What should you look for in a property when you are looking to make an acquisition? What is the process during the hold? What happen’s when the property sells and you exit?
In this episode, Tim Wallen, CEO at MLG Capital, will take you on a detailed journey through a real-life deal, to teach you what happens during each step of the property cycle.
If you’re brand new to commercial real estate, this episode will teach you what to expect when investing. For seasoned investors, be sure to listen out for Tim’s secrets on how to extract as much value as possible out of a property.
*If you like this post, be sure to enroll in our free six week course on the fundamentals of commercial real estate investing — Enroll Now.*
Real Crowd – All opinions expressed by Adam, Tyler and podcast guests are solely their own opinions and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisors.
Adam Hooper – Hey Tyler.
Tyler Stewart – Hey Adam. How are you today?
Adam Hooper – I’m great. And welcome RealCrowd listeners, to another episode of the podcast. Tyler, what’s on tap?
Tyler Stewart – Adam, we have Tim Wallen back on, CEO of MLG.
Adam Hooper – It’s been a little over a year. Just about a year actually, since we had Tim on. Talked about tax stuff last time.
Tyler Stewart – We did. We dove pretty deep into tax stuff and we decided to go deep in a different direction on this one.
Adam Hooper – We did an episode a while back, with Pat Poling, on the art of going full cycle and we thought we’d get Tim back on to talk an actual deal that went full cycle and we can learn from that.
Tyler Stewart – We dove deep into a deal, both from the perspective of how a sponsor looks at a deal when you’re looking to acquire a property, to the strategies during the hold and the strategy on the exit and then also how investors should look at the property cycle.
Adam Hooper – We did a deeper dive on some of the due diligence items that a sponsor goes through, how the investor can ask questions around that, a lot of emphasis on investors asking questions around assumptions, where they can get some of that information and the right questions to ask. I thought it was interesting too, as a manager of real estate, you have to wear both hats. You’re a buyer on the going in and you’re a seller on the exit, so we talked about that kind of wearing both hats on that front. Tim’s answer of, what did he say?
Tyler Stewart – That you want to get as much value on both sides. So when you’re buying, you want to pay the cheapest price. When you’re selling, you want the best price, but you still have to be empathetic to the person on the other side.
Adam Hooper – How to negotiate that and not make sure you’re walking away from all the money you’re spending, doing due diligence and getting everything set up.
Tyler Stewart – Exactly and then we asked him what is the biggest bang for the buck improvement you can do to a property. Very interesting answer.
Adam Hooper – Yeah, not one I would have expected. Before we got into the meat of the conversation, we were able to do a quick update with Tim on where they see the market, has their strategy changed and how they see the rest of this year playing out and talked about a few things at the end of the of the episode, kind of where they’re looking and where they’re seeing the market go, which sounds similar to what we’re hearing from a lot of groups out there. No major impending doom on the horizon and some confidence in the market. It is getting harder to find deals. He said they look at 50 to 60 deals a month, to maybe close on 1 or 2. So that’s a lot of work you’re putting in for deals that just are harder to find out there these days.
Tyler Stewart – If you like deals, this is the perfect episode for you, because we just geeked out on a deal.
Adam Hooper – Perfect. Well I think that’s enough of us talking. As aways, if you have any questions, comments, feedback or anybody wants to try to get on the show, please send us a note to firstname.lastname@example.org. And with that, let’s get to it.
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Adam Hooper – Tim, thanks for joining us again. It’s been a while since we last spoke and we’re just catching up. Sounds like you guys have been pretty active in the space.
Tim Wallen – Yeah we have Adam. We’ve, in the last year, bought about 260 million in assets, similar to the year before, so we’ve been very busy.
Adam Hooper – And is that same markets historically you guys have been in, new markets, new product types or what’s the strategy now compared to where it was a few years ago?
Tim Wallen – We were chasing in about 14 to 15 states. In the last 24 months, our acquisitions are probably in like six or seven states. You have to chase pretty hard to find deals.
Adam Hooper – That’s definitely something we’ve been hearing across the board is deals are still out there, but they’re getting a little bit more tough to find deals that pencil; more capital, institutional capital chasing deals and interest rates going up. I’m sure that’s probably affected your guys’ underwriting a little bit.
Tim Wallen – No doubt. I think there’s two major things that’s probably happened over the last year or so. Obviously the movement of the 10 year treasury from the 2% range up to 3% does have an impact, obviously, on your mathematics, but yet look on the sales side, most sellers are looking to sell for sooner cap rates, so it’s tougher to make your math work, so it has a big impact. And frankly, there’s just fewer deals on the street available. CBRE was reporting, recently, the transaction volume is down. So just fewer deals out there, in general, and with the rates being up as well and cap rates staying flat the math’s tougher.
