How to Loose Money on Multifamily!

30 Replies

One of my partners called me yesterday.  He said he had a lead from a wholesaler on an 126-unit in good part of the country that we should take a look at...

The marketplace really is quality - a stone's throw away from a major city.  Highly motivated seller with a story that made all kinds of sense - my partner spoke directly top the seller.

I come into the picture today.  My job is to underwrite the deal.  I spent 5 hours in which I researched the market, the little bit if info that I had (this is a very distressed situation), called my management contacts with boots on the ground in the geographical vicinity, and finally built a pro-forma based on available information.

According to my underwriting, the stabilized operation of this particular asset would result in negative gearing NOI to the tune of $120,000/year...

Let me say that again:

Even after everything is functioning as it should, this asset would still be loosing $120,000 of NOI! We are not even talking about Cash Flow here - NOI! No **** they are

Even if I were $100/month/door off on the rents, the NOI would still be negative $20,000.

Guys - I could not imagine that this would be the result of my underwriting.  I can look at a 4-plex and tell you if it works in 3 seconds.  The big stuff has so many moving parts, and so many line items you've never heard of that I literally had to go through the entire process to arrive at the results.  

It's really hard to underwrite mutli-unit.  And most people, whether they know it or not, loose money in this space...

Be safe and be wise!

@Ben Leybovich   so ... maybe you should give a little more detail. What I heard is that this was a C class building with average rents of around $500. You underwrote to stabalized proforma and STILL showed large negative cash flow. Thus this project had 0 intrinsic value. 

I find this very interesting and see you as making a pretty broad statement that LARGE (100+ unit) C class multifamily, IF underwritten appropriately to include real management, payroll, capex, etc, has no real value AND that the only reason they sell at all is because people don't know how to underwrite. Quite a proposition.

The next few years should be interesting as these buyers shake out.

@Serge S.  - keen sense of the obvious.   The C Class in large multifamily has an inherent handicap - it doesn't generate enough gross potential.  The thing is that expenses on an 120 unit are what they are.  Doesn't matter if it's C Class with $500 rents, or B Class with $700 rents.  In fact, expenses on a B Class should be lower!

Thus, the C Class spreads suffer simply due to what it is, and they suffer on both ends - income and expense ratio.  Now, to be fair, if this were an 160 unit, things might look better since the income increase would outpace the operating cost increase in several line items.  However, this particular deal is so handicapped that I simply do not know of a way to run it profitably...

@Ben Leybovich Your post is exactly why I'm sticking with the small stuff for now. I need more time before I graduate to the bigger stuff :)


You are right,  I am really nervous to pull the trigger  getting close to 29 units first deal. When realtor sent me financial statements with other income,  late fee, eviction, damaged ect... And RUBS systems about 30k income. If miss calculate expenses about 10k, will lost big money. 

I am seeking for help to analize the deal. 

Long Khang 

@Ben Leybovich   ,
I've been intrigued by your comments for awhile but this one finally led me to
pipe up since your data seems very similar to a property I'm currently
reviewing and your conclusion seems drastic. I hope I've missed something huge because I've been searching right in the heart of your seemingly "no mans land" of 80-120 units in that region...

Anyway I coincidentally also just received info for a 126 unit in a mid Atlantic state just
west of a city that starts with "C" and ends with "otte". High distress and
average rents in the $500 range, supposedly class C. After 15 mins research I
discovered property was directly beside a housing project and area SFH resales were
in the $15k to $25k range, which are flags for me being a bit rough area. I didn't pursue further based on this but I would love to better understand your underwriting analysis.

Furthermore I am very curious to your post synopsis and trying to grasp the full
meaning.  I think what you and @Serge S.   are stating is that the relatively high
fixed operating costs for a lower rent class C (& certainly D) properties of
this size essentially render them worthless since expenses will typically exceed income (negative NOI).

Would your hypothesis then extend across all Class C 100ish unit properties in the $500 rent range? How is this possible as there are many successful operators in this
space throughout the southeast and Midwest in this average rent range with similar "average" expenses for each category as you state in your most recent article "Most Apartment Buyers (and Sellers) Are Suckers"? Or are there? Your analysis seems to infer that these properties cannot be profitable, which I find surprising.

Your additional statement of 160 units potenitally being profitable further implies that
there is a deviation (+ and -) from 126 in which income exceeds (more units) or expenses
decrease (less units) enough to where the math does make sense.  There seem to be crossover points as you increase from 4 units (profitable) to 126 units where these properties are unprofitable, then inflect back again where 160 units are indeed profitable. Am I following your assumptions correctly?  If not, please align my reasoning.

Charles W. - not looking to share my pro forma.  This thing is obviously still out there.  Perhaps someone can do magic that I cannot...

@Ben Leybovich  

Thank you for the feedback.  For some reason it looks like your reply comments deleted, because I read them earlier but now they're gone.

