefit analysis should provide enough information to decide if this is a profitable endeavor.

Do you allow pets at your property?  If not, perhaps this is something that should be considered.  Obviously, the types of pets that will be allowed (species, breed, size, etc.) will need to well thought out, and clear rules regarding pet ownership will need to be enacted.  But it is typical for pet-friendly properties to charge an up-front pet fee, an increased security deposit as well as an additional monthly rent premium.

Does your property have a clubhouse or comparable structure?

If so, you should consider renting the facility to outside entities for parties, meetings, or other gatherings.  This not something that should be done too frequently, as tenants will likely balk at not having use of the facility consistently, but renting out the space on an infrequent basis is a very easy way to add dollars to the bottom line.

Vending machines are another very easy way to provide additional revenue to a property.  Like washer/dryers, vending machines can either be leased or owned by the property.  However, most owners choose to lease them, as maintaining and stocking the machines can be a tedious and frequent requirement.

There are many other ways and methods that an owner can use to drive revenue growth, these are just a few.  But as a prudent property owner/manager, you should constantly be on the lookout for programs that can be implemented to increase the value of your asset.

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4 Mistakes You Better Not Make in Apartment Syndication

4 Mistakes You Better Not Make in Apartment Syndication

Syndication is a multifamily real estate investor’s chance to move from the minor league to the majors.  
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But with millions of dollars on the line, it’s easy for unseasoned syndicators to get excited and make a mistake that can kill a deal or create a legal problem. 

 

In this post, my outcome is to help you succeed by showing you four of the most common mistakes I see in multifamily real estate syndication: 

Legal Trouble

The easiest way to get yourself into trouble with syndication is to have errors in your paperwork, violate SEC guidelines, and/or accidentally mislead your investors. 

The Securities Acts of 1933 lays out the rules for whether and how a syndication gets registered, if you can market, and what paperwork needs to be filed. 

That law is Gospel; Learn what you can do and what you can’t.  

Above and beyond the legal process (operating agreements, subscription paperwork, etc.), sponsoring a syndication puts you in a fiduciary relationship with your investors. That means you have to work for your investors with honesty, diligence, skill, and care. 

Let them down, intentionally or even unintentionally, and you could open yourself up to civil and criminal liability. 

How to Avoid Legal Trouble:

You don’t need your securities license to set up a multifamily syndication. What you do need is an excellent SEC attorney with experience in syndication to help you navigate the process

 

Don’t try to go it alone.

 

Funding Woes

For beginning syndicators, it can be hard to know whether you should start with finding the deal or locating the investors. I often see rookies go wrong by looking for the deal without lining up their funding first. By the time they find the money, their contract is toast. 

Here’s a scenario I talk about in my book:

An investor finds a 50-unit building. It’s in a great location, has a low vacancy rate, and good income growth potential. He offers $2.5 million, and it’s accepted. 

At a 70% LTV, he’ll need $750,000 down, plus $200,000 for Cap Ex and operating capital. He has $150,000 but needs $800,000 more to close the deal. 

He’s agreed to a 90-day close. Assuming he takes 30 days to do his due diligence, that leaves 60 days to find enough investors to cover the $800,000 needed. 

If this investor waits until 60 days out from his closing deadline to begin looking for potential investors, he’s almost certainly going to come up short and lose the deal. 

Don’t wait until you’ve got a deal under contract to line up investors.

Non-Existent or Inconsistent Marketing

This mistake usually comes in tandem with #2. Rookies either take an inconsistent approach to marketing their real estate investment business or they don’t bother at all. Then, when an opportunity comes along, they don’t have anyone to reach out to for funding. 

How to Ramp Up Your Marketing for Multifamily Syndication:

So many syndicators get this one wrong that it deserves an extended response. 

If you’re in syndication, then you’re in marketing. Take charge of your building your pool of investors by developing an intentional plan to put yourself out there, attract those potential investors, and keep them engaged as you search for a deal to bring them in on. 

That plan should include digital media (web and social), email marketing, direct mail, and phone.

In addition to those attractional items like a website and a blog, get proactive. Clarify your criteria, develop a list of potential investors, and start reaching out. Join your local REIA, go to an investing meetup, and troll your local Rotary club. Tell everyone you meet about your syndication business and what kind of opportunities they can enjoy. Harness the incredible power of social media and consider ways to add value to people to build a network. I have students doing their own podcasts, meetups in their towns, Youtube channels and more. 

Keep building up your list, and you’ll have no trouble finding investors to partner with you on your next deal. 

Shabby Service

At the end of the day, a syndicate is a promise. As the sponsor, you’re telling your investors that they can trust you to take their money and deliver the advertised return. 

One of the easiest ways to wreck a deal and your reputation is to break your promises. But even if you do meet your returns, you can still leave a bad taste in your investors’ mouths by offering unclear or inconsistent communication.

Happy investors are long-term investors. They’ll dive in with you on the next deal, and they won’t be afraid to bring others with them. Ignoring, misleading or over-promising to your equity investors will ensure that doesn’t happen and your syndication business goes nowhere. 