Adam Hooper – Yeah, we were actually looking at stats too. I think this was about a month or two ago. We had looked at the transaction volume five million and up year over year and it was down, from what we could gather in our data, it was down, pulling info off of CoStar, it was down about 30% year over year total number of transactions. That is. That’s a lot fewer deals that are happening.
Tyler Stewart – Do you see that as a short term trend or is that a larger move in the overall market?
Tim Wallen – I think it’s that same thing I just said, cap rates that buyers/sellers want to achieve has stayed relatively flat, so they’re expecting the same multiple on their earnings that they had historically, but yet the sellers aren’t really acknowledging yet that the 10 year treasury’s up. So I think that transaction volume’s really connected to that same scenario. So that’ll take some time to get in peoples’ heads that if they really want to liquidate for cash, they’re going to have to be real about the change in interest rates overall. We have our ways of sourcing deals. You just have to have a high volume of chase and you just have to look at more deals now, the really achieve the same goal. So even though cap rates are up, we still bought a similar quantity of assets this year versus last year, but you have to work harder to achieve that same kind of goal and volume.
Tyler Stewart – Got it. So you looked at more deals this year versus last year.
Tim Wallen – Yeah. We actually increased the number of states we’re chasing in. We were chasing previously in about 7-8 states and now we’re up to 14 an 15 states that we’re chasing in. So we just increased the geography, to increase our probability of sourcing deals.
Adam Hooper – You guys are typically a lower leverage borrower, right, and with interest rates moving up, how have you seen that impact your underwriting, in terms of as it relates to net yield to an investor? Have you seen 25, 50, 100 basis point change in what those return profiles are?
Tim Wallen – Yeah. Definitely really impacting the cash and cash yields more than anything else. The benefit of being lower leverage, we get better pricing than if you’re doing 75% debt. We’re typically at 65% debt or lower, so we do get more interest from the lenders and get more competitive pricing. We have seen the margin that’s added to 10 year treasury to determining your interest squeeze downwards. We expected that to occur, so even though the 10 year’s up 75-80 basis points, we’re only seeing the borrowing rates up maybe 30 or 40 basis points because of that squeeze on the margin.
Adam Hooper – So a little bit of insulation there where it’s not a one to one with the treasury moving to where your borrowing rates are.
Tim Wallen – That’s a misnomer in our industry. The 10 year treasury going up is not as damaging to cap rates. There will be some movement in cap rates, but it’s not as damaging as you might think. Our view is it’s your debt constant is the key driver on cap rates, so those rates go up, if the margin squeezes down… And remember a good portion of what you’re paying is also the principal and your principal is fixed, so that doesn’t get changed by insurance going up, so the big issue is what’s your debt constant and that’s the big driver, from our opinion, on cap rates.
Adam Hooper – And for listeners out there, debt constant, that’s probably a bit of an industry term there. Can you describe debt constant for the listeners?
Tim Wallen – Sure. Debt constant really is what is your annual debt service payments, relative to the loan. So just like on your home mortgage, you got principal and interest. So your interest rate might be 4.5%, but if you’re paying 1.5% in principal as well, your debt constant would be the 6%, which is the total of your interest payment plus your principal payment for a total of 6% per year, even though your borrowing rate’s 4.5. We think that debt constant, 6%, is a bigger driver of cap rates than the interest rate itself.
Adam Hooper – Right, because that’s the effective cost or the effective payment that you’re making on that loan, right?
Tim Wallen – Correct.
Adam Hooper – Good. So we’ve done a couple episodes this year about the tax bill. You being a tax guy Tim, how has that affected your business or have you guys seen any impact from the tax bill, even as it trickles down to the investors? Have you seen any impacts there? Has that affected pricing? Do you see that having any impacts going forward?
Tim Wallen – Absolutely. There’s a couple of things. Obviously the reduced regulations out there as well as the tax bill really putting more money in the large corporate America. There’s a lot more capital investment that’s occurring. So it does have an impact on overall economy, which increases demand for our space, increases occupancies, allows us to charge higher rents. All those kinds of things are a benefit of a better economy but there’s also the real mathematic benefit of a lower tax rate. The top tax rate on the ordinary income piece of rental real estate was previously 39.6% and with the discount for pass through entities and the top rate dropping to 37%, the effective rate on ordinary income pass through is down to 29.6% on an ordinary piece of rental income. So obviously a great enhancement to investing in private real estate.
Adam Hooper – And I know the episode that we did with you before was around fund investing versus individual asset investing. How does that equation play out for the investor, on the tax front again? Any difference, with this tax bill impact on investing in a fund versus and individual asset?
