The Biggest Mistakes You Can Make in the Multifamily Property Business

The apartment business doesn't seem like the kind of arena that can kill you. It's not likely to cause one of those obvious tragedies, and I'm not trying to make light of them. But the apartment business could kill you financially. In my opinion, financial death happens when you lose money and lose a property. It's one thing to not make a return on your money for a period, but it's entirely different to lose the money you've invested.

The Worst Mistakes

Here are the biggest mistakes that could wind up getting you “killed.” You’ll want to be on the lookout for these potential risks.

Overleverage

Here's an easy one to spot. High leverage (we refer to it  as  high  octane  debt)  is  typically  not  offered  by  traditional lenders. These are loans above 75% loan to cost. The traditional sources (Fannie Mae, Freddie Mac, Life Insurance Companies, etc) utilize debt service coverage ratios (DSCRs) in order to determine their loan amounts and maintain some certainty of repayment. Certain groups (mainly CMBS and Debt Funds) allow borrowers up to 95%, based on pro-forma projections at a higher interest rate. Given how low rates have fallen, it's  not  surprising  that  aggressive  lenders  have entered the space in order to make an additional spread on their money.

Here's how overleverage gets you kiIled:

The sponsor borrows 90% of the project cost for an acquisition. It's a 3-year loan, because the business plan is to push rents and then sell as soon as the asset stabilizes. Well 3 years go by and the sponsor wasn't able to push the rents (sometimes the market is soft, due to overbuilding or lack of employment growth.)

The initial loan comes due, and unfortunately, the debt funds are no longer out there giving 90% loans. The only options are traditional lenders, who'll only give 70% - not enough to repay the existing loan.

Now the sponsor has no choice but to dip into their pockets, or to ask the investors to cover the difference. Not all investors are able to do this, so they have to give deals back. It's how a high return proforma can quickly return a complete loss for investors.

Single Employer/Industry

I watch employer statistics for my renters very closely. In one of my early deals,  50%  of  the  units  were  occupied  by Chevron contractors, so I'm always aware of who's paying our customers so our customers can pay us.

Houston is very well known as the oil and gas capital of the world,  and  that  brings  certain  challenges  as  multifamily property investors. It's important to have some diversity  in employment  among your  renters, because  layoffs  lead to  drops in occupancy, and low occupancy gets you killed.

Here's an example:

The sponsor finds a deal in Freeport, TX. It's got a much better in-place return and cap rate compared the deals Barvin is sending.

Freeport  has been booming because of chemical  plant expansions and a new LNG  terminal.  Things start off great, but  all   of the sudden 50% (or more) of your renters move out. You can't lower rents enough to get anyone to walk in the door.

It turns out that one of the plant expansions got canceled, and everyone living at your property was there to work on that project. When the plant let them go, they didn't stick around Freeport. They went to  the  next  town where  they could find  work.

Unrealistic Expectations

As a regular investor, it's hard to understand what's realistic. The best way  is to have  the sponsor  send you their  income and expense projections compared to the property's current performance.

I get a lot of push back that my returns are low compared to other  offerings. While  I  admit  that  I'm  conservative, definitely push the needle. It's just that other groups push it way past the point of what's actually possible.

I saw a deal the other day  for  a  property  that's getting $1,400  rents,  in a  location  where  all  the other  units are around that same price. Over a 4 year period, they expect to raise rents to $2,200. An $800/month increase over 4 years is $200 per renewal (15% annual bumps). That's a tough sell,  even  with  a  renovation.  It's  unlikely  for  the  rent  push  to occur that quickly. It's also possible that they've over-renovated the property,  so now no one can afford  to live  there and they'll lose occupancy. Regardless, the investment package showed no mention of current  or historical  performance,  and was entirely based on projections for 20%+ IRR to investors.

When the exit depends on this kind of unrealistic income growth, it gets you killed.

Property Taxes

Texas is a non-disclosure state without specified property tax bumps. For instance, we have properties that will increase 50% year over year based on the appraisal districts valuations. It's important to protest and fight the values to get the lowest possible property tax valuation. Other states, such as Georgia and Arizona, disclose the purchase prices and have fixed annual bumps. This makes it easier to pro-forma future projections.

Here's a quick story on property taxes:

A friend bought a 600 unit dilapidated property for $600K in a very rough neighborhood. After a renovation,  his total investment in the property was $1.2M.

A buyer purchased the property for $10M ($16K/unit). They didn't realize that the tax value could adjust from $600K to something close to their purchase price amount.

The buyer couldn't service the debt as well as higher taxes, and lost the deal. My friend bought it back from the lender for $2M.

Forgetting the Customer

I love our investors, but they're not our customers. I think of investors as our partners, because we are all in these projects together. The renter will always be our customer,  and they come  first above  all  else. If the renter isn't happy, then it doesn't matter what nice things you've done for your investors.

Here's how this plays out:

The sponsor tells their friends to invest in an apartment complex, promising to pay 8% return on your money.

A few months into the process, the operations go south. Instead of keeping cash in hand to make the  property  nicer, advertise for renters, etc, the sponsor starts cutting costs in order to keep up the 8% distributions.

At first, it's the little things, like cleaning the pool biweekly instead of  weekly.  Then,  when  residents  need  work  done  to their units (appliances break, AC units, etc), the sponsor takes materials from vacant  units  in order  to save  money  and avoid buying new stuff.

After a few months, they have a bunch of vacant units that have been stripped of materials in order to use them for other units on the property. After a while, these units are in total disrepair, but there's no money to buy the materials needed to make them livable because it's all gone on the 8% distributions to investors.

One day, the investors get a note saying that they lost the deal.  It's because occupancy  dropped, there was no money  left   to bring the vacant units back online, and the sponsor was unable to pay the debt service

The customer should always be the first priority.

Bad Partners

Check out the motivation of the partner. Are they investing along with you? What are their fees? What's their  fee  to investment ratio?

I've heard stories about undisclosed fees that end up on the closing statement.  For  instance,  a  buyer  will call  the seller  and offer to pay a few hundred thousand (or million) dollars more  than initially agreed, as long as the seller refunds  the  money to the buyer on the closing statement.

It's a way these groups avoid disclosing their fees to investors.

The way this can kill you is that it throws doubt on the partner's motivation to buy. If they're only in it for the fees, and their fee is based on the purchase price, then they're likely to pay the highest price just to get the largest fee.

Ponzi-lite

I never heard of apartment investors doing this before, but I saw it in another sponsor's  documents  recently.  I  think that it's a very questionable practice.

In my deals, I distribute the cash flow from the property. That's how I make preferred return payments. But I've seen other groups actually raise this as part of the equity stack. For instance, a group needs $10M to buy a property, but they'll raise $12M so they can start distributing at 10% immediately after closing.

In a sense, they're just returning your investment back to you on an inflated basis. If the sponsor is not able to hit their projections, those funds would run out. You'll be left in a situation where the property is not making any money at all.