Each week within the Best Ever Show Community, we post a question. Our most recent inquiry was “what is the biggest red flag for you when evaluating a potential real estate deal?” Moreover, how do you find good real estate investments?
Depending on your business plan, the entire underwriting process – which includes gathering the required data, building a financial model, performing a rental or sales comparison analysis and visiting the property in person – can take anywhere from a few days, to a few weeks to even a few months. Then, once the property is under contract, you’ll have 30 to 60 days to perform additional due diligence to confirm your underwriting assumptions and create a business plan.
When you add to that the costs associated with both underwriting and due diligence, the deal evaluation process requires quite the investment, of both time and money.
Therefore, the earlier in the process you can identify potential red flags or disqualifiers, the better, as you will save yourself both money and time.
In fact, I created a series about the top 10 tips for underwriting a deal (click here to listen to part 1). In addition, here are five more tips on things to look for when evaluating potential real estate deals.
The offering memorandum (also referred to as the OM) is a sales package created by the listing real estate broker that is used to market and provide a summary of the deal. The key word here is “sales.” The purpose of the OM is to help the real estate broker sell the property for the highest price possible, because the higher the sales price, the higher their commission.
While the OM will include a rent roll, T-12 and proforma, you should NEVER use that data when evaluating a deal. It should, at most, be used as a guide. The reason is because the information provided in the OM may not be 100% accurate.
For example, Youssef Semaan comes across many real estate deals where there is a discrepancy between the OM and the actual rent roll. On one deal, he discovered that the rents listed on the OM were $50 to $100 higher than what was listed on the rent roll. That’s a huge problem! On a 100-unit property in a market with an 8% cap rate, that is a difference in value of $750,000 to $1.5 million! To make matters worse, on that same deal, the OM listed an occupancy rate of 100% (a red flag in and of itself) while the actual rent roll occupancy rate was significantly lower. This is why you must always use the actual historical profit and loss data and a current rent roll when evaluating a deal.
Another error you might find on an OM is a calculation error. Taylor Loht came across a real estate deal where the internal rate of return was calculated incorrectly. Other examples of miscalculations I’ve seen are an incorrect cap rate, net operating income, capital expenditure budgets, and results of a rental or sales comparable analysis. While it may seem like these calculation errors are a moot point (we’re supposed to use the actual rent roll and T-12s and create our own cost assumption, right?), if the owner or listing real estate broker made mathematical mistakes on the OM, how can you trust the other information that they provide?
A discrepancy on the OM compared to the rent roll or T-12, or a calculation error on the OM might have been an honest mistake. However, there are other things that cannot be seen as anything other than unethical behavior.
For example, Todd Dexheimer caught a property management company forging the certified rent roll, P&L statements (i.e. T-12) and leases. They also claimed an occupancy rate of 90%, but the actual rate was 81%. The only reason they uncovered these forgeries was because the management company accidentally sent out the actual rent roll and then tried to recall the email.
Another example of unethical behavior happened to Eric Jacobs. Usually, in the terms of the purchase sales agreement, the owner is required to provide the buyer with the property’s financials, including a certified rent roll, T-12, leases and bank statements. However, Eric had a real estate deal where the owner refused!
Unfortunately, we live in a world with dishonest people. And, since the real estate industry is a part of the world, you may come across a deceitful person during your career. My advice on how to find good real estate investments? Run at the first sign of unethical behavior
The profit and loss statement (also referred to as the T-12) is a document or spreadsheet containing detailed information about the revenue and expenses of the property over the last 12 months. Generally, when underwriting a real estate deal, the T-12 is used as a guide for determining the stabilized income (i.e. loss-to-lease, bad debt, concessions, other income, etc.) and operating expense amounts. For example, if the other income was 13% of the gross potential rent (also referred to as GPR) and the contract services were $250 per unit per year, then it is safe to assume those same amounts when you take over the property. However, there are other times where the T-12 data is unrealistic, which means adjustments are necessary.
For example, on the income side, Ajit Prasad said that an “other income” amount that is greater than 20% of the GPR is a red flag. The incomes included in the “other income” category are late fees, lease termination fees, lease violation fees, and damage fees, which are all associated with a poor resident base. Therefore, a higher other income can indicate a poor resident base, which may disqualify the real estate deal or is something that will be reduced after you take over the property.
There may also be unrealistic amounts on the operating expenses side. For example, Joseph Gozlan said that this can occur when the owner has economies of scale in the same area. If the owner controls thousands of doors in one submarket, they may have a carpet cleaner, garbage person, painter, etc. on staff rather than on contract, which drastically reduces certain operating expenses. Or, they may have a family or friend who owners a service company (like a landscaping or pest control company) and provides their services for free or at a reduced price. However, once you take over the asset, those economies of scale and/or family and friends discounts go away.
One way to identify an unrealistic T-12 is to calculate the expense ratio. The expense ratio is calculated by dividing the total operating expenses by the total income. While it varies from market-to-market, if you see an expense ratio of less than 40%, that is an indication that the income and/or operating expense data is unrealistic.
The best way to overcome an unrealistic T-12 is to base your underwriting assumptions on how YOU will operate the property, not how the current owner is operating the property. And hiring a great property management company can help you with this.
Another factor that may disqualify a potential real estate deal is the market. Ryan Gibson performs market studies for all of his deals. If the results of his market study indicate a lack of demand or a market that is not strong enough to expand in, raise rents or execute a value-add business plan, he passes on the deal.
Last week, I posed a question to the Best Ever Community about the red flags that disqualify a real estate investment market. Here is the blog post that outlines the top six responses.
Even if everything looks good on paper, I always recommend that you visit a property in person before moving forward with a real estate deal. There are certain red flags or disqualifiers that cannot be uncovered until you see the actual property.
For example, Joseph Gozlan said that too many cars in the parking lot on a Tuesday around 11:00am is a red flag because it indicates a high level of unemployment. Also, Adam Adams visits the property and the surrounding neighborhoods to look for indications of crime.
Visiting the property in person may also change your exterior renovation budget. For example, Theo Hicks was reviewing an OM that stated the property only needed new roofs and new window A/C units for an exterior renovation budget of ~$500,000. At that point, the real estate deal made financial sense. However, after visiting the property in person, the exterior renovation budget increased to over $1.5 million. At that point, the deal did not make financial sense.
As an active investor who spends a lot of time evaluating a deal, I’ve seen a whole host of red flags. If you’re a passive investor who’s still unsure how to find good real estate investments for your portfolio, consider working with me on one of my apartment syndications. I carefully vet each property to ensure its profitability, and, if we work together, I’d be happy to review the details with you so you can be sure too!
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.