If you’re a passive or active investor in multifamily, you might be wondering “is now a good time to invest in multifamily or should I wait?”

My short answer is this: “It’s a GREAT time to invest” because of the amazing opportunities we’re seeing, but make sure you my 4 Fundamentals of Investing, or you could get yourself into trouble.

I think true wealth will be created in the next 12-24 months if you’re smart about evaluating investment opportunities, and I’m going to show you how to do that next, so watch my video below or read on!

While the 4 Fundamentals of Investing I’m going to share with you have always been important, they’ve never been more important than right now as we enter this period of uncertainty. 

While fortunes will be made, fortunes will also be lost … on which side will you be?

To ensure you’re going to profit from these opportunities, evaluate them with a critical eye and make sure that they check all of these boxes:

  • Cash Flow from Day One
  • Conservative Underwriting
  • The Right Debt
  • Sufficient Reserves 

Let’s dig into each of these rules so you know exactly if an opportunity actually checks the box.

Rule # 1: Cash Flow From Day One

How much is the asset cash flowing right now, even before the purchase? 

If there is no cash flow – or very little – I would pass immediately.

You need multiple lines of defense, and this is the first one.

A metric that lenders look at is the Debt Service Coverage Ratio (DSCR), and it’s one you should look at as well.

The DSCR is the ratio of Net Operating Income (NOI) to the Total Debt Service payment per year.

Most lenders require a DSCR of at least 1.25.

That means the NOI has to be at least 25% higher than the debt service – that’s the minimum requirement you should look for as well, but the higher that number is in the first year, the better!

In this environment, cash flow is king.

Rule # 2: Conservative Underwriting

Do NOT just compare returns from one investment to another. This is a major mistake and can cost you dearly.

Understand that a sponsor can manipulate the numbers to produce any return he or she wants.

While returns are important, what’s even more important are the assumptions behind the returns.

Are the assumptions conservative? Do they make sense given the market environment we’re in?

Here’s what to look for to ensure the sponsor built in multiple lines of defense into their underwriting:

Exit Cap Rate

What is the cap rate upon refinance or exit? Cap rates are super low right now, and while there’s a chance they could go even lower, it’s more likely that they’ll rebound in the next 5-7 years.

So what cap rate is the sponsor using in their underwriting?

My advice is to look for a minimum of 0.5% higher than the current market cap rate. If it’s any less than that, and I would be highly skeptical of the returns being sold. 

No Market Rent Increases

Given what’s going on right now with COVID and our economy, it’s unrealistic to expect historical rent increases of 3% or even higher in the next couple of years.

The sponsor should not be projecting market rent increases for at least a year, possibly even longer.

(NOTE that forced appreciation is OK; “forced” means the property is being renovated to capture the market rents achieved by comparable apartment complexes in the area).

Longer Runway to Achieve Stability

Speaking of forced appreciation, make sure the sponsor is projecting at least 2-3 years to achieve market rents through their renovation plan. 

Higher Economic Vacancy

We don’t know what’s going to happen, but it’s safe to assume that economic vacancies are going to increase when compared to the last five years. Look for at least 5% more economic vacancy than over the last few years.

Higher Expenses

One common oversight (intentional?) sponsors make is to keep the real estate taxes the same they were in the previous year. 

But in most jurisdictions, the taxes adjust after the closing and almost always go up – sometimes substantially.

If you don’t see an increase in real estate taxes in the proforma, ask the sponsor about it.

Rule # 3: The Right Debt

I think the difference between good deals and great deals is the debt, specifically the right debt.

The debt has to match the business plan.

For example, if the business plan calls for renovations and refinance in three years and the sponsors have a fixed 10-year loan with a large prepayment penalty and no supplementals, then a refinance or sale will be nearly impossible.

In that case, look for these options: 

  • A floating rate agency loan (Freddie Mac)
    • This is a good option because it allows the sponsor to exit after 12 months for a  1% fee instead of a large prepayment penalty. The rate will float so a sponsor can buy insurance against it floating up too high (this is called a rate CAP). The advantage of this option is that it gives the sponsor the highest number of exit options
    • Note: Most operators are using this option right now, and it’s very attractive with a low interest rate (sub 3%!)
  • A 12 year fixed rate agency loan (typically Fannie Mae) with multiple supplementals available.
    • This is helpful because the sponsor can use the first supplemental for a refinance to return investor capital during the hold period and the second for the next buyer to get higher leverage. Interest rates are also EXTREMELY low right now (sub 3%!)
    • Note: multiple supplementals are only available with a 12 year, NOT a 10 year.
  • Bridge loan
    • This allows for a flexible exit but is hard to come by during the pandemic and they have high interest rates at this time. If the sponsor is going this route you want to make sure they aren’t planning to stay in this for very long. 

Ask about the debt and decide if the debt matches the sponsor’s business plan.

Rule # 4: Sufficient Reserves

In Rule # 1 I said that “cash flow was king” — in general what is true is that “cash is king”.

You never want to run out of cash, especially with potentially difficult times ahead of us. 

That’s why it’s important to have enough cash at closing and building up additional cash reserves while owning the property.

When evaluating an investment opportunity, check to make sure the sponsor is adding at least 10% more in reserves than the budgeted capital improvement budget.

There can be emergencies or unforseens, and this additional reserve will allow the sponsor to deal with those after the purchase.

Also, make sure the sponsor is adding at least $250 per unit per year to cash reserves. This is a best practice to handle emergencies but also capital improvements (like a new roof or parking lot) in several years.

Some sponsors either leave this off of their proformas or they subtract after calculating the investor return.

Both are bad: you want to see your return after reserves are taken out of cash flow.

And finally, make sure the sponsor is showing 9-12 months of principal and interest being deposited into escrow as is currently required by lenders. This is a new requirement by most lenders due to the recent pandemic. 

All of these are prudent in protecting your investment but all of them reduce your returns. 

So what’s more important to you? Returns or preservation of capital?

Follow The 4 Rules and Invest With Confidence

Now is a great time to invest! You will undoubtedly see amazing investment opportunities from various sponsors. 

But make sure you follow my 4 Fundamental Rules of Investing as you evaluate opportunities.

If you do, you’ll be well on your way to financial freedom, creating wealth, and leaving a financial legacy.

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