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They Will Pay $1,000,000 More Than Me on Investment Property!?! – Idiots!

by Ben Leybovich on June 24, 2014 · 17 comments

  
They Will Pay $1,000,000 More Than Me on Investment Property!?!

If you remember, a few weeks ago I wrote an article entitled The 3 Types of Buyers of Multi-family Buyers: Idiots, Jerks, and Me, in which I explored the underlying issue of why it is so hard to find a deal in this space that makes a damn bit of sense.

Finding a syndicatable opportunity is truly akin to finding a needle in a haystack…

The main problem with finance and acquisition of income-producing real estate is underwriting of financials – process by which we assess income and expense structures of an asset in order to back into the valuation.

The underwriting process is a difficult thing indeed, specifically in large syndication-level opportunities.

The reason I would not typically “classify” as syndication-level any asset comprised of fewer that 100 revenue streams is because anything, put very simply, it’s difficult to manage small properties because there’s not enough money to facilitate payroll for the right caliber/number of personnel.

Related: What is Real Estate Syndication – Really?

As you know, or should know, management is the absolute key to success in real estate, and good management systems, run by good people, with good folks on the ground to execute costs money – more money than what’s available in a 60-unit.

Well – looking at the P&L of a six-plex is one thing, but looking at the P&L of an 165-unit community is something entirely different.

Why – because the level of meaning which needs to be extrapolated from the numbers and the magnitude of assumptions one has to make require a level of fluency which is uncommon – most investors do not have it!  And the reason most people lack this perspective is because it is a function of the images in one’s rear view mirror…

Case and Point

In an earlier article I had mentioned that I was considering an acquisition of and180-unit.

I had underwritten the opportunity and had made several trips to the property, one of which was with a property manager (you know – the guy at the top of a company that manages 5,000 units in the area – a property manager, not to be confused with a mom and pop rep).

I was days away from submitting an LOI.  This will have been a multi-million dollar acquisition and my underwriting was about $600,000 apart with what the seller wanted.  Close enough – I figured we’d meet in the middle some place and that will have been good enough…

However, knowing that proper due-diligence in a deal of this magnitude is a multi-thousand dollar proposition (between engineer’s reports, environmental, and management company audit of physical premises, lease, and contracts), I was busy looking into things preliminarily as much as I could.

This was a good thing, because as I kept digging unfortunately it became apparent that some of the assumptions I had made in my underwriting relative to operations of the building were off by a slight margin.  But, what is a slight margin spread over 180 units and capitalized at 9% – $1,000,000!

Without going into great detail, I was off by an average of $40/door in my assumptions of EGI.  EGI stands for Effective Gross Income, which is Gross Income discounted for Loss to Lease, None-circulation Units, etc.

Effectively, this little miss-assumption took a million bucks out of the deal, and therefore took a million bucks out of my strike price – who remembers the formula for Capitalized Value:

Value = Income / CAP Rate

Income = $40 x 180 x 12 = $86,400

Value = 86,400 / .09 = $960,000

Yep – I had to discount this purchase by $960,000.  I communicated this to the broker who, by the way, is absolutely top shelf in my opinion.  In the world of idiot brokers running around with pro-formas that aren’t good enough to pass for toilet paper, these guys really are impressive…  His answer to me was – I can not argue with you Ben, but this early in the marketing process the seller will not respond.

Related: A Definitive Guide to Understanding Cap Rates and Cash-on-Cash Returns

Crap – there goes the deal…

Are You Ready For This?

You better sit down for this.

Do you remember an article I wrote a few weeks ago titled The 3 Types of Multi-family Buyers: Idiots, Jerks, and Me, in which I described to you, eloquently as ever if I may say so myself, exactly why it is so hard to find a deal that makes any sense – remember?

Well – what’s a broker’s job?  Yep – in short, to find an idiot or a jerk that will pay way more than the thing is worth.  So, a couple of days ago I called to follow up and get a little guidance as to where this deal stood, and the broker says to me – Ben, I think that we are going to reach our guidance of $3,600,000; there are a couple of groups in the running…

Idiots or Jerks – what do you think guys?  These people are in the running to pay $1,000,000 more than I would or than it’s worth!  So – idiots or jerks?

This Is The Best Part:

So I say to him – That’s great!  Do you have anything else in the works that would be of interest for me?  To which he answers – we are a couple of months off on this, but we are working up 3 foreclosures for Fannie Mae…

Hahahaha!!!  I hope the irony of this hits you in the nose as hard as it did me.  Why is it that there are foreclosures in the multi-family space?  Could it be that it’s because idiots pay too much and jerks don’t even care how much they pay.

I think in a few years I may get another run at this 180-unit…buy it from the bank this time!

As my partner loves to say:    Being good does not help us get good deals, but it does help us stay out of the bad ones!

Have you ever had experience with people like this?

Be sure to leave your comments below!

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{ 17 comments… read them below or add one }

mark ferguson June 24, 2014 at 2:11 pm

Ben, unfortunately a property is worth what someone will pay for it. A 5% cap rate in Colorado for a multifamily seems to be a good deal for some people. That is why I stick to the single family properties that I can make much more money on.

