There is one common mistake I see investors make when evaluating multifamily opportunities:
They pick a deal like they’re picking a stock.
Now, it may seem wise to make investment choices based on historic and projected returns.
And with the stock market, you can compare returns between stocks to help you make a decision.
But multifamily investing is a complicated animal, and there are several factors to consider before jumping into a deal.
Returns are only 1 piece of the puzzle, and I’d argue that it’s not even the biggest or most important piece!
In fact, returns are third in line when I evaluate investment opportunities.
So what should you be looking for when analyzing a multifamily deal?
Stick around to find out!
The Sponsor & Operating Team
There are many variables at play that impact that overall ROI on a multifamily deal. But for me, there is one that rides above all others.
At the very top of my criteria list is the sponsor (a.k.a. operator or syndicactor) and the team behind them.
The sponsor is the one who is offering up the investment opportunity. In my mind, that’s The One Thing. (If you haven’t read this book, I highly recommend it, it’s fantastic!)
When you have a strong sponsor at the helm, everything else follows.
An experienced sponsor with a great team and outstanding track record is very likely to pick a good market, find good deals, and operate the property well.
Yes, you should still examine the guts of the deal yourself, but the operator is first and foremost the most important consideration.
If you find a strong one, you can trust that their due diligence is thorough, leaving you with more time to learn from them and less time doing the diligence yourself.
Related: How to Vet a Multifamily Syndicator
As you’re evaluating the sponsor, it’s important to know who’s truly behind the deal.
In today’s day and age, you’ll find there are large groups of general partners or joint ventures, and there’s nothing wrong with that.
Here at Nighthawk Equity we do the same thing, but we investigate who actually has the decision making authority within these groups, and who is running the operation once the deal closes.
We want to know – who are the people behind the people?
So if you’re investing for the first time with a syndicator, figure out who makes up their team and research their track record and credentials. People to consider:
- Property Manager
Once you are comfortable with the sponsor and operating team behind them, it’s time to take a deeper dive into the deal itself.
Margin of Safety
We’ve talked to dozens upon dozens of investors and their number one concern is always the same: LOSS of CAPITAL.
And rightly so!
A fair question to ask any operator is this: “What are the risks of this deal, and what are you doing to protect your investors from those risks?”
In other words, what’s the margin of safety that’s been built into the deal?
Trust me, you want a deal that’s been underwritten conservatively and there’s a few things you need to look for that are sometimes buried deep in the financials.
While you may not be able to find them yourself, you should inquire about these points:
- Reserves at Closing. Also known as “cash at closing”. You never want to run out of cash at any point, so the deal should have a lot of reserves at closing to fund renovations and to give a buffer for unforeseen circumstances. Emergencies do happen and you have to be prepared for them.
- Managing Cash Flow. A sponsor needs to be able to take money out of the cash flow and do it above the line. In other words, the sponsor should account for this before calculating the net operating income. If a sponsor operates below the line, it means they exclude this money from the bottom line (which is bad). More on this later…
- Rent Growth. The goal of multifamily deals is to make the property more attractive to tenants, allowing the operator to increase rental rates and return a larger profit on the investment. But this process takes time, so be wary of any sponsor that predicts large rent bumps early on.
- Cap Rate. This is the multiplier that helps a sponsor determine the value of commercial real estate. In a lot of markets it hovers around 6%. But we can’t predict the future, so when making financial projections 5 years out, what cap rate is the sponsor going to use?
Let me give you some examples of the margins of safety that we build into our deals. I think it will give you a better understanding of why comparing returns alone is not an apples-to-apples assessment in the multifamily space.
Comparing Apples to Oranges
Let’s start with rent growth. We see a lot of deals coming in that project $150 rent bumps in the first year. It sounds great, but it’s just not realistic. Why?
To achieve this, you would have to literally vacate all of the tenants, renovate the entire building in a day or two, and then get them all filled with new tenants on day three.
At Nighthawk, we plan for consistency. We believe that bumping rental rates as tenants churn over time is more realistic. This is why we plan for rent bumps in years 2-3, not in year 1.
We also see these deals where the cap rate 5 years into the deal is exactly the same as today's a cap rate. Or, they’re lower, which is even better. Sure, if I’m buying a 5.8 cap that sells at a 5% cap, I’m printing money!
These speculations are all horse manure.
At Nighthawk, we believe in conservative underwriting, so we build in a margin of safety by projecting at least a half point higher cap rate. This means that we’re projecting the value of the real estate to go down in 5 years, which could happen but is highly unlikely.
Now, let’s go back to the point about managing cash flow.
At Nighthawk, we put cash flow above the line. This, of course, reduces our returns.
Now, you can have another sponsor that operates below the line and shows an Internal Rate of Return (IRR) of 16%, compared to our 14% IRR. But, they’re not actually taking out cash reserves while they’re operating it.
Whereas our IRR runs a little lower, we are running things smoothly and operating above the line.
These multiple layers are exactly why I find that examining the sponsor, their team, and their management of funds to be far more important than stated return.
As an investor, you really need to understand if the sponsor is underwriting for the best case scenario or if they have margins of safety built in.
It’s not out of line to question what happens if things slow down. You need to know if the deal still makes sense, or if it completely falls apart.
Analyzing the Stock Market vs. Multifamily Investing
Speaking of comparing apples to oranges, how might an investor go about comparing the returns from Wall Street to a Multifamily Investment?
I’m glad you asked.
I’ve got a special report that I’ve created that addresses that question. It’s totally free and you can check that out using the link below.
Special Report: What’s the Best Investment, The Stock Market of Real Estate?
Above all, the best investment that you can make is in your own education. Check out these other resources that I’ve created for investors interested in multifamily deals:
If you’re ready to learn more about the deals that we have going on at Nighthawk, go to our website (www.NightHawkEquity.com) and click the “join” button. We’ll set up a call to get to know you and your investing goals.
Thanks for joining and I’ll see you in the next video!