Apartment Active investors buying too many door too quickly ??

19 Replies

I know over 5 Deal sponsors (active partners) who syndicate Multifamily apartment deals (they raise money from passive investors and manage the project) .

I see that in the last couple of years most of them talk about picking at least 2 deals  (value 10 + Million) and most of them have achieved (or have a target of ) getting over 1000 doors in the next couple of years.

I am based in the San Francisco Bay Area. Yes I see that real estate investment sentiment is at its top ...there are many passive investors who would like to put money to these projects based on projections  and finding money is the easy part now.

I am  how ever  not  convinced on the part that a sponsor group which probably has not seen a contraction (downturn) in market and they are buying too much too soon . Like to get perspective on how they are going to handle a market downturn  when you have so much of product in a given market  of similar type.

How would these 1000+ apartment holders(active partners)  handle these projects  when the prices and rents  go down , interest rates go up and projects need new capital infusion to survive. If we get into that market cycle how are the sponsors going to react who generally do not bring any (or very little ) money from their pocket 

We are in that camp—we could potentially add 1,000 units in 2018.  That said, I share in your concern.  

It seems that as of late everyone is suddenly a syndicator. And few if any of them have ever seen a market cycle other than the strong up market that we’ve experienced for almost a decade now. 

I’ve been through my share of cycles in my 29 years of real estate investing and I know all too well what that pain feels like. I wrote an article about it for the BP blog here:  https://www.biggerpockets.com/renewsblog/colossal-fail/

The threat is real but it is also very manageable. I learned through the school of hard knocks how to change my approach and overhaul my underwriting methods and select my assumptions to plan ahead for adverse conditions. If the syndicators are doing this right they should be fine (excepting nuclear holocaust-type of scenarios where no one comes out of it unscathed despite proper planning).  

The problem is that these firms aren’t always doing it right. I see a lot of offerings from other groups that just make me cringe.  I know that a lot of these groups are a house of cards just waiting for a slight breeze to blow them down. Their assumptions are too aggressive, they lack a flexible enough contingency plan and they don’t raise enough money to provide enough cash reserves.  

I don’t think money from the sponsor’s own pocket has anything to do with it. They could have invested all of the equity and improper planning would still put their outcome at risk if they didn’t have adequate reserves. 

If history is a guide, the answer to your question of how they will handle a severe downturn is that many of them will implode. I’ve had a lot of success in prior cycles buying assets at a severe discount from other investors (or their lenders) when the market turned against them. Those of us that have lived through this before will likely survive, or even thrive, if and when that happens. 

@Hament Raju Mahajan As always, @Brian Burke is bringing real-world advice backed by his decades of experience. 

You are correct in your assessment. But in today's world where everyone - even newbies - are looking to 10x every single thing, what do you expect? 

I cringe when I see 80% of the proformas from some semi-experienced folks as well. They grossly over-estimate revenue growth and under-estimate any bad thing that can ever occur. My biggest pet peeve is when folks with little to no background in underwriting suddenly become expert authorities on valuation based on a $100 model they downloaded online. 

The good news is that a correction will present more opportunities for smart investors. You can continue to develop your knowledge and relationships. Only pounce when there is blood on the streets. 

It takes me 6 months to find a deal. And I talk to a lot of accredited people, and they all know who all of the sponsors are - and there is concern! 

Everyone with half a brain knows that there is moral hazard in the fact that as sponsors we get paid substantive fees up-front. In that we are looking for that needle in a haystack, you can't help but ask the question...

Yeah I see about as many multifamily syndicators these days as the ads for get your free tickets for flipping houses seminars! lol. Many syndicators are front loading fees to do mediocre project after project.

That said there are always those investors who have a view so gloomy when they say they want to invest that they HARDLY EVER do anything. Years go by and they are still doing nothing. They wait for a market crash so bad to buy or invest that it never materializes. So while it is can be good to be cautious some take it way,way overboard.

When a syndicator spots a deal to buy the passive investors have to act to fund the deal in a timely manner.  

One time I had a tax accountant mention to me that for investing 100k he wanted to control the books and make all these decisions almost at the level of GP. He was just wanting way to much control. He approached me and I did not approach him.   

 

Originally posted by @Joel Owens :

Yeah I see about as many multifamily syndicators these days as the ads for get your free tickets for flipping houses seminars! lol. Many syndicators are front loading fees to do mediocre project after project.

