What are your deal breakers?
Evaluating a deal varies from property to property. My focus these days are Class C and Class B deals, so it really depends on the business plan for the property which drives the underwriting process. This includes gathering the expense and income data, building a financial model, performing rent and sales comps and in-person visits. All this can take anywhere from a few days to a week. Then, once you negotiate the fine points and get it under contract, you will have 30 to 60 days to perform due diligence to confirm your underwriting assumptions and build out your business plan according to what you find. When you consider the costs of both the underwriting and due diligence process, deal evaluation becomes an investment of both your time and money. So, the sooner you can find any deal breakers, the better.
Here are my 5 tips on potential deal breakers to look for when you are checking out a multifamily deal:
1) Mistakes in the Offering Memorandum
The offering memorandum is a marketing document created by the sellers’ broker that summarizes the deal. Note that I just said “marketing.” The purpose of the OM is to support asking price the sellers’ broker. All the photos will look very nice and the typesetting will be impressive. The intent is to sell the deal for the highest price possible – and yielding beefy commission check for the broker.
Typically, the OM will include a pro forma, trailing 12 month and a rent roll. You never use that data when analyzing a deal. At most, you should use it as a guide because most of this data will not be accurate. Sometimes they are even totally fabricated. Remember, this data is to pull in the highest offer.
I have looked at many deals where the rent roll in the OM and the actuals from the property manager were off by over $100 a unit. If you are looking at an 80-unit deal in a 9-cap market, it could mean the value is pumped up by $500k to $1MM. They also had occupancy at 100%. As soon as you see anything ending in a zero, you know it’s bull – especially when you see the rent roll historically showed 87%. I can assure you that they are not chaining tenants to the refrigerators! You must always use actual historical data and a current rent roll when looking at a deal.
Another time, I found they didn’t add the expenses up property and it made the deal appear like it had a higher cap rate. Other times. the internal rate of return was wrong. And other times when someone transcribed the rent roll from an 86-unit deal from paper to Excel and the numbers were all wrong. I know that people may make mistakes, how can you trust the numbers if there are so many errors in the OM? Again, understand that these numbers are all for show. Use them as a guide only when underwriting.
2) Unrealistic Pro Forma
The pro forma contains detailed information of the financial performance of the property. Generally, when you are looking at a deal, the T-12 is used to see if income and expenses of the property is stable month over month.
Here is an example that happened to me recently: I was looking at a 150-unit deal. The financials showed gross income for the previous 5 years starting at $780k and increasing by about $12k annually, which seem reasonable. The pro forma showed gross income for the coming year to be over $250k from current and it showed 100% occupancy. Additionally, the expense ratio was at 39%. Even the very best run properties with little to no maintenance run at a 40% expense ratio. While it is possible, the property would be a very well-run machine and those tend to be hard to come by.
On another deal, I found the expenses were super low compared to what they should be in the area. For instance, the annual water and sewage bill for a 30-unit deal was about $5k and the property was sitting on 1.8 acres of land with a lot of grass. Just doesn’t seem right.
The best way to overcome an unrealistic pro forma is to base your analysis on how you will run the property. If you are leveraging partners – like a property manager – ask them to prepare a pro forma of their own based on the seller data and knowledge of the area.
3) A Bad Area
One of the factors that tends to be an automatic deal breaker for me is the area it’s located. I’m looking for good deals in good markets. If there is no demand for people to live in the area or there aren’t jobs moving in, it may not be for you. If you are not able to raise rents or you need to worry about appliances getting stolen in the middle of the night, just don’t do it.
4) Unethical Property Manager and the Owner with a Bad Reputation
Let’s say the financial data in the OM was done by mistake or it was created by an intern not familiar with the numbers. We already decided we will not take them at face value. But, there are things far worse than bad numbers in a document and that is people that purposefully cloud the deal to hide expensive problems or even flat out lie.
I hold events on a regular basis with multifamily investors. One of our attendees discovered that the property manager was forging rent rolls, leases and other important data. The property manager also said they had 91% occupancy when it was more like 80%. The only reason my friend caught the property manager in the lie was because someone inside the company forwarded an email by mistake. He would have discovered it eventually because the numbers would not have balanced with what was in the bank, but he would have been further down the road.
Another time, someone sent me a 200-unit deal. Doing a quick search for the address on the Internet to see what the residents rated the property, I came across a video on YouTube where the landlord was shouting at a news crew! They were accusing him of providing no heat for the many of the tenants in the middle of winter. Something about paying a bill or a not repairing the boilers. I know that kind of stuff can be fixed easily with proper management, but if this is just one indication of one problem, I don’t want to see any more.
Regrettably, people don’t always tell the truth. If you get an inkling that something isn’t right, you walk away.
5) Issues Found at the Walk-Through
Even if everything looks good on paper you need to do a walk-through of the property before locking it down. There can be plenty of deal breakers that you can only see when you actually see the property.
For instance, if I see a lot of cars in the parking lot on a Wednesday mid-morning, it could be an indication of high unemployment in that building. Or if the surrounding area around a very nice prospect looks bad and run down, it could be an indicator of for crime.
Performing a site visit may impact your repair budget. Recently, I went to visit a 4-story property that looked promising on paper. When we walked around back, it looked like the back wall was splitting in two. From the very top to about the middle was breaking apart! Clearly the sign of an expensive problem. That would have cost a great deal of cash to repair and it killed the deal.
What’s your biggest deal breaker when you are looking at a deal? Let me know in the comments.
If you like, share.