All Forum Posts by: Justin Moy

The demand for apartments continues to grow, making the multifamily sector thrive nationwide. But rising interest and cap rates are affecting lenders and investors.

Interest and cap rates refer to the amount of money that banks charge to lend money and the rate of return that investors expect to receive. These rates are increasing, making it more difficult for investors to make a profit.

Tom Noble, a capital expert, thinks that rental growth needs to go down for the market to improve. This is because rents are a significant part of the inflation metric that the Fed looks at.

The market is good for lenders, but it’s a different story for investors. Multifamily investors are finding it difficult to structure their investment. For long-term investors, the key is to source the right type of capital.

As the economy changes, deal terms and strategies are changing too. Deals now have more cash flow challenges, meaning investors need to have more reserves upfront.

Panelists at the GlobeSt’s Spring Multifamily Conference agree that rents have to decline before rates improve.

Despite these challenges, the panelists are optimistic about the long-term growth of the multifamily sector.

Commercial loans (5+ units) typically require some type of commercial experience, so having experience managing similar properties will be a big help. If not, having a partner who is willing to sign on the loan and partner on the deal would help bridge that gap and maybe that partner could also provide the additional gap funding.

As a passive investor your work is done upfront in the due diligence process. There are a few key items you need to check off your due diligence checklist before making an investment:

Due Diligence on the Operators:

1. What is their experience with this asset class and in this market

Most operators will specialize in a specific type of investment, and many think success in one asset type equals success in others. That is many times not the case and even as operators expand their horizons they can experience growing pains.

Understand what their experience with the asset type you’re investing in is, and if they have strategic partnerships to help them avoid mistakes if they’re taking on a new asset class.

With multifamily: Understand their experience in that class of property (A, B, C, D). There are operators who absolutely crush it in certain asset classes and may struggle with others.

Understanding the market: Real estate is hyper local. One of the biggest benefits an operator can have is hyper local knowledge. If they aren’t boots on the ground, is there a partnership that is providing that? Not understanding the market is a big red flag, and also with bringing on a new staff, managers, contractors, and new geographical team, there can also be growing pains here.

2. What does their organization look like

Are they a huge organization? A smaller local operator? Family business?

There is no wrong answer to the type of operator to invest in, but each will have their pros and cons. Some investors like to be part of a larger organization, others might like the intimacy of a smaller one.

One thing that is a personal preference of mine is I would not invest with a solo operator. Nothing against them, but if something happens to that one operator it can jeopardize the investment.

(In Kevin O’Leery’s famous words: “What happens to the business if you get hit by a bus?”)

3. The big question

One thing I think all passive investors should ask their operators is “Out of the investors who choose not to invest with you, besides lack of liquidity, what is the #1 reason they choose not to?”

This will tell you a lot about the operators because if the #1 reason is a reason that’s really important to you, you can know they may not be a great fit, but if the #1 reason isn’t important to you, you may feel more comfortable with that group.

As a bonus, it also allows you to know how well the operators understand their business and track feedback to continue improving.

Due Diligence on the deal:

1. Headwinds or tailwinds?

Is the asset class we’re investing in going into headwinds, or tailwinds? Tailwinds are things that will push that industry forward, a great example is what multifamily was experiencing over the past few years. With robust rental assistance programs tenants were willing to and able to pay more, and collections saw historic highs and vacancies saw historic lows.

Headwinds are what the multifamily industry is seeing now, with rental assistance programs drying up and rents pushing affordability beyond what tenants could naturally pay, we’re seeing vacancies increase and rent growth stall or decline in many markets.

Headwinds can also provide more opportunities, so headwinds aren’t totally bad, but the business plan would have to be sustainable for a longer term deal to weather those headwinds.

2. Tenant income

We want to know the average income of our prospective tenants in the area. Most people understand housing costs have greatly outpaced tenant income, and in some markets these ratios are stretched to their limits.

We want to know how much the average prospective tenant for this property will be making and see if our rent growth projections can be sustained at current income levels, if we’re seeing tenants incomes are already stretched to their max we might be hesitant to project more aggressive growth.

BONUS: The debt

Debt is generally the #1 killer of real estate deals. Almost all distress in CRE is debt related and forced sales typically come from balloon payments coming due.

When analyzing a deal you really want to understand the debt on that deal:

How long is the loan? Is the rate fixed or floating? If it’s floating is there a cap? Has the property been underwritten at the max interest rate? What are the prepayment penalties? And very important for short term loans, what are the extension options?

Asking these key questions will help you avoid forced sales and will statistically be one of the best pieces of due diligence you can conduct to avoid deals going bad.

I'd be inclined to give it to the long term tenant. It makes more sense to me that the person there all year would get it as opposed to someone who comes and goes and the garage could possibly be empty some weeks out of the year. Also logistically if a tenant is moving in and out it's one more piece of equipment (the opener) that you have to track and be sure gets turned over. Not a huge deal but just an extra step to consider

MF has had a huge influx of investors in the past few years which has driven up prices. The performance of the asset in general especially through covid drove up prices and in some markets even paying ridiculous amounts made sense because rents kept growing at record levels. 