That said there are always those investors who have a view so gloomy when they say they want to invest that they HARDLY EVER do anything. Years go by and they are still doing nothing. They wait for a market crash so bad to buy or invest that it never materializes. So while it is can be good to be cautious some take it way,way overboard.

When a syndicator spots a deal to buy the passive investors have to act to fund the deal in a timely manner.  

I literally lol'd when I read about the tax accountant part! I have a similar but different story where an "experienced" finance guy wanted to be the asset manager all the while contributing less than $150K. His rationale: He was way more experienced in finance (not real estate) and would "open doors" for us. 

Suffice it to say, we thanked him for his time and passed on the opportunity. 

Yeah if people want that level of control they need to be the GP and do their own projects.I am convinced some people say they want to be passive from what they used to be active but they still want to control everything. 

@Hament Raju Mahajan great post!

Sooner or later the correction will come and you'll see who the real players (eg @Brian Burke @Omar Khan @Todd Dexheimer are few) are. They will be the ones acquiring even more units when the market corrects.

For now, our firm is focused on quality A- to B- assets with long term, rate locked debt. 

I am excited to watch my investment thesis/model accelerated as we enter the next correction in real estate. It's likely a ways off though. Many central banks across the globe are colluding to keep money cheap and inflation in check.  Japan has kept rates low for a couple of decades which leads me to believe there's more cheap money runway left.

All the best!

How could these conflicting driving forces between the syndicators/deal sponsors (active investors )   and the passive investors be balanced and optimized.

In a scenario , If the controlling member screws it up , the passive folks should not be penalized for it.

I have heard of a very successful hard money lender in the san francisco bay area  who came up with a mortgage pool fund. He placed 10% hard cash as active owners equity and raised the rest and placed his equity at risk before the passive investors equity. He had been very successful with this approach (even  when the market was in a different cycle trend ) .

Are there any syndicators like that in the multifamily space who would bring their own  cash in the deal and also place this active owner  equity  at risk first ? or it is a unicorn in this space?

Originally posted by @Ivan Barratt :

@Hament Raju Mahajan great post!

Sooner or later the correction will come and you'll see who the real players (eg @Brian Burke @Omar Khan @Todd Dexheimer are few) are. They will be the ones acquiring even more units when the market corrects.

For now, our firm is focused on quality A- to B- assets with long term, rate locked debt. 

I am excited to watch my investment thesis/model accelerated as we enter the next correction in real estate. It's likely a ways off though. Many central banks across the globe are colluding to keep money cheap and inflation in check.  Japan has kept rates low for a couple of decades which leads me to believe there's more cheap money runway left.

All the best!

 Thank you for the shout out! I love the strategy that you are putting to play. Long term debt with great rates, along with being in a good cash position, with a value add strategy will set you up for success even through a down turn.

Originally posted by @Hament Raju Mahajan :

Are there any syndicators like that in the multifamily space who would bring their own  cash in the deal and also place this active owner  equity  at risk first ? or it is a unicorn in this space?

That might be a useful tool in a mortgage pool where the typical loss scenario is a loan foreclosure that results in a partial loss of principal on a single loan or a small percentage of loans.  The sponsor feels comfortable making this gesture because when the loans are originated the pool is in first position and they have the borrowers equity behind them. These investors are in a debt investment which by nature is lower risk and the expected returns are also lower, commensurate with the lower risk.

But in a real estate syndication, the investors are equity investors at the top of the capital stack. They are taking a higher risk than in a debt investment and are compensated with potentially higher returns. 

The typical loss scenario in this type of investment is more often an all-or-nothing situation than what you’d find in a mortgage investment. What tends to happen is either things go well and everybody makes money, or things don’t go well and the hold time gets extended far beyond what was intended while waiting for the market to come back, or things go very wrong and all of the equity is lost. Putting sponsor cash in first loss position doesn’t help the investors at all in that third scenario.  Everyone loses everything. 

One could certainly argue that it helps in the second scenario because the sponsor could sell at a small loss, take the loss themselves and return their sponsor’s cash. I doubt any sponsor would accept that arrangement.

That said, I know that I’ve done it several times. I’ve had deals go sideways at no fault of my own and I’ve cut checks to cover the loss. These were deals where I had none of my own money in the deal and was under no contractual obligation to do so...but I’ve never had an investor lose principal and I wasn’t about to start. I’ve also written huge monthly checks to cover the debt service on struggling properties during the downturn. I wrote about one example of that in the article I linked in my earlier post in this thread.  I didn’t do this because I had to, I did it to protect my investors and ultimately my reputation.

