10 Things I look at before committing to a deal
If there is anything military reconnaissance operations taught me is that there is a process in planning and basic fundamentals that need to be second nature. Only after you have this repeatable process down, why its used, and how, can you deviate when a situation presents itself in an obscure or non-conventional way. That’s why I use these 10 steps every time I look at a property before I start to seriously consider it.
Step One: The visual cue. When I get an address from a broker or see a listing the very first thing I’ll do is look at the pictures. It’s a gut check. If it’s bad, I’m not wasting time convincing myself its good. I’m not going to be a slumlord. If I wouldn’t live there, even after fixing it, I’m out. There are always exceptions with a good story and great plan but, they are far and few. If I expect tenants to live there, I would want to live there.
Step Two: How many doors and at what cost? It is a simple mathematical equation – the more doors you have the more you can spread out risk on a property. If it’s got four doors and one unit vacates, I’m operating a business at 75% capacity. That is a large swing and a lot of risk quickly. Properties should be able to absorb turnover without removing a quarter of the revenue every time. It also leads to another quick filter – the 1% rule. Generally, if a unit costs $350k per unit I should be at 3500/month in rent. Now, San Diego and Southern California are a niche market, and most properties don’t clear this threshold but, it is still directionally accurate.
Step Three: Every property has a story; from why it is being listed and what the seller’s motivations may be, to stubborn tenants, exceptions with the city, and often times what differences you can hear about before ever looking at a proforma. I’ve seen properties listed as 8 units to quickly find out they are actually 4 residential units, 2 for short term Airbnb rental only, and 2 business retail, with one as a commercial kitchen, all because the city wanted to tax the property a certain way. Wasn’t I glad I didn’t waste time underwriting that property.
Step Four: After speaking with the broker and hearing the real in place rents or having the pro forma defended I like to have a validation step. I sanity check rents. Zillow, Apartments.com - whatever gives me a real feel for what people are actually paying nearby. It’s quick, I get to see the competition nearby, stay in tune with the market, and have a realistic feeling of the money in the area.
Step Five: If I have gotten through the first four steps it is time to get serious about how risk is measured and weighed. Conduct an underwriting using formulas that expose bad deals fast. It’s simple – what is my yearly revenue with realistic rents, what are my expenses likely to be based on tax, utilities, maintenance etc. and what is my NOI. I plug in lending terms from what is expected from conventional lending, nothing creative at this stage, and I get a clear mathematical picture of the deal.
Step Six: Now some analysis can take place. The first thing I look at is DSCR. Banks look for a minimum DSCR of 1.25 and I like to be above that. If it is close already it probably isn’t going to work. Trying to justify here or get creative starts making bad deals look good.
Step Seven: For the first time I’m about to look at how cash flow is going to look for investors. Is there enough distributable cash flow where this makes sense for investors and myself as a GP. What could the capital expenses be that change this? Am I placing enough into reserves? Newer properties generally have limited to no deferred maintenance while older properties will need larger reserves and that is going to impact cash flow back to the investors. Once dialed in move on.
Step eight: Stress time! A good plan will anticipate the plan failing. Start stressing the downsides to find out what is going to break first, by how much, and what effects are going to come from it. Will vacancy spike? If the interest rate come in 100bps higher, does it still pencil? Are operating expenses 10% higher? Rents flat or fall? I never frame the upside but looking at the downside and it’s effects give a feel of how resilient a property can actually be.
Step Nine: What is the exit strategy? A common hold is about five years before the exit or refinance. Through the underwriting process, solve for the loan balance and principal remaining through the years, figure how much rent is going to increase, and is project a cap rate expanding or contracting? Once this is solved a refi-gate is created and the property will have a clear pass or fail clearing the loan amount and giving capital back to the investors.
Step 10: Only after the previous nine steps are complete will I start to solve for a new price. At this point I think it’s a good place, know some comparables, have a feel for its resiliency, see how it finances, and what the risks are. So, if there is a price that would make a deal work this is the place it would be identified. If you start playing with price too early, you can make anything look like a deal. That’s how bad deals slip through. Having the previous information makes it easier to know realistic rents, expenses, and cap rates which makes finding a real price even easier.