Apartment Active investors buying too many door too quickly ??

[Hament Raju Mahajan]

I know over 5 Deal sponsors (active partners) who syndicate Multifamily apartment deals (they raise money from passive investors and manage the project) .

I see that in the last couple of years most of them talk about picking at least 2 deals  (value 10 + Million) and most of them have achieved (or have a target of ) getting over 1000 doors in the next couple of years.

I am based in the San Francisco Bay Area. Yes I see that real estate investment sentiment is at its top ...there are many passive investors who would like to put money to these projects based on projections  and finding money is the easy part now.

I am  how ever  not  convinced on the part that a sponsor group which probably has not seen a contraction (downturn) in market and they are buying too much too soon . Like to get perspective on how they are going to handle a market downturn  when you have so much of product in a given market  of similar type.

How would these 1000+ apartment holders(active partners)  handle these projects  when the prices and rents  go down , interest rates go up and projects need new capital infusion to survive. If we get into that market cycle how are the sponsors going to react who generally do not bring any (or very little ) money from their pocket 

[Brian Burke]

Originally posted by @Taylor L.:

@Brian Burke what do you think the top 1 or 2 weaknesses of new syndicators' deals are? Bad revenue and cost estimates?  Bad future cap rate projections? Something else?

It’s hard to just pick 1 or 2 so I’ll just list a few.

• Improper economic vacancy assumptions 
• Aggressive year 1 gross receipts projections (they immediately jump the income to new rents with no phase-in which is simply impossible)
• Underestimated expense assumptions
• Improper use of cap rates and/or incorrect exit cap rate assumptions 
• Failure to properly account for property tax reassessment post-sale (in states that do this)
• Basing exit prices on capitalized value of the income without accounting for the subsequent owner’s property tax reassessment
• Failure to account for all of the costs incurred in putting together this type of deal and purchase real estate of this size
• Failure to raise enough money to pay the down payment, closing costs, finance costs, syndication costs, immediate capital improvements and still have enough money left over for capital reserves
• Incorrect calculations of income, cash flow, cash-on-cash return and IRR and/or a clear lack of understanding of those calculations and how to use them
• Lack of waterfall calculations
• IRRs and cash-on-cash returns that are inflated because they aren’t raising enough money—and once they realize that and raise more at the last minute the Projected returns would adjust lower but it’s too late now for the investors to evaluate the what the projections should be because they already subscribed 

This list is just off the top of my head—if I sat and thought about it long enough I could probably double the size of this list. And these are just the common ones.

These mistakes probably originate from two sources. First is a new syndicator doesn’t know what they don’t know. When I was first doing this I thought I knew everything but as I look back now I can clearly see that my actual knowledge then versus now is like a middle school student versus a graduate school student (yes that means I’m still a student even after decades, hundreds of deals and thousands of units).

The second source is lack of tools. New syndicators typically use an underwriting model that they got from a guru class, downloaded online, bought on the cheap or built themselves (but haven’t fully developed it).  These models commonly have weaknesses by either being too simple for the complex analysis needed for sophisticated transactions, or even contain errors in the formulas that haven’t been weeded out yet. 

And there is one more factor at play here. Sellers and brokers want to sell to proven buyers. The only way they sell to an unproven buyer (no matter how good the unproven buyer thinks their relationship is with the broker) is if the price is higher than everyone else or no one wants this particular property except that unproven buyer. So this forces them to use improper assumptions in their underwriting to project the performance needed to attract capital. I call that “underwriting to the price instead of pricing to the underwriting.”

But let’s not forget that the acquisition is just the beginning. The rubber meets the road during the operations phase of the investment. This doesn’t just mean things like property management, it also means things like calculating investor waterfalls during the hold and after the sale. That sounds like it would be the easy part but it’s not. One of my senior accounting staff related a story while she was on a contract hire for a VERY large multifamily syndicator. Her assignment was to compare the waterfall calculations with the operating agreements to ensure that the distributions were being calculated properly. The result?  They were ALL incorrect!  I’d bet that I could compare the operating agreements with new syndicator’s calculations and find the majority aren’t correct (but who has time for that??!!).

All of that said I have nothing against new syndicators—we all have to start somewhere and I was there once too. I also can compare myself then to now and realize that there is such a difference that investing in a great deal with a new sponsor carries greater risk than investing in a mediocre deal with an experienced one. So suggesting that all syndication opportunities should be evaluated the same is unfair. It isn't just about chasing the highest proforma IRR or the most favorable splits or lowest fees or highest co-invest. Use those things to adjust the risk profile when investing with the new syndicator, but recognize that those things by themselves do not mean it's a better deal.