When I was 16 years old, I aspired to become an airline pilot. Using the money I’d earned from a week of bagging groceries, I took one flying lesson a week at our local airport after school. Learning to land an airplane was an incredible experience. After you complete your first unassisted landing, you feel like you are at the top of your game.
One day, my instructor set up the airplane on final approach to the runway. He intentionally set up the plane so that we came in too low with an airspeed that was too slow. It’s a condition called “being behind the power curve”—a concept I had not yet been introduced to.
“You have the airplane,” my instructor told me. It was time for me to take over the controls and complete the landing.
As I crossed the runway threshold I cut the throttle, just as I had done on every other landing (not that I had done many in my whopping five hours of experience). And then, almost immediately…WHAM!
The plane literally fell out of the sky. Fortunately for me, we were only about 10 feet up or so, so instead of a crash it was just a very hard landing. Surely I must have damaged the airplane, I thought. I’d never felt such an impact before.
We assessed the damage: there was none. I had dodged a bullet this time.
What happened? What did I do wrong? Well, a lot. And also nothing.
I failed to recognize what was going on because I’d never experienced this particular configuration before. I didn’t realize that I should have gone full throttle to get the heck out of there and start over. On the other hand, I did nothing wrong because I did what most students do when they are learning and lack experience. We make mistakes. And we learn from them.
Never again will I get behind the power curve on a final approach. Never again will I cut the throttle when I’m going too slow for the airplane to keep flying. The point is, you learn these things in training so you don’t learn them with passengers.
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What Does This Have to Do with Real Estate?
Everybody wants to talk about their successes. But talk about their failures? No way! What failures?
Come on. We all have them, so just be up front about it. Here’s why.
Other people’s money fuels the growth of our real estate businesses, right? Attracting that money requires that you have a spotless record and never make mistakes. It is perfection that impresses investors and makes them want to invest with you. No one wants to invest with someone who has screwed up. Right? No; wrong!
In just the past few years, I’ve raised over $60 million, so you can imagine that I’ve talked to my share of investors. I’ve found that plenty of investors will trust you because of all of the things you’ve done right. But nearly just as many have decided to invest with me only after hearing a story about one of my failures. Failure is where the best lessons are learned. Your true colors show when you fail. Investors don’t want to get caught up funding the “rookie mistake” phase of someone’s career. But they do trust their capital with those who act with integrity in the face of adversity.
The Rookie Mistake
If you’ve read my articles on Multifamily Myths, you know that there are many things about investing in income property that new investors don’t yet know (think: student pilot). Proceeding under the assumption they have all of the knowledge necessary leaves them vulnerable to mistakes that lead to hard landings.
Such was the case early on in my multifamily investing career.
My rookie mistake was underestimating the power of an adverse economic cycle and its effect on economic vacancy. And overestimating the relevance of buying at a discount to the previous owner’s basis.
It was spring of 2008, and the real estate market had already seen a significant collapse. This allowed me to buy a 60-unit apartment building for half of the price the previous owner had paid. This (incorrectly) convinced me that I was getting a great deal, buying after a downturn at a steep discount. What could possibly go wrong?
At first, nothing went wrong. The business plan was ticking away flawlessly. I was renovating the property, upgrading units, replacing roofs, you name it. Occupancy went from about 80 percent to 99 percent. I was getting higher rents on my new leases. Life was great. It looked like this multifamily syndication would go down as a success.
But 2008 was offering up a double whammy. The earlier collapse in real estate prices finally made its impact on the greater economy, and by fall 2008, we suffered what can only be described as the Great Financial Collapse. In September, Bear Stearns and Lehman Brothers, both thought to be solid as a rock, came tumbling down in a subprime mortgage meltdown. Banks were failing. Companies were closing. Jobs were disappearing. And my apartment building had just hit 99 percent occupancy, and stayed there—for about a week.
“People Always Need Somewhere to Live”
They say that residential real estate is a safe investment because people always need somewhere to live. While there is some truth in this assumption, the reality is that people will live wherever they must—even if that means doubling up with friends or moving in with family. It could mean moving from apartment to apartment until the Eviction Grinch catches up to them. That’s where this old saying comes in: “Half of the units are empty, and the other half aren’t paying.”