Tim Wallen – No. It should still be the same. The concept of your passive losses and collectively your passive losses are allowed, to the extent of passive income and it really doesn’t matter if it’s coming from a fund or individual investments.
Adam Hooper – And we will caveat those prior comments that RealCrowd nor Tim or MLG are tax advisors, so always consult your independent tax professionals before and investment decisions.
Tim Wallen – Thank you. That’s a very important comment.
Adam Hooper – I think the bulk that we want to get into in this episode … We did an episode a while back with Pat Poling about the art of taking a deal full cycle. We wanted to have a conversation with you guys about a deal that actually did go full cycle and talk about some of the specifics in that, what drew you to the deal, what some of the challenges were, how you overcame those and the results with a deal we did on RealCrowd a few years ago, Northwood Apartments. But before we get into that, maybe you can just give us kind of a quick update out there for listeners that might have invested in that deal or others. How are things going on the proformance front? Are deals looking good in this environment, beating projections, any challenges out there that you guys have been seeing in your current portfolio?
Tim Wallen – Sure. We’ve taken three different projects through the RealCrowd model. Our first was Fund 1, which was effectively 5 years ago. We were buying assets from 2012 to 2014 in that fund, five years forward. We returned all the investors’ equity back. We paid a full 8% rate of return on their capital and we still own 9 more properties in that fund. We expect our IRR, internal rate of return, to investors to be over 20%. We had projected they would be 13 to 15% and we’re going to be over 20. And what’s crazy about that, we’re only 52% leveraged, so you don’t have to use high leverage, guys, to achieve high returns. That’s what makes us very unique in the industry, because we do a lower leverage in our structures overall. And on the Presidio investment, which is an apartment complex down in Allen, Texas, which is Dallas Metro, we bought a project for 91,000 a unit in 2015. Fast forward three years from then. We’ve projected to get to 125,000 per unit in value in five years. So we’re three years in and we think we’ve achieved that value today, so we are bringing that asset to market for sale. We think we’re going to greatly beat the 125 per unit sales price. We think we’ll be greatly over 130 a unit, actually. And that was also a deal that was only 62% leveraged, likely to be over 2x in equity in 3 years. So all of our things look pretty good with you guys so far.
Adam Hooper – One of the things that we’ve been talking about in the podcast and we’ve been trying to help investors understand is those deals are great, those are phenomenal returns, but the market has shifted. The deals that you’re underwriting today, I’d be curious how today’s underwriting and the reality, again, of interest rates rising, as we talked about, more capital chasing deals, how has that affected the target or expected yield on deals today and going forward versus what you might have been underwriting in 2011 through 2013, 14?
Tim Wallen – In that timeframe, we were targeting all returns to investor in that 13 to 15% range, all in per year, again with lower leverage, usually in the 60 to 65% range leverage point, which lower than most industry. But many times we found deals that, frankly, in that timeframe were returns that were far in excess of that 13-15. What’s happened now, we’re not finding many deals at all that are beating that 13-15%, so the deals we’re doing now look like they’re going to keep 13-15%, some as low as 12%. So our range is probably more 12-16%, what we’re seeing on the numbers, what we think we can do, but we’re looking at a lot. We’re looking at 50 to 60 deals a month, to find one. It is a deep effort of chase to source things that make sense. You can buy a lot of real estate all the time, but to buy deals that you believe the assumptions and you believe the story and hit the target returns is very difficult.
Tyler Stewart – When you’re looking at 50 deals a month, one: how do your source that deal flow and then two: what are the quick checks you do to filter through those 50 deals?
Tim Wallen – For our group, we have a good sized group. There’s roughly 260 people in our organization, about 35 focusing on the pursuit and acquisition of assets. For MLG what we do, we have three primary markets, Wisconsin, Texas and Florida where we’re your traditional operator. We manage 9,000 units, all that kind of good stuff and 8 million square feet of commercial assets, but in other markets we actually source and look to partner with other operators that are local. We’re working, in context, with about 1,000 different real estate folks around the country and talking about those deals and what they’re doing. We have to be active with those 1,000 people, which sounds like a crazy number, but it takes a lot of effort to generate those 50 or 60 deals a month, a lot of time and effort and chase and even some travel time. The investors never see the work that we put into that and the long nights and my team stay overnight in hotel rooms and on planes, away from their family and the efforts they make to source deals. It takes a lot of effort.
Adam Hooper – Maybe you do, maybe you don’t, but when you’re looking at deals as a principal operator yourself versus where you might joint venture with another sponsor, how does your look at those deals differ or is it the same set of underwriting, same criteria?