But now that cash has dried up and rates have shot up. We're still in the gap period where sellers are gripping onto the past and buyers aren't able to pay those prices. It'll take some time to normalize. 

But yes what you're seeing is what almost all experienced investors are seeing, stay active and keep underwriting properties but know that a vast majority won't work out at sellers prices right now unless there's seller financing or a great assumable loan

I'd definitely say to hire a lawyer at least to create a template you can use. YOu don't have to pay them everytime you need a lease, but even using something like legalzoom to hire a onetime lawyer for this. 

You really don't want to leave any gaps in the lease or any other legal document!

If anyone has looked into being a passive investor in private REITs, funds, or syndications, but you haven't, what's stopped you? 

Is it a lack of money, knowledge of good operators / companies, you'd rather take on the work yourself? 

Curious what your thoughts and experience has been!

Many investors look for cash on cash return as a king metrics in evaluating deals, but there is another metric - return on equity - that can help investors make informed decisions on their portfolio.

Return on equity typically decreases as you hold a property long term.

Return on equity is different from cash-on-cash because it is the amount returned versus the equity you have in a property - not the cash investment you’ve made.

Let's say you purchase a $100,000 property with a 20% downpayment and also you paid 5% in closing costs.

You’ve invested $25,000 into the deal, and every year you have a net positive cash flow of $3,000 after debt service.

To calculate cash on cash you’d take $3,000 and divide it by the $25,000 cash you put in and you’d get a 12% cash on cash return, which is pretty good.

Now if you’ve purchased your property in an appreciating area chances are the rents from that property will increase, so it wouldn’t be uncommon to see your cash on cash grow slightly every year as you can charge a bit more for rent and you experience some loan paydown as well.

If you put in 20% as a downpayment on a property, that means the bank owns 80% of it. So in this case you have 20% equity on the property. So in this scenario you still owe $80,000 to the bank.

But, here’s where return on equity comes into play.

Let's say it’s been 10 years of owning this property, and in that 10 years you’ve paid down your debt from $80,000 down to $60,000.

This increases your equity in the property from $20,000 which was your initial down payment, up to $40,000 because now you’ve also paid off $20,000 from your mortgage payments.

Lets say during that 10 years you’ve also increased your annual cash flow from $3,000 to $4,000. Since you still only invested upfront cash of $25,000 your cash flow has jumped from 12% to 16%, because now you’re taking $4,000 in annual cash flow and dividing it by the initial $25,000 invested.

But if you take into account the additional equity you have in the property, your return on equity actually drops.

Now you’d take the total equity you have in the property, your $20,000 down payment plus the $20,000 in loan paydown you’ve made to equal $40,000 of total equity.

If you take your annual cash flow of $4,000 and divide it by $40,000 of total equity you have in the property, you get a 10% return on equity.

This is an important metric because as investors we’re always looking to keep our velocity of capital high, and as we pay down loans and increase our equity in a property we will eventually see that return on equity amount decrease and once it gets to a certain threshold you may be able to pull out that equity from either a sale or refinance and deploy it into another asset.

When you have properties and locked up equity you should always ask yourself if there are other opportunities that equity would be more effectively deployed to and you can use return on equity as another metric you can use to make educated investing decisions.

Quote from @Christen G.:

I’m in contract on a 7-plex for well under listing. It’s a C class property - which I’m familiar with and have operated. On paper this is a win of a purchase for me. I can provide a fast purchase and close (buying in cash). Realtor noted that 1 tenant was in arrears and they’d provide more info but hasn’t. The inspection is happening and I’m awaiting the report but in the mean time the seller is not providing rent rolls or leases so I can do due diligence. They said once that rent rolls “were coming” and now they said they’ll provide at closing. This seems like a big red flag for me. Two questions:

- all things considered: is this a giant red flag for you, too?

- how common are estoppel agreements? I’ve never used / issues one.

Thank you for your input.

Huge issue. Financials are typically received very early on in the due diligence process - for us we review those before we conduct our physical inspections. They are stalling. Hopefully your PSA has some type of language that requires those documents to be released before your due diligence timeperiod can expire (and gives you time to review them). If not no problem, but do not close or 'go hard' on your EMD without having enough time to review those docs

Quote from @Ed Brown:

I have an ocean view triplex in Orange County, CA. Value 3MIL and paid off; excellent location and strong rental market. Just thinking I'm not getting much income as income is about $7,000 per month before expenses (probably under market by about $1500, so income s/b $8500) . I'm thinking I would like to sell and get a larger building, where I can leverage my money and increase my income.  However I'm in my mid 60s and the property is not a problem with tenant turn over and a waiting line if there is a turn over. I don't want a headache property. Thinking of a commercial building or a strip center but those would have to be out of state, opinions? Also have a duplex and 2 SFRs 

At some point you have to think about return on headache versus return on investment. I'm not sure how much cash flow you're looking for but if you factor in a new mortgage compared to your paid off property it may not be worth the additional work to find, acquire, and manage a new deal. 

Have you thought of doing something more passive like a syndication or a fund? It may not have the returns of owning yourself but it could help give you some extra income while remaining passive. 

Overall, what type of cashflow return are you looking for?