No Money Down Apartment Investing Deals = No Brains?

Multifamily Apartment BuildingThe Apartment Investing Market is heating up as a result of dropping vacancy rates, pent up demand entering the market, and the return of readily available low cost financing.  This is further enhanced by the low build rates over the last 5 years.  The bankers that wouldn’t return my calls 3-4 years ago think I’m a pretty cool guy again and even want to treat me to lunch.

As the current cycle goes on banks will see less and less risk and they’ll drop their DSCR’s (Debt Service Coverage Ratios) lower and lower. Debt service is paid after all operational revenues and expense have been accounted for.  In other words…its the ratio of NOI (Net Operating Income) divided by the Principle and Interest payment.  Before the crash there were some loans that were 1.15 DSCRs some were even lower.  This is risky, but it allows you to buy a lot more for your equity…in a rising market this is like having your own slot machine.  In the bad times of finance we saw some banks suspend lending at all DSCRs, while those that remained lending were at 1.4o.

The second effect of good times is that banks will increase the LTV (Loand to Value) ratios. That means for less money down you can buy more property.  Right now you can get 82% LTV debt.  That means you can buy a $1,000,000 with 180,000 equity down.  In the harder times of finance many banks were only going as high as 55% LTV.  That translates into a requirement of $450,000 of equity to get the same return as you can now get for $180,000.  The higher the LTV the more leverage you are employing.  When times are good, it is leverage that makes “Cash Cows” that produce amazing amounts of profit.  The downside?  If the market turns your “Cash Cow” can turn into a “Cash Alligator”, an animal with an appetite for cash reserves.

I am a fan of sound levarage. If there is one thing the wise ones learned from the last cycle is that what goes up will come down. An acquisition strategy with sufficient DSCR and low enough LTV financing to ward of the darker days is important.  One of the very best of the real estate investment gurus is John Wilhoit Jr.  The article that follows is from his blog…where he shares his concerns about buying without enough skin in the game:

 

The Dangerous Game of No Money Down Deals

by John Wilhoit Jr. on November 6, 2012

Attempting ye old standard “by the book” cookie cutter tactics lamely taught over and over again for single-family investing and applying this to a commercial multifamily deal is a recipe for disaster.  In fact, it is a very dangerous game as the end result is that you, the brand spanking new owner of that apartment property, probably have risk your entire net worth for the privilege.  Congratulations, cliff dweller.

When was the last time you were, figuratively speaking, thrown under a bus?  With respect to nothing down deals, too often people go willingly- under the bus.  Year in and year out we get emails seeking guidance on multifamily deals where the buyer has limited or no capital; the proverbial nothing down deal.  Lets me be succinct: DON’T DO IT!  There. I said it.

Few people seem to appreciate this response prior to gushing with deal specific particulars.  Doesn’t matter- don’t do it. I don’t care if your uncle is giving you the deal of a lifetime.  Sounds harsh, doesn’t it? Let me explain.

Maybe your uncle is a really nice guy, you took care of him when he broke his ankle and he’s doing a good deed in return.  With a three million dollar deal where the first mortgage is two million and Good Uncle is taking back a second for a million, you are toast (good intentions or not).

First of all, on the surface, Good Uncle has set the purchase price at three million.  Are you going to spend a few thousand on a commercial appraisal to validate that a reasonable price is three million?  At this level of leverage (100% financing) every available dollar will be going to debt service.  In reality, there will likely be a monthly deficit.  How will your relations be if the payment due on the second mortgage  is $5,000 monthly, but the asset is only kicking out $3,000 monthly?  Uncle wants his money.  After All, you bought the deal.

Second, what makes you so special?  Why are you being offered this deal? Is it your good looks, because you dress well?  What do you bring to the deal?  Consider the following:

If the answer is the ability to “fog a mirror” and “sign a paper” then these talents have nothing whatsoever to do with acquiring a quality multifamily asset AND having skills to run the deal- no matter the capital stack.  The capital stack is just one component of Multifamily ownership and asset management. Yet so many people get caught up in this segment of the deal that every other aspect becomes diminished.  This is tragic.  Why? Because while getting this right is imperative, it is just one leg of the table.  And a single strong leg does not a table make.

Most people selling a nothing down deal are looking to get out of Property Management.  They didn’t really know what they were getting into when they bought this asset and it’s kicking their butt- property management, vendors, dealing with tenants- this is not what they signed up for.  After trying to sell the deal and failing, they come up with the bright idea to sell the deal to someone they know for nothing down.  This is in the same category as living with you mother-in-law; it works sometimes, but is generally a bad idea.

So here you come, with limited input on Deal Structure, maybe some property management experience, and limited to No Working Capital.  You are… crispy toast just waiting to happen.

It really boils down to Capacity.  Yet, capacity by itself is not enough to make the deal work if every other aspect is out of whack with reality (including valuation).

So for those un-convinced, for the brave few that wish to proceed, please consider the following:

1. The transaction should be provided the same or more due diligence than any other deal- more actually because of the significant threat posed to your personal net worth.

2. The transaction should be arms length.  Meaning even if the sellers are known to you, there are no short cuts. Hire the same service providers you would for any other deal; appraisal, closing, attorneys, environmental, etc.

3. Listen to your attorney with respect to the assumption of existing debt.  Assuming a commercial loan has more thorns than any rose bush.  Getting it right requires quality counsel.

4. If DSC (Debt Service Coverage) is 1.0 or less ($1 of Net Operating Income  to pay for $1 of monthly debt  obligations) then you must have cash on hand to address any shortfall from day one.  And for the next month, and the next if necessary.  Otherwise you are dead in the water on the day of closing unless you have a source of funds for that unexpected, un-anticipated, yet immediate, $5,000 monthly negative).

5. Identify and price property management. If you have no experience in property management, this is not the time or place to learn the trade.  If you do have property management experience, great, cost out work and time required to address the asset. If the time required to manage is beyond your abilities, then you must hire a manager or PM company.  Factor these cost in.

Other articles you may like:

Multifamily real estate investment basics – part 1 of a series | Rose City Commercial Real Estate

Demystifying Selling Multifamily Assets | Rose City Commercial Real Estate

Insurance Costs Down for Apartments | Rose City Commercial Real Estate

REIT Multifamily Equity Index Surges | Rose City Commercial Real Estate

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