3 Important Real Estate Deal Flaws that are Often Overlooked by Investors

When it comes to reviewing multifamily investment opportunities, ultra-high-net worth individuals, serious investors, and family offices are quite astute at spotting flaws in the investor package that a sponsor or JV partner puts in front of them. While the obvious “red flag” flaws are easy to spot, like unreasonably high returns, risky debt structure, or a bad location, there are more subtle flaws that are sometimes overlooked, even by experienced investors.

In my experience as a syndicator and investor, I’ve seen these flaws on many deals. I began my career in real estate working as a commercial real estate lawyer in 2007 and later transitioned to a property manager role. After I received my MBA from MIT, I started Blue Lake Capital and became a syndicator. My company purchases Class B multifamily value-add properties in Texas, Georgia, Florida, and the Carolinas.

The flaws I see are often apparent in the investor packages, which generally contains a summary, a description of the opportunity, an overview of the market, a business plan, and an overview of the financials, or a proforma. While there are several to watch for, there are three flaws in particular that are of great importance, so I’ll discuss each one in detail.

Flaw #1: Business Plan Assumptions

One of the items usually found in many investor packages are beautiful photos of the property, often showing what the project will look like when fully renovated. Part of the business plan talks about value-add renovations of the units, but what isn’t always apparent is when the renovations will begin and how long they’ll take.

The renovation timing and length is something investors should pay attention to because renovating 200 units in 1 year may not be a reasonable assumption, unless the syndicator has an entire team that can renovate quickly. During COVID, the renovation length assumption has been put to the test, because sponsors may not be able to renovate that quickly even if they have the right team in place. When my team underwrites a deal these days, we assume no renovations in the first 6-12 months, just to be on the safe side; after all, tenants may not be able to pay the premiums for the renovated units in the near future due to COVID.

As a passive investor, I’d advise you to investigate whether the syndicator has the systems and experience in place to renovate the number of units they are committed to renovate, and what was the thought process behind their assumption. This is an important question to ask, and one question that you don’t want to skip over.

Another business plan assumption that may contain flaws is the cash reserves. Does the syndicator indicate how much he or she plans to have in cash reserves to cover major unexpected expenses? Unfortunately, most investors don’t ask how much is planned for reserves, but it’s an important question to ask.

As an investor, you want to be sure that there is enough money placed in reserve for one-time capital expenditures, such as a new roof or replacing an HVAC system. During COVID, lenders were asking syndicators to have 9 to 12 months of debt payments in reserve. Syndicators would either have to raise this additional money or take it from expenses and move it into reserves. However, if you have to use all of the reserves to pay for an unexpected expense, there won’t be any money left to pay investors.

Flaw #2: Aggressive Exit Cap Rate

As a reminder, the cap rate is a number reflecting the expected rate of return on a multifamily property. You can calculate the cap rate by dividing the Net Operating Income (NOI) by the current market value of the asset. As an example, if a property costs $2 million and generates $150,000 of NOI per year, it has a cap rate of 7.5%. As a general rule, as you raise the cap rate, the value of the property is lower.

An exit cap rate is the expected net income for the year that the property is sold, divided by the property’s sale price at the end of the hold period. It’s an important number to consider for several reasons.

By using the industry average cap rate, you can determine how much your property will generate when you sell. In secondary markets, the average exit cap rate ranges from 4.5% to 5.5%. However, as a conservative syndicator and investor, I always assume that the real estate market will be worse when it’s time to sell in 5-7 years, and adjust the exit cap rate accordingly.

If you purchase a property at a 5% cap rate, you don’t want to have the exit cap rate be the same after the 3, 5, or 7-year hold period. You actually want to have the exit cap be higher, because it will mean the property’s value is lower – which is what you want as a conservative investor. Our rule of thumb is to have a cap rate increase by 10 basis points each year that we’re holding the property.

Many investment packages that passive investors review don’t discuss the exit cap rates, but you always want to do a comparison between the initial cap rate and the projected exit cap rate. Cap rate numbers are easily manipulated, so you have to do some due diligence when examining them. It’s hard to assume that cap rates will be strong 5 years from now, because there are so many variables that can affect those rates.

As a general rule, a conservative investment is one that has an exit cap rate that is higher than the purchase cap rate.

Flaw #3: Aggressive Income and Expense Assumptions

One of the first things I notice that even astute investors sometimes overlook are faulty assumptions with regard to the proforma income and expenses. Some investors tend to glance over the bottom line in the financials that are part of the proforma, failing to do a comparison to the prior year’s numbers.

As a general rule of thumb, compare the year 1 proforma to the property’s previous 12 months of operations (called “Trailing 12” or “T12” in short). You’re looking to see a reasonable increase in income and increase in expenses, comparing the T12 to year 1 proforma, and year 1 proforma to year 2 proforma, and so on. Certainly, you want to see an increase in Net Operating Income (NOI) but if the sponsor is claiming a substantial increase, 20% for example, it’s important for you to take a closer look at those numbers.

Ask yourself, “Is that number reasonable?” Ask how the operating income can increase that much in a 12-month period. There might be a good explanation, or the sponsor is being overly aggressive. Ask what numbers you are comfortable with – is 5% - 6% acceptable? That amount is a reasonable expectation, but much higher opens the door to questions.

Expenses are another area to look at. If you see that the sponsor indicated expenses remained flat year over year, it’s a flaw. Everyone knows that expenses are growing, 2% to 3% is considered a healthy growth, but anything significantly over that amount should be looked at.

Summary

There are several subtle flaws that even experienced investors and family offices often overlook in a real estate deal, and these are the things I that I look at before looking at anything else.

One of the first things I look at are the business plan assumptions outlined in the investor package. Often, the assumptions discuss value-add renovations and their impact on the Net Operating Income, as value-add renovations usually result in rent increases. However, if the sponsor indicates they plan on renovating half of the units in a 200-unit property, it’s worth questioning their experience and ability to undertake such a monumental task, and whether it’s a reasonable assumption during COVID. If the sponsor doesn’t have prior experience at this level, it just won’t be possible.

Another assumption to examine is the amount of reserves planned for the property. If the subject isn’t mentioned, ask about it. You’ll want to know the amount placed in reserves in case a major capital expenditure is required, like a new roof or an HVAC system. If a syndicator has to use all of his or her reserves for an expenditure, there won’t be any money left to pay the investors.

A second flaw to examine is the exit cap rate. If you see an exit cap rate that is too low, it can indicate a problem. A conservative investor wants to have an exit cap rate that is higher than the purchase cap rate – often at least a full point higher per 5 years of holding. You have to remember that it’s hard to predict what the cap rates will be 5 years from now, as there are many variables that could impact the numbers. If exit cap rates aren’t discussed, ask about them.

Finally, don’t overlook the assumptions made about income and expenses. Always do a comparison between the past 12 months of the property’s operation and the previous year. You always want to see a reasonable increase in income. It’s the same with expenses – if the syndicator indicates that the expenses will remain flat, question it. Everyone knows expenses are growing at 2% to 3% per year, so it would require an explanation if no increase is indicated.

By doing your due diligence, you won’t overlook the flaws that often are missed.

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About the Author

Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.

Ellie is the host of REady2Scale , a podcast that highlights honest, insightful, and thought-provoking discussions on the multiple approaches for successful real estate investing.

She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.

Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.

You can read more about Blue Lake Capital at www.bluelake-capital.com and learn more about Ellie at www.ellieperlman.com.