Economic vacancy is made up of several components: Loss to lease (the difference between market rent and the actual rent on the lease), physical vacancy (empty units), concessions (discounts or free rent given to attract a tenant), bad debt (the half that aren’t paying), and non-revenue units (down units, models, employee units, etc.).
During an adverse economic cycle, it’s hard to raise your tenant’s rent—you don’t want to rock the boat on those below-market leases. This way, your loss to lease doesn’t burn off. Units go vacant so your physical vacancy loss goes up. You offer concessions to prospective tenants because you are in an all-out war with your competitors to fill units. Tenants are losing jobs, so your bad debt goes up and your eviction costs rise.
If you don’t appreciate all of those elements of economic vacancy, each of them can catch you off guard. They can also all team up to deal you a knock-out blow.
I got hit by them all. By the middle of 2009, my property was collecting just enough income to pay for the operating expenses, but there was no money left over to service the debt. I was definitely behind the power curve now, and applying full throttle to go around and try again wasn’t an option. The engine wasn’t working.
Stuck Between a Rock and a Hard Place
This is a terrible position for a syndicator to find themselves. If you don’t make the loan payments, the lender will foreclose. Your investors will lose all of their money. You can sell the property, but because the income is only enough to cover operating expenses, the net operating income is roughly zero. This means that the property’s value is unlikely to exceed what would have been a conservative loan in the first place. So at this point, if you sell, you might pay off the loan (or perhaps the lender would agree to a short sale) but in either case, your investors would lose all of their money.
Although this was my first multifamily syndication, I had already done many single family syndications and a couple of commercial (non-syndicated) deals. Up to that point, I’d never had an investor lose their principal on any investment they had done with me. I wasn’t about to start now. So I was looking for a third option, and I found it.
I started paying the debt service out of my own pocket. At first I simply had to feed in a few thousand dollars. But it was only a matter of months before the situation deteriorated to the point where I was fronting the entire $15,000 monthly loan payment.
After a couple of years, things started to turn around. Eventually I started generating some income beyond the expenses and was able to reduce the amount of money that I was feeding each month. By the time the property could stand on its own, I had put in over $400,000. I had loaned the entity more money (interest free) than my investors had invested in the first place.
The property was originally forecasted to be a five-year hold. Five years turned into eight. We sold the property in 2016. Fortunately for me and my investors, the multifamily rebound was just as strong as the decline. We sold for a price that not only paid off the loan, but returned all of my investors’ capital. We even made enough to pay back all of the funds I’d loaned for servicing the debt. On top of all of that, we all managed to make a profit.
Apply These Lessons to Your Business
When underwriting income property, build all of the components of economic vacancy into your income forecast. Be sure to use conservative estimates so you don’t get caught off guard when things aren’t perfect (they never are). Don’t underestimate the power of an adverse economic cycle. And don’t let the concept of “everyone needs a place to live” lull you into a false sense of security.
So you want to syndicate real estate? First, know what you are doing. Make your rookie mistakes on deals that you fund with your own money—or get an experienced partner so that you don’t make rookie mistakes at all. Raising money from others is a serious responsibility. You don’t want to practice on the back of the hard-earned cash of others.
Your job as a syndicator does not end once you raise the funds and close the deal. That’s just the beginning. A good syndicator can salvage the best outcome from a really tough situation. A bad one can ruin a perfectly good real estate deal and destroy relationships with investors.
Always do right by your investors. When things aren’t going according to plan, be honest with yourself about it. Come up with a new plan. Communicate with your investors. Tell them what is going right, what is going wrong, and what you are doing about it. Airline captains will tell the passengers to put their seatbelt on when there is turbulence ahead. You should do the same. Don’t sugarcoat anything or make up excuses. And don’t lie or say all is well when it isn’t.
Student pilots don’t get a license to carry passengers until they’ve had the necessary amount of practice and can demonstrate a specific level of skill. These rules are in place for the safety of the passengers, of course. But there are no similar rules in place for real estate operators who take “passengers” (investors) on their real estate journey. Do yourself and your investors a favor: get enough practice to get past the “rookie mistake” phase of your career before you put anyone’s money at risk. Your hard landings will make you a better operator and allow you to add extreme value to your investors.
What mistakes have you learned from?
Share your experiences below!