Tim Wallen – Same criteria. Same math. Everything’s about doing smart real estate deals. Are the assumptions real? Do we like the location? Are the assumptions achievable, within a reasonable five year period or so? You have to be disciplined on the mathematics of what we do, otherwise you get yourself in trouble.
Adam Hooper – Perfect. Well let’s transition that then into Northwoods Apartments. Take us a just a little bit through high level where it was, why were you guys in that market, how’d you come across the deal and then we can kind of dig into specifics from there.
Tim Wallen – Sure. We bought a number of deals in Jacksonville, over the years. Jacksonville was a market that got hurt pretty bad in the downturn, but in 2014, when we bought this asset, at that point in time Jacksonville had the largest level of improvement and occupancy any place in the state. It was about 7% occupied at the time that we bought the asset, so it was turning the in the right direction, but because the market was so tough in Jacksonville, in the downturn, there was really a low supply of new development in the deal flow. Real estate at it’s core is simple economics of demand and supply, so if you got slow supply growth and then you partner that with job growth, Jacksonville was experiencing almost 2% job growth per year, but yet there’s very little new development, so the trend was right. So that’s what attracted us to Jacksonville as a market and then specifically the local deal. The math was good. This was a foreclosure situation where a lender took it back. The lender was not a great operator. Lenders tend not to be the best operators. Unfortunately. I feel bad for them, but their job is to convert bad loans into cash and go back into the lending business. They’re not in the business of owning assets, so the rents were too low and expenses were too high and we love that kind of scenario.
Adam Hooper – That sounds like a pretty good fundamental. It’s something you can get in there and fix.
Tim Wallen – Maybe one thing, a little bit about that, it would be interesting to note: that deals is an example, we actually, MLG corporate, didn’t find that deal. It was a local sponsor in Jacksonville and we partnered up with them. We let them do the local property management, which is important to them. It’s important not to manage stuff remotely. There’s a lot of real estate guys, when they buy assets they tend to manage them remotely and that’s tough in getting good people to do a good job in the asset. So that was a different kind of acquisition for us to be partnered with their group.
Adam Hooper – I think that’s a good point, having a local team that knows that market in and out, that can have the boots on the ground and be your local operating partner changes the equation quite a bit from someone that’s having to do it all remote with third parties.
Tim Wallen – We manage 9,000 apartment units. It’s not like we don’t know how to do it. We still outsourced it to a local group, because it’s really about people. You have to have good people to do the job and we all put these proformas together and to achieve our assumptions and our goals, you have to have people that have real talent and understand the market and understand the dynamics of the local submarket and it’s really hard to do that remotely, when you don’t have a deep bench of operation and people in that market.
Tyler Stewart – I want to jump back to something you said earlier. When you’re in the Jacksonville market, you saw there was a low supply growth with job growth. For our listeners out there who are looking to circle some markets to keep an eye on, where could they gather information on that local market, how can they find the job growth and the supply growth.
Tim Wallen – All the large brokerage firms put out market reports. Marcus & Millichap, CBRE, they all publish reports. We also look at the Census Bureau data, which is available online. This information’s generally available online, with a little bit of effort. I have, in front of me, a printout of the Census Bureau of occupancies by market and nationwide. That is readily available.
Tyler Stewart – And then with that deal specifically, again, you said that you purchased it from a lender that had foreclosed. When you’re going into a situation like that, how does that differ from more of a traditionally marketed asset? Are there questions that you guys need to answer? Is there more diligence that you need to do, because it’s been foreclosed on? Does your process change at all, depending on who the seller is?
Tim Wallen – Not really. Obviously all real estate guys get all jazzed when they see a foreclosure situation and they’re thinking they’re going to steal it. I’d say lenders are usually very disciplined. They hire professional investment sales folks. So it really doesn’t change the way we underwrite. When we looked at deal that rents for about 85 cents per square foot per month, we thought the market was closer to a dollar and our goal was to get to 96 cents per square foot. We think we can do that. In that particular situation, the property was 98% occupied at the time and we always love when I hear 98%, because that tells me, generally, if you’re that high occupied, your rents are too low. The submarket was 88%. Jacksonville as a whole was 93% and you’re sitting there at 98. There’s a reason why it’s over the market and that smells and creates opportunity in our minds. In addition, in that particular situation, the bank was running expenses about 5,500 bucks per unit per year and we thought we could run the unit properly for $4,700 per unit per year. So the lender thought they were selling the asset for six cap. Under our math, we thought we were buying it at an eight cap, based on what we thought we could run it for. This is an on market deal and it’s rare that we win on market deals, but we just looked at this asset different and we were able to buy it on market, even though that can run the prices up on on market like that.