If I interpreted your theme correctly, it's essentially a waste of time to pursue most C class mid size apartment complexes in the flyover states and SE US.  Class A & B property CAPs seem to be seriously compressed even in tertiary markets so the numbers don't make sense there either.  May I ask how you're pursuing your syndications, as I'm on a very similar journey and seem to be running across similar issues with valuations?  5 hours research per crappy "deal" seems like a quick path to burnout if the near term flow of reasonable projects seem dire.

Do you think we're too far along this market cycle to discover and acquire sizable portfolios?  One off "needle in the haystacks" are possible I guess, but no way to build a business.  My goal was to acquire several complexes within this size range but it's seemingly discouraging as each day passes and we move further along the cycle curve...

I have owned a 106,125,128, 135, and 144 sized  apartments in the past.  They were successfully giving off decent cashflow at the time.  These were all purchased between 2004 and 2006 when prices were a little better than they are now.  I do think you can have success with them. 

As Ben says, the better the area, they easier it is to make money.  But, those properties are harder to find listed for sale.  C and D locations are much more management intensive and do take up a larger chunk on the expense side. 

Aggressive management and marketing techniques really help.  We would flyer cars and go into large businesses with treats and handouts.  We would also go to parks and flyer cars during sporting events.  Nobody liked to do it but we made it part of the mandatory culture at our place of business.

We also worked hard at tenant retention and had a number of programs in place.

@Charles Williams  - I do think we are too far along into the cycle.  At this point it's all about one-ofs...lead here and lead there; perhaps something works.  But, I am not holding my breath...

I spend time reaching out to brokers and wholesalers and follow up on everything.  But, it's all about understanding the dynamics of syndication to be able to act at a minutes notice...

Makes sense?

@Ben Leybovich  

It absolutely makes sense.  It's just discouraging after recently making the decision to transition from single family to multifamily, getting educated with underwriting and syndication, to have missed the apartment asset boat this cycle.

Since I'm a huge believer in the cash flow model I struggle with whether to keep striving for that one off apartment, expand the single family portfolio or shift focus to another asset class such as mobile home parks.  I believe there's huge demand for MHPs due to many economic drivers and have a similar underwriting process with much less expense and headache to apartments.  I don't quite have the monthly financial capacity to wait for that ideal property, I have to create a deal.

Thank you for your feedback, much appreciated.

@Steve Olafson  

Thank you for the insight.  Are you finding similar underwriting issues on your side of the country as well?

@Charles Williams  

Oh yes...  I am selling most of my properties at what should be considered crazy prices.  I bought one retail strip center recently but can't find anymore.  So, I am going to sit on cash for a while.  I don't know if it is the right move or not but the last three years have been good to me.  Time for a break.

@Charles Williams My take away is not that C Class has no value. The low rents certainly make everything exponentially harder. There are talented operators that have and will make money in this sector. The question is can it be done the "right" or way. The "right" way involves many expenses that are not accounted for by the local owner operator that will be doing it his own way. For example, if I am buying a 100+ unit out of state, I will need 2-4 employees and all the costs that come along with that such as payroll, WC, etc. I'll need to budget the realistic cost of capex (done by professionals) and need to leave plenty of margin for the exit to drive my IRR.

Now my local competition, his underwriting will look much different. He will plan to run it with less or no employees, try to do the handyman work himself and cut all sorts of corners that will save him real money. For that guy, his underwriting looks much different and the deal much more appetizing. And to his credit, that guy knows the market much better than me and has a better chance to capitalize on resale margins. As such, he can pay much more for the same deal. @Ben Leybovich is not this guy and it sounds like you are not either. Especially if you want to do this in scale.

@Steve Olafson   gives some good examples. He is on the ground where his investments are and will be plastering cars with marketing. He has infrastructure to deal with the management. You as the out of state syndicator will have a tough time sourcing and competing with the guys like Steve. The deal your looking at, Steve already passed on. Once you buy, you will be using a PM that believe me, will not be marketing like Steve. Your capex numbers will look very different than your local competition.

So ... its not so much that these properties are "worthless junk" like Ben seems to think. They are worthless junk for guys like Ben. For locals that can actually get it done there may be value. Not that I necessarily advocate doing it yourself but thats a completely different debate and a different business model.

Personally, I am pretty much done with large multifamily for the time being. In today's market just about everyone else in the food chain will make more money than the multifamily owner. Better to be the broker, property manager, construction company, etc than the owner of C class multifamily bought at a 5% fictitious cap rate. I only see the downside.

I agree with @Serge S.  

There are some good management companies but they are few and far between.  I still hire employees as a local operator but each of them are trained specifically how I want things done.  This is important.

It is really tough to find a deal these days.  The locals with experience are no longer buying.  The deep pocket teams that came in and bought all the distressed properties in Phoenix are selling, not buying.  REIT's, and out of state buyers are what I see in the buyers position right now. 

I think the deals will start to show up again when the REIT buyers leave town.