How Not to Alienate Your Investors

If you want to impress your investors, under-promise and over-deliver. Analyze conservatively, understate your returns, and let your diligence and persistence generate a positive surprise for your investors. If you promised 15%, 12% is a disappointment. But if you promised 10%, that 12% is a huge win. 

Second, communicate regularly. Keep investors in the loop. Let them see you doing everything you can to make the deal as profitable as possible. Even if you do post weaker numbers than expected, regular transparent communication will keep your investors from putting all the blame on your shoulders.

 

Conclusion

Over 90% of all apartment transactions are syndicated right now. If you’re not getting your feet wet in syndication, your multifamily business is going to hit a ceiling… fast. 

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“Value-Add Opportunity” What does it mean, and should I consider it?

“Value-Add Opportunity” What does it mean, and should I consider it?

If you have spent any time at all researching potential apartment investments within the last several years, I am certain that you have been presented with a property in which the seller and/or agent have presented the deal as a great “value-add opportunity.”

In this article, I will discuss exactly what a value-add opportunity is, how to determine whether or not a value-add program will actually work, an indication of which properties are best suited for a value-add program, and a brief discussion of specific actions you can take to make this program work best for you.

 

 

Before defining the term, it is necessary to state that, in my opinion, this term is grossly over-used.

 

I would estimate that at least 75% of the deals I am presented with claim to offer a great value-add opportunity.

In fact, I have looked at apartment communities that are only a few years old that claim to offer this.  You will understand why this is ridiculous on its face by the end of this article.

 

Although there is no actual definition, a value-add deal is one in which a potential buyer could take advantage of market disparities by adding value to the property and allowing for higher monthly rents.  This typically comes through a combination of a capital improvement program, re-positioning the asset, and increased operational efficiency.  All of these will add value to the investment.

 

So, given the above definition, how do we find opportunities that offer real value-add potential?  More importantly, how do we find those deals that offer the best value-add potential?

First, be careful if you’re presented with a “value-add” opportunity where the previous owner has already completed significant renovations and raised rents but is stating that you could still get another, say, 10% rent bump with “minor” additional upgrades.  These are the properties that you want to be the buyer BEFORE they get renovated. 

 

If I were to describe the ideal value-add investment, I would define it as the “weed in the flower patch”.  In other words, it would be an older property that is located in an area that is highly desirable (i.e., the flower patch), but is the one property that has been neglected in terms of maintenance and/or management (i.e., the weed).  It is a property like this that offers the best opportunity to increase value.

However, there are additional criteria that the property must meet in order to be successful.  Primarily, the problems at the property must be both solvable and financially viable.  If the property suffers from major structural deficiencies and/or extensive deferred maintenance, the cost to remediate the issues may be too high to recoup costs through increased rents.  Generally the increased revenue must pay for the upgrades/repairs within 4 years to make the investment worthwhile.

 

Also, the property may be functionally obsolete.  For example, the unit mix may consist of all studio/efficiency and small one-bedroom apartments in a neighborhood that demands larger one and two-bedroom options. Problems such as this are difficult if not impossible to solve.

So, what we are looking for is a well-located property that is below market rent and has minimal to moderate deferred maintenance and/or management deficiencies.  It is this type of asset that offers the best chance for success.  You’re not just betting that rents go up forever but actually re-positioning the property.

Now that we have identified the property, we need to develop our value-add program.

 

The best way to demonstrate this is through a hypothetical example.  Let’s say we have identified an eight unit property in one of the more desirable parts of town.  The current owner has had the property for several decades and has not upgraded the units more than occasional new carpeting, painting and necessary repairs.  Because he has little to no debt on the property and prefers to just collect checks without doing much to make the property competitive, the rents are severely under market.

He is retired and now wants to sell the asset.  The units are all two-bedrooms, and currently rent for $800 per month.  For simplicities sake, we will assume the property is always fully rented.  This is key – you can’t bump rents at a property that’s 85% rented.  Something else is wrong. 

Back to our example – the owner wants to sell the property for $600,000 or $75,000 per unit.  We know that the property generates $76,800 in income annually, and through due diligence, we find that the annual expenses for this asset run at $40,000 per year.  This leaves a Net Operating Income (NOI) of $36,800.  With a purchase price of $600,000, the “going-in” capitalization rate (NOI/Purchase Price) is 6.1% – an aggressive but reasonable cap rate for the local market.

 

Now, let’s assume that we invest $6,000 into each unit ($48,000 in total) for upgrades including new laminate flooring, new appliances, new lighting and plumbing fixtures and new counter and vanity tops.  Let’s also assume that post-renovation we can rent these upgraded units for an additional $150, or $950 per month.

Does this “investment” make sense?  Let’s find out.

 

The new “cost” of the acquisition is $648,000 (Purchase price + $48,000 in improvements) and we have increased revenue (after all eight units have been renovated and rented) by $14,400 per year.  So, our new gross revenue is $91,200 and our expenses remain at $40,000, yielding a new NOI of $51,200. 

Using the capitalization rate we calculated at acquisition (which we felt was reasonable) of 6.1%, and applying this to the new NOI results in a new property “value” of $839,344.  Under this scenario, we have increased the value of the asset by $239,344 (Current value of $839,344 less original acquisition price of $600,000) and it only cost $48,000 to do this. 