Adam Hooper – As Tyler kind of alluded to when you guys were looking at 50-60 deals a month, are there immediate qualifiers or disqualifiers, I guess, is a better question? Are there immediate disqualifiers, when you look at a deal that immediately just gets dismissed? At what level of diligence do you, on the 50 or 60 deals to find those ones that you want to move forward with?
Tim Wallen – I think the biggest thing is what assumptions are being made versus the reality of the local market conditions. We can generalize what’s going on in every asset class across the board, but the fact that multi-family’s 95% occupied nationwide doesn’t really matter when you’re talking Milwaukee or Dallas or Denver or Nashville. Each of those local markets you have to kind of dig into. So it’s a deep dive into the assumptions that are being made. If you’re looking to grow rents by 3% a year or even greater, why is that real? So you have to go through the mathematics on that or for example, I mentioned on the Northwood deal that we’re going to run it for $4,700 per unit per year in operating expenses, are those assumptions real? What you’re assuming for insurance expense, what you’re assuming for maintenance, are those real numbers? It’s really that deep dive into each element of each assumption that you’re making and are those believable, achievable numbers. That’s the key in the underwriting side. Anybody can put a proforma together with assumptions that make it look like you’re going to make money, but the question is what are you assuming. If your assumptions are believable and achievable then you got a good chance of achieving the goals that are set out in the proforma.
Tyler Stewart – This is something we’ve talked about on the show before, that as an investor that’s maybe not a real estate expert, how can they do a sniff test on these assumptions? Where would they get that information from? How can they start to have more of a critical look at what these assumptions are building this proforma with and whether they’re realistic or not?
Tim Wallen – I would say, in general, it’s hard to get the expense data, in the industry, other than if you’re an experienced operator. So if I was an investor looking to invest in another guys deal, I’d ask them, from a due diligence perspective, can you show me how you’re operating other assets in the area. If you’re assuming $4,700 per unit in expenses, can you show me what’s happening there. On the rent side, hopefully the information that you’re being given includes some comparable rents, but you got to be careful that you’re comparing apples and apples. There can be a class A asset next to a class B asset next to a class C asset and the rent’s going to be very different and they’re really not comparable. So you got to make sure the comparables are real, truly comparable in nature, overall. The rent information, you guys can get online, from like apartments.com, even Craigslist. The rental information, rents are readily available online, of comparable properties, so you can do some of your own due diligence on the rent side of the equation. It’s tougher on the expense side, overall. I think you really have to ask the operator to share that with you and demonstrate it.
Tyler Stewart – Sure. And then listeners, through RealCrowd, have access to the real estate sponsors’ due diligence material. Are there any documents they can go to to find the assumptions being made?
Tim Wallen – There should be proformas in all the offering documents that detail what are you assuming for maintenance, insurance, real estate taxes, all the things that go into running a project and an asset. The same is true on the rents. Those rental assumptions are going to be in the proformas that any kind of investor can look at and make their own determination in their mind does it look reasonable what they’re assuming.
Adam Hooper – With Northwoods, you like the market; you like this deal, a foreclosure. The lender was not operating it correctly, figured you could lower expenses, increase revenues, which is a pretty good formula. You make an offer. You win the deal and now you’re in the due diligence period. Any differences, again, from a more traditional marketed deal where the seller is a traditional seller versus lender? Just walk us through kind of what your diligence process looks like, what investors might be able to learn from that; as Tyler asked you, what materials might be made available to investors, with that deal.
Tim Wallen – Again, it doesn’t matter if it’s a foreclosure asset or not. The due diligence process should be the same. So let’s walk through what we do in apartments. We walk 100% of the units. This is a question you should ask the sponsor, are they doing that. Literally, you go into every unit and make sure there’s not been some fire, really poor units and maintenance. If they’re telling you that 30% of the units have been upgraded, you verify that the units have been upgraded. So you walk the units. That’s an important part of the process. You do a full audit on all the lease files. If they say their rents are $700 per month for the 2 bedrooms, on average, you need to go through the lease files and verify that. You need to verify are the people actually paying their rent. It’s one thing to have a signed lease, but are they paying you. So that full lease audit’s very important. It’s important, on tenants, there’s credit quality issues, there’s criminal issues, when you’re letting tenants into your building. Are they following those disciplines in the leases that you’re inheriting, because remember, you get to inherit every tenant that’s there when you buy the asset. Roof inspections, site inspections on the HVAC equipment, all the service contracts, utility bills, getting a bid from the insurance company on insurance costs, bidding your capital improvement, verifying the parking lot’s condition. Those are all things that you’re looking to do in the process of due diligence as a sponsor and those are the kind of questions you can ask the sponsor
Tim Wallen – and make sure they’re doing those kinds of activities.