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Ben Leybovich June 24, 2014 at 5:29 pm

I hear you Mark – people are free to be stupid…lol

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Nick June 24, 2014 at 2:36 pm

I hear you, Ben. I got exact same experience in the small multi space (4-10 units). Only it is worse percentage wise. The properties I am looking at are overpriced by at least 50%!

Nick

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Ben Leybovich June 24, 2014 at 5:30 pm

Nick – just pay more…:)

:(

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Roberto Reyna June 24, 2014 at 4:17 pm

Better wait, then buy it from the bank at your price not theirs.

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Ben Leybovich June 24, 2014 at 5:31 pm

Yep!

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RoyN June 24, 2014 at 4:33 pm

Ben,

We just went through a similar scenario, albeit on a smaller scale. We ran the numbers on a 16-unit, even showed the owner how we could structure the deal to minimise their tax exposure and, how we could turn their building into an de-facto annuity if they elected to carry.

The bumpy part was that the operations numbers of the building supported a price 12K/door less than what the vendor wanted. We worked though this with the vendor (who agreed with our math) and were ready to start paperwork when some other group dropped in and over-paid by more than 150K.

I’m curious to see how they are going to make it work.

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Ben Leybovich June 24, 2014 at 5:32 pm

Makes you wonder…

Thanks Roy

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Eric June 24, 2014 at 5:04 pm

I found the same deals in 2006 and 2007. In 2008 I started to get them at the right price. Now it’s getting the same way.

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Ben Leybovich June 24, 2014 at 5:33 pm

Exactly!

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Jeff Brown June 24, 2014 at 6:19 pm

Those in San Diego’s investment property market from 1976 through around 1990 who kept telling anyone who’d listen that everyone was ‘over paying’ ended up with squat. Those who bought a duplex in 1975 for around $30,000 coulda sold it in 1990 for 5-7 times that price.

And often did just that. I’ve seen so many fortunes lost while singin’ the chorus, ‘Everyone’s paying too much!’ Sometimes they’re spot on, and sometimes they miss the golden window of opportunity. If only we had reliable crystal balls, right? ;)

I feel for ya, Ben.

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RoyN June 24, 2014 at 7:17 pm

Jeff:

I see that with “residential” (1-4 unit) and, to a lesser degree, small multi-family properties here …. they are priced on comps rather than as a business.

However, larger buildings are typically priced based on what they produce … even when CAP rates are ridiculously low. The folks who snatched the 16-unit from us are not going to be able to make it do much more than break even if they can command rent in the top 10% of the market … especially given there has been a sharp rise in vacancy rates from <4% to 7.5% due to more capacity coming on-line over the past two years.

I'm open to the distinct probability these folks are smarter than I am … that's why I'm interested to see how they make it work.

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Ben Leybovich June 25, 2014 at 6:21 am

LOL Jeff, comparing a duplex (small multi) to 180 units is like comparing a male organ to a finger – if ya know what I mean…:)

Not at all the same thing…lol

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Nick June 25, 2014 at 6:46 am

Bingo, you hit the nail on the head with, “Why are there foreclosures in the multifamily space?”

It still absolutely blows my mind that there are people out there throwing millions of dollars around at deals who probably don’t even have the knowledge to buy a cash flowing sfr correctly.

IMO there are two main problems.

1. Some of the very large syndicators with large overhead have to do deals just to make the fees just to keep the lights on.
2. CD’s still pay nothing so people think…Well 5% on this building is better than 1% in my CD

Did any of the brokers I sent you pan out to anything at all?

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Ben Leybovich June 25, 2014 at 7:03 am

Yeah – this is fun to watch, for sure…

I called one (Scott’s boss). He sent me a pig that fell out of contract. Now, he won’t return a call (that seems to be corporate attitude around there). So, unfortunately No…

I am working very seriously on another deal though – let you know if anything happens :)

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Keith Weinhold June 26, 2014 at 5:51 pm

Sorry, Ben. I guess that you gained due diligence and syndication experience so you cannot see it as a complete waste of time. Probably not the outcome you wanted though. Insightful column that you wrote, as usual.

Some overpaying multifamily buyers get foreclosed upon. Others are simply wealthy and don’t need positive cash flow.
__________

I invest in both rental SFHs and multifamilies.

In my smaller city of 305,000 residents – Anchorage, Alaska – the market continues to heat up for multifamily purchase prices. Rental occupancy is very high. Yet rents are constant, not rising.

NOI / Purchase Price = Cap Rate

This means that investors are chasing cap rates down – not up – as they’re willing to pay a higher purchase price for the same Net Operating Income (NOI).

Additionally, interest rates are a little higher now than they were early last year.

Cap Rate minus Interest Rate = Arbitrage.

Consequently, arbitrage is being squeezed from both sides here.

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Shaun July 6, 2014 at 3:04 pm

That is nuts.
On a large property like that it is hard to believe that someone can be that stupid to overpay that much.
I see DUMB money all the time in the small residential space here for Rehabs, but you only have to have one dolt that half read one to many guru pieces to see that.
On a big syndication deal you have to convince a lot of people your numbers make sense.
Clearly it happens (as you said WHY are their foreclosures if people are really buying things right) but amazing it seems like it happens a lot based on what your experience.

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