However, we also need to look at the payback time for this investment.  Since it cost us $48,000 to get a $14,400 per year increase in revenue, that equates to a 3 1/3 year payback ($48,000 divided by $14,400).  This falls within our 4 year maximum so it will bump our returns without exposing us to an extended pay-back time frame.

However, let’s say the cost to renovate is $10,000 per unit, and we can only increase rents by $40 per month.  Using calculations similar to those above results in an increased value of the property of $62,950, but the cost to renovate is $80,000.  As such, this value-add scenario results in an actual “decrease” in net value of $20,000 and would require nearly 21 years to pay back.  This clearly does not make economic sense.

This is just one hypothetical example, but it should provide you with a foundation to understand how the value-add process works and how to determine whether or not such a program makes economic sense.

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What You Need to Know About Multifamily Real Estate in a College Town

What You Need to Know About Multifamily Real Estate in a College Town

As I often say, your success in multifamily real estate depends on one thing: cash flow.

One of the keys to cash flow, of course, is keeping your units occupied. This is what makes investing in college towns so attractive. Every Fall, you’re guaranteed an influx of renters who’ve already paid tuition and need a place to live.

But, of course, renting in a college town raises all sorts of concerns. What if the students aren’t qualified? What if they wreck my property? What if the college goes under?

 

 

In this post, I want to share the pros and cons of investing in a college town, followed by some advice for how you can wisely take advantage of this great opportunity.

 

Pros: Why you Would buy Multifamily Real Estate in a College Town

There are plenty of reasons why multifamily real estate does well in college towns:

 

  • Consistent Demand — Every year, like clockwork, you’ve got a fresh batch of renters ready to come in and take over. While this may cause some trouble with timing (see below), higher demand means lower vacancy and higher NOI.

 

  • Built-in Rental Increases — With revolving occupancy comes built-in rent increases. You may prefer to rent long-term, but the benefit of an ongoing parade of 1-year leases is that you can increase regularly without “losing” a tenant.

 

  • Stable Rental Market — Consistent demand also leads to a strong, stable rental market. So long as the school is operating well and its financial position is solid, there’s virtually no danger of the bottom unexpectedly dropping out on you.

 

  • Appreciation — It’s hard to escape the pervasive effect a healthy school has on its surrounding economy. As the neighborhood thrives, so will your investment.

 

  • Decent Return on Investment — Lower vacancy, higher NOI, a steadily advancing rental market—all these factors add up to make for healthy returns on college town multifamily investment.

Cons: Why you Wouldn’t buy Multifamily Real Estate in a College Town

 

Even with all the pro’s I mentioned above, there are some potential drawbacks to buying a multifamily property in a college town:

 

  • Turnover — Tenant turnover is the bane of every landlord’s existence. Even if you stack leases one after another (which you certainly should), you’ll still have to deal with the typical headaches and expenses of turning a unit. Keep in mind, however, that smart college landlords work leasing and cleaning fees into every lease. In most college towns, these conditions are par for the course.

 

  • Timing/Competition — Each town is different, but you’ll normally encounter a narrow window when renters swarm the apartment scene looking for units for the next year. In general, this is a good thing. But, if your tenant breaks a lease early and you find yourself off cycle, it can be difficult to find a renter “out of season.” Don’t forget, though, not all college town renters are students.

 

  • Parties & Problems — This is the standard worry for every college landlord. The last thing any of us wants is for one of our properties to end up as everybody’s favorite weekend party house.

 

  • Poor Upkeep — College students rarely know how to take care of a property. After all, this is likely the first time they’ve ever lived alone or outside of a dorm. That means you can expect plenty of deferred maintenance at the end of the year.

 

  • Management Intensive — If you self-manage, you can expect college students to require more interaction than your typical tenant. Again, they’re not used to living on their own. You can also expect added nuisances like noise complaints, roommate conflict, and early lease breaking.

 

Advice: How to Succeed with Multifamily Real Estate in a College Town

 

On balance, I think the pros outweigh the cons college town multifamily investment. That said, there are a few steps you should take to ensure you protect yourself:

 

  • Do Your Homework — Find out what’s happening with the school itself. Is it growing or is it shrinking? What do on-campus housing rates look like? Does the school impose a cap on neighboring rental rates? Also, what’s the ratio of on-campus to off-campus housing in the area? The last thing you want is to be undercut by an oversupply of cheap on-campus housing.

 

  • Skip the Undergrads — Unless you’re local, focus on property classes that serve mid- to high- level demographics. In other words, invest in the kinds of properties that will serve graduate students, faculty, and administrators.

 

  • Get Professional Help — Especially if you’re not local, take the time to learn the market from experienced investors who are already there. On top of that, find an experienced property manager who knows the market and works specifically with college housing. With a nuanced read on the renter population and experience with the school, they’ll be able to help you edge out the competition.

Do you have specific questions about a particular property or market? Bring them to our Multifamily Real Estate Investing Group on Facebook. There, you’ll find more than 20,000 investors ready and eager to help you succeed in multifamily investment.

 

 

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