Tyler Stewart – And then a typical timeline from … I guess even taking a step further back. You make the original offer. There’s going to be some period of negotiation, until you win the contract. What does a typical timeline look like from an initial offer through diligence and then closing?
Tim Wallen – It’s kind of what we want to have and what we get, in the marketplace. What we love to have is 30 days review, 30 days financing, 30 day close, but that doesn’t win you deals. Generally we’re going to squeeze down that process that I just mentioned is really squeezed down to 60 days. It might be 30 days for due diligence and financing and then 30 days to close. Or maybe it’s 30 days for due diligence, another 15 days for financing and then 15 days for close. In general, to win deals, you have to be promising a 60 day close or you don’t get the deals, in general. It’s very difficult to be competitive in the offer process and win deals if you’re doing something different than that.
Adam Hooper – And naturally that will change with the market cycle, right? So in down markets, that window can extend a little bit. Hot markets, that’s going to compress or are you saying 60 is pretty much a constant throughout market cycles right now?
Tim Wallen – I think you’re still in that zone. If you do an off market deal, sellers in the off market space, they might not be as experienced and you might get a longer period of time, but I’d say for most on market deals I see the range of 60 to 75 days. You still got some sellers that are reasonable and they’ll give you 75 days, because it’s a heck of a lot easier getting it done in 75 days than 60 days, but I’d say that range is really 60 to 75 days.
Tyler Stewart – What does that due diligence period look like? I know you talked about walking the asset. What sorts of things are you doing during that due diligence period?
Tim Wallen – In addition to the walking of units and verifying the various elements of your expenses and capital improvement budgets, you’re starting the loan process. You start your loan application process. You start organizing your equity capital. You have to put together your offering documents for raising that capital. Generally, within probably 15 days or so of getting an accepted offer, you have your offering documents all put together to raise equity, you have your loan submittals and as a realty sponsor … Sponsors take a lot of time and risk and effort. They have earnest money deposits up with the seller. They have a lot of money invested in the due diligence process, the legal process, putting all the legal documents together. So it’s really the loan process, the equity raising process and then verification of all your assumptions, reviewing the elements of your assumptions, whether it be the revenue side or the expense side or capital side of the asset.
Adam Hooper – You mentioned the upfront cost of getting into one of these deals, by way of legal and diligence. When you put a deal under contract and you’re going through this, you got to have a pretty good feel that it’s a deal that you want to actually execute on, right?
Tim Wallen – Correct.
Adam Hooper – I guess, how do you address that? Sometimes the diligence, if you say if 30% of units are marketed as renovated and maybe it’s 10% or if there’s a big issue in diligence, how do you overcome some of those challenges? Do you walk, do you give up that money and that dead cost or do you negotiate for reductions? How does that process typically play out?
Tim Wallen – Obviously it’s a wrestling match between the seller and the buyer and if there’s issues that come up with due diligence, I would say, in general, if there’s something that was materially different than what was represented by the brokerage community or the seller, in general, you can get sellers to do some modification of the purchase price to accommodate that issue. Some sellers are stubborn and they’ll just say, “Nope, not going to do it.”, and you have to be willing to walk away. That’s tough for real estate guys, because they probably have a couple hundred grand that they’ve put at risk and maybe it’s 50 grand. It goes in tranches. It might be 25 grand and then 50 grand, 100 grand and you see real money at risk and when you walk away from some of these deals you just don’t get it back. So it is frustrating for real estate guys. It’s part of the risk they take bringing opportunities to RealCrowd.
Adam Hooper – We’ve actually had, I think, a handful of deals, maybe two or … Well, probably less than five, I think, that have not closed, because of something that was found in due diligence. Where you do fall on the line of pushing … You’ve got this money sunk into the deal. Do you just push through and accept it and close it or do you back out while you’ve got that capital lost and communicate with that investors, that might have been excited about the deal, it’s really better to pull out.
Tim Wallen – It really gets back to at MLG we’re targeting returns in 13 to 15% range to our investors and the question is if you suck it up, does it still fit within that range. Is that return that you’re getting, on risk adjusted basis, worth it? If it’s materially different, we go back to our investors and say, “Here’s a modification in the proforma.” You can’t ignore the issue. You have to modify your proforma. You have to modify your assumptions and most of the time your going back to the investors, unless it’s minimal, and saying, “Hey guys, this is a changed proforma. Are you still in? We think it still makes sense.” Or maybe it’s, “Guys, we’re killing the deal. We can’t make sense of it. The seller’s not being reasonable. We don’t recommend going forward.” And it’s usually one of those two fact patterns that occurs, when issues come up.
Adam Hooper – And what would be one of those red flags that’s an automatic we’re dropping the deal and aren’t going to close it or is there a price for anything?
