Updated: May 24, 2021
As a former real estate lawyer and now a current real estate owner and sponsor, I have an ongoing dilemma. The lawyer in me is very conservative by nature, and like most lawyers I’m always looking at each multifamily opportunity for all the wrong things that can happen with a deal. That’s how I approach each deal, so I can protect my investors from all potentially bad scenarios and outcomes. I’m also a graduate of MIT, so I’m always looking for hard data to support my assumptions.
My dilemma is that while I need to be cautious and conservative, I also need to be bold and take risks in order to make an investment profitable. That’s especially true now, as the stock market continues to fluctuate and investors are eager for more secure investments such as real estate, which drives property prices up. If I don’t take any risks at all, then you will never invest. So, how can you be both bold and conservative at the same time?
Evaluating Deals Using a Conservative Approach
When it comes to evaluating multifamily property deals what does “being conservative” mean? I look at deals with a conservative eye. For example, if a sponsor makes rent growth assumptions that are unrealistic, a red flag goes up. Because of the pandemic, many markets have flat rent increases, although we were able to raise rents at some of our properties by over 29% during a pandemic.
Now, I project rent growth in new deals at 1% to 2.5% only, because until the economy stabilizes and unemployment drops, that’s a realistic and conservative number. In addition, our business model is to buy Class B value-add properties, and when doing renovations, it may take some time to increase rents. We look at the comparable rents in the market, and if we’re below market, we’ll adjust our rents. But we don’t use aggressive numbers in our proposals when it comes to rent increases.
Net Operating income (NOI) growth is another area that can show whether a sponsor is using a conservative approach. If, for example, you see a projection in the NOI proforma of 15% to 20%, the sponsor is probably using a very aggressive assumption. As a conservative sponsor, we like to project an income growth of 0% - 5% during the first 1-2 years of operation. Our goal is much higher, but we wouldn’t project anything higher.
Another red flag when evaluating deals is seeing a sponsor with no cash equity in the transaction. I always invest in our deals. It’s all about having “skin in the game,” and some investors feel that when a sponsor doesn’t have any of their own capital in the deal they might not be as aggressive to keep the deal moving successfully as they would if they did have equity in the transaction.
Finally, look at the bad debt projection. If the sponsor uses a very low number, it’s not conservative underwriting. Most bad debt projections should be in the 2% to 3% range. The sponsor should also have put aside funds for rent concessions, which are often needed to retain tenants. Also, they should indicate higher concessions during the first year, not lower.
Finding the Right Balance
If you’ve never tried to find the ideal balance between being conservative and being bold, you’ll find it’s not that easy. However, there are some steps you can take that will help to make the process easier.
Rely on Data to Make Bold Decisions
There are many opportunities to be bold, but never be bold when it comes to underwriting and making assumptions about the numbers. If you see a property that is appealing and it’s located in a strong real estate market, let the data drive your decision-making process, not emotions.
Whenever we look at underwriting a potential deal, we use Axiometrics, which is an AI (Artificial Intelligence) and machine learning technology that analyzes key metrics about a property. This includes projected occupancy, delinquencies and bad debt, rent concessions and other factors that could impact the investment. In addition, we’re able to use the data to compare retention rates, lease terms, average vacant days and other market data on over 500 markets. The key benefit of using AI when making investment decisions is the accuracy of the data analytics.
The Axiometrics technology also provides our team with market research that includes rent and sales comps, construction pipelines, lease transaction data, and operational forecasts. This information helps us understand what the competitive field will look like in the future.
One of the advantages of AI when analyzing a deal is that it can examine vast amounts of data and project potential outcomes that includes not only potential income, but also the property’s future market value. AI can examine multiple aspects of a market that helps to eliminate personal bias, such as where current tenant demand is very strong and whether there is potential for future growth.
While AI and machine learning are providing investors and sponsors with data analysis, the most important function of AI for sponsors and investors, as it is in most other industries, is predictive analysis. The AI algorithms are able to analyze multiple patterns and trends and then make predictions based on the data that’s analyzed. Predictions can include neighborhood forecasting, tenant patterns, and predictive maintenance. All of these factors can help us determine whether a property is a good investment.
Be Bold on Hard Money If You Can
Another way to balance the scale between being bold and being conservative is to be bold on the hard money in your deal. So, let’s look at what hard money is. When using the term “hard money” in this context, you’re basically talking about the initial deposit or down payment you submit when you make an offer to a seller. The hard money is usually non-refundable, so if the deal falls through for whatever reason, the seller keeps the hard money.
It all comes down to how confident you are when making an offer. After you review all of the numbers and details involved in the proposed deal and feel that your assumptions and numbers are accurate and that the underwriting is solid, you’re ready to submit an offer to the seller.
One of the ways to win the deal is to offer the seller a significant non-refundable deposit. I’ve personally seen many deals that were awarded to a group that was willing to make an offer with $1 million in hard money on day one. That’s being bold with hard money.
There’s a saying, “once a lawyer, always a lawyer,” and that certainly applies to me. Before forming my company, Blue Lake Capital, I was a real estate lawyer. That has made me very conservative by nature. I’m also an MIT graduate, which means I’m always looking for hard data to support my assumptions. As a syndicator of multifamily properties, I also need to be bold and take risks in order to be successful. The trick is finding the right balance between the two, particularly in a hot and bullish real estate market, which is where we find ourselves now.
One approach is to rely on quality data when making decisions. We look at key metrics like projected occupancy, delinquencies and bad debt, rent concessions and other factors to make our decisions. We also use artificial intelligence and machine learning technology, like that of Axiometrics, for data analysis. In addition, AI is able to provide predictive analysis to help us determine if a property is good investment. It’s able to analyze larger volumes of key data that simply can’t be done using traditional methods.
Another approach is to be bold with hard money in our deals. If we’re extremely confident with our data analysis and feel the property is a good investment, we’ll submit the offer with a substantial amount of hard money, which in this form refers to a downpayment. Being bold with hard money means taking risks, because hard money is usually non-refundable. I’ve seen deals where the group that was bidding made an offer with $1 million in hard money. That’s a bold approach!
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About the Author
Ellie is the founder of Blue Lake Capital, a commercial real estate investment firm specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie partners with both institutional and individual investors to grow their wealth by achieving double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
A defining factor of Blue Lake Capital’s strategy is founded in utilizing machine learning/artificial intelligence throughout the course of all acquisitions and asset management. This advanced technology enables the company to produce accurate and data-driven forecasting for all assets on a market, property, and even tenant basis. In doing so, Blue Lake is able to lead commercial investments with the full capabilities of today’s technology.
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.