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Would you drive your car at night with your eyes closed? Probably not! It would lead to disaster. But many investors do this with their investments. They make blind investments without understanding how the market works, how the company operates, or where the company is going. This really isn't investing. It's a form of gambling.
What most people do with the stock market is they throw money blindly into companies "hoping" to get a great return but then they're shocked, angry, and depressed when they lose money. These "investors" never understood how the company makes money, how the company is structured, personally know the owners, or the owners' vision for the future, etc.
As the legendary investor Warren Buffet said, "Never invest in something you don't understand." Investing in real estate is no different. It is important to understand your investment.
Let's discover together what metrics to evaluate in a passive multifamily investment so you can make the right choices.
It's not a gamble if you know where it is going.
Step 1: Evaluate the Sponsor Team - Your Pilots:
Just as the pilot is crucial for a safe and efficient flight, the sponsorship team plays a vital role in your investment journey. A great deal can crumble with a bad team, while a mediocre deal can transform into a great one with a rock-solid team.
So how do you evaluate the sponsor team (general partners)?
Begin by looking at their track record. There may be someone on the General Partner (GP) team who is educated but inexperienced. But as a team, they should have experience in finding the deal, underwriting it, conducting due diligence, securing financing, developing the business plan, and ultimately executing on the business plan.
Evaluate their performance in terms of acquiring, managing, and selling the type of property they are presenting. A team with a consistent track record of generating attractive returns for investors demonstrates their expertise and competence.
As part of their track record, an effective team should possess a deep understanding of the market in which they operate. Thorough market research, including local economic factors, supply and demand dynamics, and trends, is essential. Ask the team about their knowledge of the specific submarket they are targeting and how they plan to capitalize on emerging opportunities. A team that can demonstrate a comprehensive understanding of the market is more likely to make informed investment decisions.
More important than their track record, in my opinion, are their values. A great indication of a team's values is how they communicate. Open and regular communication is vital in maintaining a healthy partnership between the GPs and LPs because it builds trust. Inquire about the team's communication practices, including the frequency of updates and reporting. A reputable team will provide timely, and more importantly, transparent information regarding the investment's progress, challenges, and performance. A passive investor needs to be able to trust the GPs, and clear, open, and transparent communication is foundational to trust.
Step 2: Evaluate the Market - Charting Your Course:
Market conditions and dynamics greatly influence the potential success of an investment opportunity. Just as you would want to evaluate the GP team's market and submarket knowledge, you also want to do a bit of market research yourself to ensure accuracy.
Look for economic factors such as job growth, unemployment rate trends, population growth, and how diverse and robust the local economy is. Additionally, look for crime trends specifically in the deal's location. The following are trends you are looking for:
Rising job/employment growth year over year.
Shrinking unemployment rates year over year and quarter over quarter.
Steady increasing population growth for the past 10 years.
Shrinking crime stats year over year.
Consistent rental growth year over year.
Median household income supports the rent growth.
Consistently shrinking or low vacancy rates.
Diverse industry. Are there many industries in the area driving economic and job growth, or is the market being supported by one large industry that, if they packed up and moved out of town, the local economy would collapse?
Some great resources to find this information are Berkadia multifamily quarterly reports, the Bureau of Labor Statistics website, the U.S. Census Bureau website, Neighborhood Scout website, and Rental Café or Zumper website, just to name a few. For crime data, a simple Google search of the submarket crime data or calling the local police department and asking them about the neighborhood will help gain significant awareness of where the neighborhood is headed. More importantly, ask the GP team where they gathered their market research from.
At the end of the day, only invest with a GP team that has experience and you trust because you know they act with integrity. That is why step 1 is the most important.
Step 3: Evaluate the Financials - Counting the Mile Markers:
Once you have a good idea of the demand and rental growth in the market, it's time to move on to the deal-specific financials. The GP team should provide you with this. You'll most likely see this in their offering document or investor presentation. If not, ask for items like the trailing 12 (T12) profit and loss (P&L) statement, rent roll, and how the team conducted the underwriting.
Income potential: Can this deal demand more income based on the GP team's business plan and market data you gathered in step 2? Consider factors such as occupancy rates and rental growth in the area. Assess the stability of the income streams that the property is projected to generate.
Assess operating expenses: Carefully analyze the operating expenses associated with the property. These expenses include taxes, insurance, property management, maintenance and repairs, contract services, utilities, legal and administrative fees, and other overhead costs. Review the historical data from the T12 and P&L statements and compare them to projected expenses after taking over the property. Scrutinize any significant increases and decreases in expenses and understand the reasons behind them.
Review financing and debt structure: Assess the terms of the loan, including the interest rate, loan duration, amortization period, and any prepayment penalties. Understand the loan-to-value (LTV) ratio and the impact of leverage on the investment return. Consider the debt coverage service ratio (DSCR) to evaluate the property's ability to generate sufficient cash flow to cover debt obligations.
Step 4: Evaluate the Business Plan/Investment Strategy - Navigating the Route:
Take a close look at the business plan. It should outline their goals, objectives, and the strategies they intend to implement to achieve them. Consider whether the plan aligns with your investment objectives and risk tolerance. Look for a clear vision and a well-thought-out roadmap that demonstrates the team's expertise and understanding of the market.
Many multifamily investments offer value-add opportunities, where the GP team plans to make improvements to the property to increase its value and generate higher returns. Assess the viability and feasibility of these value-add initiatives. Are they supported by market demand? Do they align with the current and projected trends in the local rental market?
A robust business plan should address potential risks and outline strategies to mitigate them. Evaluate how the GP team plans to handle challenges such as economic downturns, increased competition, or changes in market conditions. Look for contingency plans, risk diversification strategies, and proactive measures to protect investors' interests. A comprehensive risk management approach demonstrates the team's commitment to safeguarding your investment.
Understand the GP team's exit strategy for the investment. Every good story has an ending, and every investment needs an exit strategy. How do they plan to generate liquidity and provide returns to investors? Assess whether the proposed exit strategy aligns with your investment horizon and goals. Consider factors such as market conditions, the projected holding period, and potential exit avenues such as refinancing, selling, or holding the property long-term. A well-defined exit strategy showcases the GP team's foresight and their ability to adapt to changing market dynamics.
Investing in passive multifamily real estate can be a smart move if you approach it with the right mindset and follow a thorough evaluation process. Remember, it's not about driving your investments with your eyes closed and hoping for the best. It's about being the Warren Buffet of your own portfolio, understanding what you're getting into, and having a trusted pilot to navigate you through the market turbulence. So, buckle up, keep your eyes open, and let's soar towards financial success together, because as they say, investing wisely is the key to avoiding a crash landing and enjoying a smooth ride to your investment destination. Happy investing!
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