9 Red Flags that we look for in Apartment Investing
People are often surprised to learn that it takes us evaluating 75 or more deals in order to bring a single apartment syndication offering to our investors. Some of the 75 deals won’t pass our screener tool. The deals that pass the screener are then run through a more extensive underwriting, which will filter out a considerable number of unfavorable opportunities. The ones that pass through underwriting then undergo exhaustive due diligence. The 20 or so that pass through that due diligence then trigger offers to be made. And from that 20, maybe only one deal is secured and becomes a syndication offering for investors. While success in syndicating apartments is predicated on “winning” deals, we believe the fundamentals of screening and underwriting is where the principles of capital preservation best serve the interests of our investors. When we make protection of investor equity a priority, we are bound to identify more red flags that tell us to walk away.
Here 9 potential red flags that will instantly kill our interest in a deal:
Unreliable seller financials
It would seem reasonable that a multimillion dollar business, like an apartment complex, would maintain accurate and reliable financial reports. It would also seem reasonable that the seller of an apartment complex would be willing to share accurate and reliable financials with potential buyers. However, this is not always the case. When we identify a potential property in a target market, one of our first steps is to request annual Profit & Loss statements, rent rolls, list of concessions, etc. The best properties and sellers will already have this available to share instantly with us. However, sometimes we’ll come across financials that may be incomplete. That is a red flag. If we cannot have access to accurate and complete data, we won’t even proceed to underwriting.
Historically poor occupancy
One simple element of our property screener is occupancy. While we believe in value-add properties, we avoid “distressed” properties. If occupancy is below 80%, it does not align with our objectives and business model. Still, if occupancy is below 90%, we would want to dig deeper to see how that compares to the “comp set” and identify any reasons (or potential problems) that are creating subpar occupancy. Also, we look at the longer term trendline for occupancy at the property. Is it flat, up, or down? Our goal, in these situations, is to determine very early in the process if the current occupancy is an opportunity or an insurmountable headwind.
Local market with poor or declining employment
The viability of an apartment asset is directly linked to the health of the local job market. The nicest looking property can make for a poor syndication if it’s located in an area with unemployment that is either below the national average or on a historical decline. With value add properties, investor returns are predicated on the increase of rental revenue. If employment is unstable, it threatens the rent growth needed to make a syndication successful. When we notice a property that meets other screening criteria but it’s local job market is in decline, we move on to the next property. Another point of caution for us in this focus is to be weary of a job market that is mostly dependent on one employer or industry. While there is great benefit to having large employers who are in expansion mode, there’s also caution to be exercised when there is a lack of employer/industry diversity in the supporting market.
Violent crime at the property
As we dig deeper into the characteristics of a property, we will pull a crime report on the location and the surrounding area. While many value-add properties may reside in larger cities that have overall crime, we are looking specifically at the history of violent crimes at the property and in the nearby neighborhood. First, a pattern of violent crimes at a property raises potential liability concerns for potential owners. Secondly, crime incidences and local crime rates may affect loan terms from lenders.
Low Income-to-Rent Ratio
As mentioned earlier, employment rates in the surrounding market are important. Also, the wage and income quality of that employment is critical. Specifically, we look at the average income-to-rent ratio. How does the average monthly income compare to the rent of the target property and relevant comp set? If the ratio is low, the market is telling us there is very little headroom for rent growth–which is our key driver of investor returns.
Comp set with declining rent growth
As we start to evaluate a property, we also seek to identify a relevant set of comparable properties (comp set). The key is to make sure the comp set is truly relevant or similar to our target property. Then, we look at the historical rent growth statistics for that comp set. Is rent growth positive or negative for this relevant comp set? A red flag for us would be to see a comp set that has declining rent growth. The local market is telling us it would be a hard fight to execute our business model.
Underwriting that relies on unrealistic rent growth
At New Sight Capital, we are often invited to join as General Partners (GP) in a syndication that has already made an offer. While we weren’t involved in the original underwriting, we will always do our own underwriting of the deal before we decide to join as a GP and bring the offering to our investors. Not every syndication sponsor shares our conservative underwriting principles, which is often evident in how they project rent growth. While the value-add business model can produce significant rent growth, we prefer a conservatively realistic modeling of rent growth. While the relevant comp set may show there is ample head room for rent growth, we will not join as a GP in a syndication that bases its investor returns on unachievable growth in rents.
Underwriting too aggressive with economic vacancy
Economic vacancy is another underwriting projection we closely evaluate when deciding to join as a GP in an apartment syndication. Economic vacancy is the sum total of losses from physical vacancy, loss to lease, concessions, non-revenue units, and bad debt/collections. It’s a very important factor for revenue. We ask: how does the underwritten economic vacancy compare to the property’s historical financials? How does the underwriting model project economic vacancy over the lifetime of the hold period? What assumptions are being made to reach these projections? If the assumptions and projections are too aggressive, the economic vacancy may be unrealistically too low–which would artificially elevate investor returns. With an eye towards investor capital preservation, we’ll decline to join syndications that are too aggressive with this line item.
Investor Returns based on overly favorable assumptions for interest rates and cap rates
Interest rates and capitalization rates are at historical lows. However, with our conservative underwriting approach we believe it protects our investors’ interests to assume they will worsen over time. If we are asked to join as a GP in a deal already in motion, this is one key area we scrutinize. While it’s impossible to predict how high interest rates and cap rates will be in 4 to 5 years, we prefer underwriting models that project them to be noticeably higher. Considering these two rates significantly impact the resale value of the property, we will not join a syndication that doesn’t incorporate rising rates as potential headwinds.