Tim Wallen – I guess if there’s some major environmental issue, that’s probably the number the one thing that hey, the deal’s just dead. There’s no solution to that, some major environmental type situation. Most issues are economic in nature and you can come up with the math of what it’s costing you to fix that issue. You just have to do your mathematics on that and say, “Okay, I need a price reduction of x. If I don’t get that, we have to walk this deal.” Or if it ends up in some middle ground range and maybe it’s still in your target returns, then you go back to your investors and say, “Hey guys, we found this out in due diligence. We think it still makes sense to do this deal. Are you still interested in being part of this deal, yes or no?”
Adam Hooper – So you just make your case and take it back to the seller. Hopefully they’re reasonable and you get a reduction, you can move forward with it.
Tim Wallen – Correct.
Adam Hooper – What percent of the time does that actually happen? Are most sellers reasonable for things or is it just kind of the game and you get what you can get and you win some, you lose some?
Tim Wallen – I would say, for the most part, we work so hard on the process of making offers, I can only think of 1 or 2 deals in the last 10 years that we ended up walking away from because of stuff. It’s a low occurrence, for us at least, where we don’t find some reasonable middle ground to go forward.
Tyler Stewart – I’m always curious what’s the negotiation strategy look like. You don’t have to give us your inner secrets of how you approach the negotiation table, at a high level view, what’s the overall strategy? Are you trying to make sure both sides walk away feeling like a winner or how do you approach the negotiation table?
Tim Wallen – Are you saying on the front side buy in?
Tyler Stewart – Yes.
Tim Wallen – Obviously it changes dramatically if it’s an off market or on market deal. What I mean by on market, for the audience here, is if it’s listed by a professional investment broker and there’s 20/30 companies chasing to buy that asset and you somehow want to be the winner of that bidding process and then off market. In the on market situations, it’s really a competition for price. You can win deals and not be the highest bidder, if you can demonstrate that your closure … There’s other factors. It’s not just price. If you’re known as a closer and you’re reasonable and you’re known for not backtrading on price then it enhances your probability of getting accepted as the buyer for an asset. It might even be at a lower price than somebody else, because sometimes people that aren’t really credible put offers and they don’t have a history of being able to raise the capital and they don’t have a history of closing, so they’ll bypass that offer and accept something lower. In a competitive situation, you really have to be disciplined. You put together the numbers that make sense for you and you just hope the seller picks you based on the factors of what makes sense and history as a good buyer. Then hopefully, you as a sponsor, have a good idea what to do with that asset. So it’s a really competitive situation on the on market deals. Off market’s a little different. You put together and you can play a little bit more of the back and forth. You offer something less than what you think it’s worth and the guy can counter higher
Tim Wallen – and say we’ll split the difference kind of thing, on pricing. Whereas an on market deal you’ve got to be aggressive on what your offer is, otherwise you’re just not going to get accepted and not be in the game for acceptance, so you got to really like the asset, really like the story when you’re buying on market deals. Off market deals, there’s a lot more negotiating ability when you’re in that environment.
Adam Hooper – With Northwoods specifically, did you guys end up at the initial offer price, did you find anything in diligence that you were able to try and negotiate with or how did that look?
Tim Wallen – I probably should have the answer for. I do recall we had a small item we got a purchase price reduction on. I can’t remember, of the top of my head, at this point. A lot of times, if you’re asking for say 50,000 off, it’s kind of a little theory that pigs get fat, hogs get slaughtered, so if you ask for something that’s reasonable you’re likely to get it. If you ask for too much they’re going to say no. I do recall getting some modest price adjustment for something that we found in due diligence. Honestly, I can’t remember exactly what that was.
Adam Hooper – So you’ve gone through diligence. You’ve negotiated maybe a small purchase price reduction, because of something you’ve found. You’ve done your diligence. You’ve got your strategy, your business plan ready to execute. You’ve closed the deal. Now it’s time to operate and execute. How does that process play out? Take us through a strategy for Northwoods specific and then how that looks beyond that in the rest of the portfolio as well.
Tim Wallen – First of all, it depends if you have a large capital improvement plan or not, but part of the process is … The first thing we do is really implement our leasing standards. If it’s a multi-family asset: criminal history, background history, income history, credit history. Those are things that are not negotiable for us in leasing. So you got to put those policies and procedures in place. And then on the expense side, you got to go implement. For example, on the Northwoods deal, we were able to do the insurance for about $400 per unit. The bank was paying $1,000 per unit for the same insurance policy. So it was just implementing some of those basics. We were able to reduce the operating expenses by about 700-800 per unit, by a couple different things that we did on the operational expenses. You have to implement those cost reduction ideas. You have to set in place the rent strategy. In this particular case, we thought the rents were materially below the market, so even though Jacksonville rents were growing by about 3% per year, we moved our rents up by about 6% per year for the first couple of years. And really the guy that owned the asset before us overimproved the asset for the submarket, so there wasn’t really that much to do on the capital side. There was roughly 20 units out of 152 which weren’t renovated yet. So there wasn’t a big capital strategy here. It was really just having the competence that the rents were below market and then if we raised the rents up we weren’t going to lose all of our tenants.
