10 Multifamily Real Estate Horror Stories
In my more than 25 years in this business, I’ve seen several common mistakes investors make when doing deals that have ended in quite a horror story. Here are 10 of them: Horror story number one, Bob the investor didn’t hire a property tax consultant before or after the sale. I’ve seen this happen so many times oh my does it cost a lot of money. You can actually hire a tax consultant before you close on the deal and they can help you estimate your taxes before closing and prevent surprises. But if you don’t hire before closing, you should certainly hire one after you close the deal. It will you a ton of money. For example, let’s say your taxes right now are $50,000. A tax consultant might be able to get that down to say $40,000, which is totally possible. You’re saving $10,000 per year in taxes. And if you divide that by a cap rate of 6%, that's $167,000 in value. That's a lot of money! And it costs a fraction of that to hire a tax consultant, so it’s definitely worth doing as soon as you go to contract. Horror story number two, investor Bob didn’t bid out the insurance while he was in due diligence and before his deposits went hard. He just assumed he could get the same price as the current owner. For instance, in a real case I experienced, the insurance expense was listed as $9,000 in the investment package, but it was under a huge umbrella policy the seller had that covered thousands of units. So naturally, his rate was really low. The buyer purchased his policy just prior to closing and was quoted $16,000. That's a $7,000 difference divided. Divide that by a 6% cap rate and yeah that’s a $117,000 loss. Don't be investor Bob! Get at least three bids during the due diligence process and avoid this mistake. Horror story number three, investor Bob puts so much emphasis on cap rates that he loses out on millions of dollars in opportunities. Relying strictly on cap rates instead of concentrating on cash-on-cash returns and IRR is going to lose people a lot of money. Cap rates just measure the current income of the existing investor. It completely ignores debt, how you might be able to increase the income or reduce the debt, the vacancy rate, or how you can save on the expenses. Let's say you have 50 units, and you plan to increase their rents by $20 a month, per unit, and you do that for five years. Divide that increase by a 6% cap rate to a buyer who only concentrates on cap rates and that's an increase of $1 million in value. And if that investor also takes into consideration debt and concentrates on cash on cash, it could be worth more than a million dollars. Horror story number four, investor Bob doesn’t do an environmental test during the inspection period. No asbestos, mold, lead-based paint, or a phase 1 was done. Let’s say you're buying a 50-unit apartment complex, and three parcels over 50 years ago used to be a gas station that leaked onto your property, you're responsible for that. They don't care that you didn't do it, you're responsible for it. And you know what the average cleanup for fuel cleanup is? $300,000. Horror story number five: investor Bob hired the wrong property manager. Don’t hire your cousin George who manages a few rental houses to manage your 20- or 100- or 200-unit apartment complex. Instead, ask the seller for referrals, or even your lender if they can recommend a good local vendor. And interview more than one potential property manager. Ask each one for a list of the assets they manage as well as ask for references of current customers so you can call and ask about their performance. Also, ask for sample reports they provide so you can see if they give you the type of information you need to understand how your property is performing. Horror story number six, which gets missed all the time, is doing a multi-year capital expenditure accounting. Hiring a professional to do a multi-year analysis of when different capital expenditures are needed and in what year and at what cost affects your returns. For instance, they'll be able to tell you if there are six air conditioning units that are going to fail in the next five years, or maybe a new roof will be needed in year 13. You need to account for these items when determining your potential profit from a sale. Depending on when you sell the property, the timing of these capital expenditures can make or break a deal. Horror story number seven, investor Bob never did cost segregation right after closing. There are many components of an apartment complex that can be accelerated much earlier in the ownership period which will decrease the amount of net income you have to pay taxes on. For example, let's say you have $2 million in building improvements. The standard depreciation life that the government allows is 27.5 years so that allows you to write off roughly $73,000 per year against your income in depreciation. But hiring a cost segregation specialist can sometimes get you many more times that amount in the first several years. This is particularly important if you're only going to be holding for three to five years. You can go ahead and get a lot more depreciation upfront, which allows you to have more returns and pay your investors more returns. Horror story number eight, good old investor Bob relied way too much on the broker pro-forma. As a broker myself, I can confidently say that you shouldn’t rely solely on broker pro-formas. It's not that they are trying to be deceiving. It's just that their estimates on income and expenses and debt may not be the same for you. It's fine to look at it as a guide, but you want to make sure you do your own research. And always look at the seller's actual financials because oftentimes what happens is the seller will give the broker a price goal and the broker will create a pro-forma to meet that price. Horror story number nine, investor Bob forgot all about the power of principal reduction and has missed out on a number of exciting opportunities. The year 2020 afforded many with extremely low debt rates, sub-three in some conditions. The lower the interest rate, the more principal is being paid by the tenants, and that becomes super powerful over time especially in the rate of return. As a matter of fact, there is an extra 3-5% on cash-on-cash returns when you're borrowing for anywhere between 2.75 and 4% on a 30-year amortization. Particularly if you're a long-term holder who isn't using syndication money, this can be a really powerful tool and wealth builder. And horror story number 10, investor Bob is using less than 30-year amortization when buying his multi-family complexes. Amortization periods are really important because they keep your payment low, which allows for more cash flow to either service yourself or your investors. It's typically the local banks that only offer 15- 20- or 25-year amortizations. And it's usually the larger banks, credit unions, and government institutions like Fannie and Freddie, that do 30-year or better amortization periods. Investor Bob thinks that by having a shorter amortization period he can pay the mortgage off faster. You can have a longer amortization period and just pay more on it to pay it down while having the flexibility. To drive home the power of amortization periods, let’s assume we have a $10 million property, with $568,000 in net income, at a 3% interest rate, and you borrowed 70%. Look at the cash-on-cash returns. On a 30-year ammo that's 6.78%. Just going down five years to a 25-year ammo, that lowers you a point and a half to 5.38%. A 20-year ammo cuts your returns in half to a 3.24% ammo, and forget about it on a 15-year ammo. NEGATIVE .39%! At that point you have no cash flow to put in your pocket, pay investors, or handle any issues that come up with the property.
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