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