@Serge S.  - I disagree.  The difference between owning a few doors and big stuff is that while it's understood that there just isn't spread to afford management for a few doors, and it necessitates self-management, big stuff is for us to grow into and out of self-management.  It is not a deal if I have to manage cause there's no room for reasonable and proper pay roll - like I need a of all people know what my life is like!

Then, to top it off, you are not only self-managing, but you are managing C class tenant base.  There's simply no money in the world that I'll do that for on a large scale...

I am a nothing down guy.  What this means is that I don't like to buy CF with down-payment.  If the thing doesn't CF to my standards under 100% financing, then it's just not a deal.  Well, I sure as hell don't wanna buy CF with my time, effort, and excessive intestinal fortitude.  If proper personnel and management doesn't underwrite, it's not a deal in my book.  Class C does not - not in most cases...

Now, I know @Steve Olafson  has done amazing things.  I can't wait to learn more!

@Ben Leybovich  

Every transaction brings on new perspectives.  I am certain that we will all teach each other.

@Ben Leybovich   I see the problem that you are experiencing to be sourced from the opposite angle from which you are looking.  Yes, deals, as you define them, are difficult to find. Why?  Because other people define a deal differently than you.  

You see, the problem isn't that the property will not support the expenses to operate itself (well, this can and does happen but I don't think it is your predominant obstacle). Most properties will generate a positive NOI even with proper staffing levels and management structure. If they didn't, every 100 unit C deal would be in foreclosure or torn down / abandoned.

So if it's not the property, WHAT IS IT?  It's...cost of capital.  

To syndicate a deal you have to attract investors. You do this by producing a return on their investment. Since you don't have deep relationships with capital investors you likely have to show them an IRR in the mid-teens to attract them to the deal. This means that only the very best deals will make the cut. Mediocre deals don't qualify. You can't squeeze out mid teens from them and still take a cut for yourself.

REITs and private equity firms have deep relationships with their capital partners. They might have to produce a 4 or 5% return to their investors. Even mediocre deals will do that and still leave room for their promote when they borrow 2/3 of the capital stack at 3.85%.  They can turn your great deal into a mediocre deal simply by submitting a higher offer than you. The property didn't change at you can't say the property was a bad deal, only that they got a bad deal (at least as you define it).

Family offices are looking for parking places for boatloads of capital and they can't put it all in treasuries at 1.8%. So they buy some real estate and put in a risk premium that still results in a return much lower than you need in order to make your investors happy.

1031 exchange buyers arguably have a negative cost of capital because if they don't buy something, even at a zero percent return, they lose money to the IRS for capital gains.  

The buyers in these last two categories have no carve outs...there's no general partner or syndicator to share with.  100% of the return goes directly to them.

Those with a lower cost of capital than you can outbid you every time. Your only chance is to buy a deal that they don't see.

I have given up on wholesalers. The crap is so overpriced it is ridiculous. I do not search them out they just send me stuff.

A lot of times it is just an overpriced seller hoping this wholesaler will find an idiot to buy the property.

I only deal with highly motivated sellers for good properties. I don't spend time playing games anymore. I want to make every second of the day productive whether that is family time, friend time, business, etc. I do that by weeding out the time wasters.

Give the wholesaler your definition of a deal and tell them to only bring you stuff that meets it. Many are lazy and you never hear from them again. Not bashing wholesalers but it is one of the most unprofessional and untrained avenues out there.    

@Brian Burke  - everything you are saying is absolutely true.  This particular deal, no matter how much you and @Serge S. try to convince me otherwise, is negative to slightly marginal NOI. We are not talking CF here - NOI...I saw the numbers :)

It's not a matter of it not being syndicatable deal.  It's not a deal.  Nothing in this deal is to market.  Rents have to be lower by a good margin to attract anyone to the location.  Operating costs have to be higher by a good margin.  Not capx; operating costs...

I have a friend who owns 600 in Ohio.  His vacancy in C+ and up runs 5% today.  Vacancy in D Class is 18%.  With 600 units, you have some of all of the above...

This subject stabilized, which means low rents and working with Section 8 almost exclusively, is still going to run 15%-20%.  No matter MSA - I know mid west.  It's 8 hours from me, things don't change that much - D location is D location...  Any thought of 5%-10% vacancy is lunacy in this class.

And yes, it was me that pulled the plug. It may be possible to squeak positive NOI, but life is too short for that kinda game...

This may be a dumb question for all you season investors out there. @Ben Leybovich  during your 5 hour market research what things are you looking for? Jobs available? How things are selling? Also, what are some good resources to find the type of information you look for in your market research?

Originally posted by @Ben Leybovich:

This particular deal, no matter how much you and @Serge S. try to convince me otherwise, is negative to slightly marginal NOI. We are not talking CF here - NOI...I saw the numbers :)

I have seen these types of deals before and have even bought some of them.  Zero cap rates on existing numbers.  This is my bread and butter.  Obviously you will need to see great potential in the deal though.  Doesn't sound like it is there in the deal you looked at.

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