So how does the passive investor stack the deck in their favor?  Easy...choose the sponsor you are investing with very carefully. Pick one that’s been through cycles, has demonstrated integrity in the face of adversity, has ample reserves, a strong track record and an experienced team.  This doesn’t guarantee you won’t lose money but it certainly reduces the risk.  Or you could choose an inexperienced sponsor that puts their money in first loss position (because they need to in order to attract investors because they don’t have the track record to attract them).  But you could all lose 100% together if they screw up.  :)

Originally posted by @Hament Raju Mahajan :

How could these conflicting driving forces between the syndicators/deal sponsors (active investors )   and the passive investors be balanced and optimized.

In a scenario , If the controlling member screws it up , the passive folks should not be penalized for it.

I have heard of a very successful hard money lender in the san francisco bay area  who came up with a mortgage pool fund. He placed 10% hard cash as active owners equity and raised the rest and placed his equity at risk before the passive investors equity. He had been very successful with this approach (even  when the market was in a different cycle trend ) .

Are there any syndicators like that in the multifamily space who would bring their own  cash in the deal and also place this active owner  equity  at risk first ? or it is a unicorn in this space?

Every investment carries an inherent level of risk. That's the price one pays to get returns. 

This is why it is imperative to do research on the sponsor. The market and deal come a distant second and third. 

My blog posts which you might find useful: 

The Inside Track to Vetting A Multifamily Deal Sponsor

Deal Screening Checklist for Passive Multifamily Investors 

Most folks say they want to be active but refuse to do all the work associated with it. A bit like Arnold's saying: "Everyone wants to be a bodybuilder, nobody wants to lift the weights."

Some MF groups are bringing their own equity into the game but they co-invest alongside the LPs i.e. LP capital is not "senior" to their capital. That type of structure is more common amongst institutional players but they are also cutting bigger checks than the typical $50-200K LP investor. 

Nonetheless, most Sponsors do have skin in the game - their reputation. Money can come and go, but hardly anyone can recover from a bad reputation. And this business is all about having a rock-solid reputation.

@Hament Raju Mahajan a fair question to ask.  Disclosure we are a Self-Storage syndicator but I think the same rules apply to both asset classes.

@Brian Burke and @Omar Khan both make great points regarding the risk of growing too quickly.  It's all about the underwriting.  

Without a plan for the market correction in your debt assumptions things are going to get sticky. The key component you should be able to dig into is the LTV. If/When the market corrects and your debt comes due this is where the risk is for the operator/investor. I have seen some scary LTV (80%+) that are basing their debt service coverage ratios on consistent rent growth. That is where LP equity is at risk. Market corrects, rents go down, NOI drops, value drops, loan comes due. Now you have no options for refi or sale and this is where operators got into trouble in 2008 and it will happen again based on some of the deals I have seen this year.

I think you also need to evaluate with this type of hyper growth what infrastructure is in place to support it.(3rd party management, accounting, etc.)  No matter the asset class the people who are behind the desk everyday have a huge impact on the returns and performance of the project.  A vertically integrated operator is a significant advantage in my opinion when it comes to managing day to day operations.

The key is making sure the operator you are partnering with is somebody that you can trust.  I am sure it has been said on these forums before BUT:  A bad operator can ruin a good project and a great operator can make a bad project manageable!  

Do your homework, engage due diligence groups like 506 group or @Ian Ippolito group.  Honestly with the amount of information and resources on the web there has never been more transparency into our business.  The good operators welcome it!

Good Luck!

Kris

@Hament Raju Mahajan great question and excellent responses from @Brian Burke @Ivan Barratt @Omar Khan and others. I’ll add that you should ask these operators that exact question. The good ones should be able to show a sensitivity analysis to demonstrate how much stress the deal can take and address those concerns. There are a lot of brilliant minds that have been through cycle corrections and newer operators would be wise to surround themselves with more experienced syndicators.

@Brian Burke what do you think the top 1 or 2 weaknesses of new syndicators' deals are? Bad revenue and cost estimates?  Bad future cap rate projections? Something else?

I recently saw a deal around 100 units, sponsored by some new syndicators and a more experienced co-GP. All sponsors live multiple states away from the property and they have no other properties in the market. Numbers notwithstanding, I don't have a lot of confidence in the management team's ability to manage their manager.

