You’ve looked at many different apartment building deals, and you finally have one under contract. Congratulations! Now the real work begins: due diligence. If you don’t uncover anything new that materially changes the deal, you’re well on your way to closing.
But many times you DO uncover things during due diligence that you weren’t told about upfront or that you just didn’t know. Here are 4 tips to help you figure out when it’s time to walk away.
How to Know It’s Time to Walk Away From an Apartment Building Deal
Tip #1: Set Your “Trading Rules”
There was a time when I learned to trade options. At the heart of trading stocks and options are “trading rules.” These define when to enter a trade and when to get out, either at a loss or a gain. My mentor insisted on writing these trading rules down so that when you’re in a trade and emotions are running high, you can refer to your written rules and (hopefully) stick to them.
It’s the same thing with real estate investing. In the case of apartment building investing, before you get into a deal, you should decide on your trading rules. These will include:
- Cash on Cash Return: Do you require a minimum cash on cash return when you get in a deal? If so, what is that minimum? Or will you tolerate negative cash flow for a while? What is your desired cash on cash return once the property is stabilized?
- Overall Return: This return is measured by adding up all profits from cash flow, loan amortization, and appreciation and dividing it by the cash invested. Divide that by the number of years you plan to hold the property, and that gives you your average annual return. What is the minimum you will need?
- Property Condition: Would you consider a value-add deal that maybe requires some work to stabilize? If so, how much “work” will you tolerate? Would you do an empty building that requires a complete renovation? Or are you looking for more stable properties?
- Property Size and Location: How big of a property would you consider? What’s the smallest deal you would do? Which areas would you do a deal in?
There may be other trading rules, but those are the main ones you need to be clear about. It will help you focus on which deals to consider and which ones you shouldn’t. These rules will guide your underwriting, i.e. how to determine your offer price. They will also allow you to re-evaluate the deal during due diligence and help you determine if you should stay in the deal or re-negotiate.
Trading rules are critical.
Tip #2: Have a Sound Financial Model
Trading rules do you no good if you can’t model them. You need some kind of deal analyzer that helps you determine the key metrics like cash on cash return and overall return. The input in the model are things like purchase price, loan terms, closing costs, and renovation costs. Your income and expense projections certainly will affect these metrics. And your exit strategy and assumptions will need to be factored in. You can create a model yourself, or you can Google “deal analyzer” and purchase one.
A good financial model is critical; otherwise, you’re flying blind.
Tip #3: Continue Re-Evaluating the Deal Throughout Due Diligence
As you progress through due diligence, you’re constantly looking for new information that might affect the deal one way or another. You’re not so concerned about little things. You’re looking for showstoppers and game changers.
For example, you might discover after examining the seller’s bank deposits that only about half the tenants are actually paying their rent. Hmm, that might have an impact on your net operating income, wouldn’t it?
Or on your initial walk through, you discover that the property is in much worse condition than the broker led you to believe. When you submitted the contract, you put a repair place holder in your deal analyzer of $25,000, just to be safe. Now you discover that the property needs a new roof, probably all new windows, and all of the railings and woodwork are rotting. And the units! They’re a mess. You and your contractor determine that you probably need to spend $75,000 to get this building to at least an average condition.
Tip #4: Determine if You Should Re-Negotiate the Deal or Get Out
A $50,000 increase in estimated repair costs will put significant pressure on your returns. If that pushes your returns under the minimum return you require (your trading rules!), then it’s a sure sign that you need to re-evaluate the deal.
Re-evaluate means to either (a) re-negotiate the terms or (b) get out. You should always try to re-negotiate the deal, but if you can’t get the terms back in line with your trading rules, it’s time to terminate your contract.
Note that the key is to complete all of this before your due diligence period expires. Otherwise, there’s a good chance you might lose your security deposit if you decide not to proceed. If all of this back and forth is making you run out of time, then extend the due diligence period.
Be very clear about what a good deal looks like to you. Normally this is defined by the cash on cash return and the overall return. A good deal analyzer financial model is critical to allow you to determine whether a deal meets your trading rules or not. Update your model as you uncover new information during due diligence. If anything materially changes your assumptions, you may have to re-negotiate or get out of the deal.
If you follow this process, you won’t lose your security deposit, unnecessarily spend money on due diligence and avoid major mistakes.
Investors: How do you make certain your prospective apartment deal is a solid one?
Leave your comments and tips below!