Another deal I saw had a wildly inaccurate IRR calculations. Talking they'd overprojected IRR by 7%. Another newbie operator/experienced GP raising capital. If I can spend 10 minutes checking your math in Excel and proving it wrong, I'm going to run away - FAST.

@Ben Leybovich Perfect point on the moral hazard issue.

Originally posted by @Taylor L. :

@Brian Burke what do you think the top 1 or 2 weaknesses of new syndicators' deals are? Bad revenue and cost estimates?  Bad future cap rate projections? Something else?

It’s hard to just pick 1 or 2 so I’ll just list a few.

  • Improper economic vacancy assumptions 
  • Aggressive year 1 gross receipts projections (they immediately jump the income to new rents with no phase-in which is simply impossible)
  • Underestimated expense assumptions
  • Improper use of cap rates and/or incorrect exit cap rate assumptions 
  • Failure to properly account for property tax reassessment post-sale (in states that do this)
  • Basing exit prices on capitalized value of the income without accounting for the subsequent owner’s property tax reassessment
  • Failure to account for all of the costs incurred in putting together this type of deal and purchase real estate of this size
  • Failure to raise enough money to pay the down payment, closing costs, finance costs, syndication costs, immediate capital improvements and still have enough money left over for capital reserves
  • Incorrect calculations of income, cash flow, cash-on-cash return and IRR and/or a clear lack of understanding of those calculations and how to use them
  • Lack of waterfall calculations
  • IRRs and cash-on-cash returns that are inflated because they aren’t raising enough money—and once they realize that and raise more at the last minute the Projected returns would adjust lower but it’s too late now for the investors to evaluate the what the projections should be because they already subscribed 

This list is just off the top of my head—if I sat and thought about it long enough I could probably double the size of this list. And these are just the common ones.

These mistakes probably originate from two sources. First is a new syndicator doesn’t know what they don’t know. When I was first doing this I thought I knew everything but as I look back now I can clearly see that my actual knowledge then versus now is like a middle school student versus a graduate school student (yes that means I’m still a student even after decades, hundreds of deals and thousands of units).

The second source is lack of tools. New syndicators typically use an underwriting model that they got from a guru class, downloaded online, bought on the cheap or built themselves (but haven’t fully developed it).  These models commonly have weaknesses by either being too simple for the complex analysis needed for sophisticated transactions, or even contain errors in the formulas that haven’t been weeded out yet. 

And there is one more factor at play here. Sellers and brokers want to sell to proven buyers. The only way they sell to an unproven buyer (no matter how good the unproven buyer thinks their relationship is with the broker) is if the price is higher than everyone else or no one wants this particular property except that unproven buyer. So this forces them to use improper assumptions in their underwriting to project the performance needed to attract capital. I call that “underwriting to the price instead of pricing to the underwriting.”

But let’s not forget that the acquisition is just the beginning. The rubber meets the road during the operations phase of the investment. This doesn’t just mean things like property management, it also means things like calculating investor waterfalls during the hold and after the sale. That sounds like it would be the easy part but it’s not. One of my senior accounting staff related a story while she was on a contract hire for a VERY large multifamily syndicator. Her assignment was to compare the waterfall calculations with the operating agreements to ensure that the distributions were being calculated properly. The result?  They were ALL incorrect!  I’d bet that I could compare the operating agreements with new syndicator’s calculations and find the majority aren’t correct (but who has time for that??!!).

All of that said I have nothing against new syndicators—we all have to start somewhere and I was there once too. I also can compare myself then to now and realize that there is such a difference that investing in a great deal with a new sponsor carries greater risk than investing in a mediocre deal with an experienced one. So suggesting that all syndication opportunities should be evaluated the same is unfair. It isn't just about chasing the highest proforma IRR or the most favorable splits or lowest fees or highest co-invest. Use those things to adjust the risk profile when investing with the new syndicator, but recognize that those things by themselves do not mean it's a better deal.

Simple answer is that many of them won't survive. The ones that will are the ones with strong, very conservative assumptions in their underwriting and adequate cash reserves raised during initial funding.

As a passive investor, you don't need to be an expert in underwriting assumptions, but there are a few things that you can look for, which, if they are overly aggressive, you should take as a red flag and walk away (i.e. occupancy rate, rent growth, projected rent premiums, taxes and other expenses, etc).