Tim Wallen – So we raised the rents up 6% per year and we went from 98% occupancy down to about 94% occupancy, but that was okay. It was part of our plan. When you sell assets, buyers don’t give you credit for being 98% occupied. They’re going to take you down to market occupancy, even if you’re above it when you value your net operating income and capitalize that value, they’re not going to give you credit for the high occupancy. You want higher rents that are going to get you market occupancies, when you’re creating value in a multi-family asset. So implement the income strategy, which includes proper controls on tenants. Implement your expense saving ideas. Implement your capital improvement plan if there is one. We did a few modest things here, but it was not material to the strategy here. It was really expense reduction and rent growth, because the rents were below market.
Adam Hooper – You made a comment earlier, when you guys were talking about the diligence process, that you inherent whatever the tenant roll is, coming into the space. We get emails from investors all the time that say, “I checked the Yelp reviews for this apartment complex and it’s terrible, it’s horrible. I would never buy this building.” That’s the opportunity, right?
Tim Wallen – Absolutely.
Adam Hooper – That’s always struck me as kind of misunderstanding of the opportunity set there. If there is challenges with the tenancy or the management, that’s a value that you can create and unlock, right?
Tim Wallen – No, no doubt. It’s hard. It takes time. If you have a property that’s got a reputation for poor management and people that are disruptive and just not great neighbors, it takes time to change that perception. So you inherit that tenant base and it’s our job as managers to clean that up. If there’s a problem tenant don’t renew their lease. You have to have the confidence that you’ll lease those units back up and you don’t need tenants that aren’t paying their rent on time, you don’t need tenants that are disruptive to their neighbors. Then you have to take care of your tenants, as a manager. You got to be timely on fixing problems, with a problem with an asset. These are your customers. The tenants are your customers, so you got to take care of your customer and that’s an important part of what we do as real estate sponsors is doing that customer service side and try and improve those reviews online. We work really hard on all of our properties to make sure we’re getting positive reviews, including encouraging our tenants that like us to give us positive reviews, because that helps for future leasing. It’s all tied together.
Adam Hooper – I don’t know if we want to delve too deeply into philosophical debate. There is, when you’re coming in and increasing rents, naturally that’s going to displace some tenants. How do you guys balance the desire to keep tenants in place and not be too disruptive to the lives of these people, but also, at the same time, your mission as a real estate manager is to create that value. How do you balance that as an operator coming into a deal like this.
Tim Wallen – It’s always a challenge, because I’m a socially minded kind of guy and sometimes you think oh, I’m raising rents on these people that maybe can’t afford it. Which is really hard, but the way I look at it is no matter what income stratus you’re at, if you improved your house and improved your kitchen and you improved the flooring and you cleaned up the landscaping you would expect to sell your house for more, right? No matter what, if it’s a $200,000 house or a million dollar house or $500,000 house, you would expect to sell it for more and the same is true for apartments. If we fix things up and improve the appearance of an asset and we clean up and get rid of the bad tenants on the property and we do those things that make it a better community to live in, there’s a value in that. My viewpoint is we’re making a better community, a better place to live and there’s value in that and it costs us money. We have to have quality people to do the job, to do all those things and that costs money. So you’re getting a better product. If you wanted a lesser product, you can go move someplace else that has lower rents and less service. That’s a choice, no different than buying a home. You can buy a lesser house that’s not fixed up and it costs less or you can buy one that’s all fixed up and pay more. It’s that same concept. If you make that connection then people go okay, I get that. I got new appliances, I got new countertops, I got new vinyl luxury tile floors, I don’t have bad tenants around me anymore. I’m willing to pay more for that. My viewpoint, as long as we’re creating value,
Tim Wallen – I don’t feel guilty about raising rent because I’m doing something for that.
Adam Hooper – And then when you look at renovation plans, I guess it probably varies from property to property, but how much of your time would you say, or dollars, are allocated towards the interior of the units themselves versus common areas, amenities, the overall exterior of the project?
Tim Wallen – That is a very specific location by location basis and it depends on the … You got to be careful not to overimprove, based on the submarket. I would say we go anywhere from … We always have some kind of capital improvement plan. Probably in the low end it’s 2 or 3 thousand per unit on multi-family, but sometimes we’ll spend 20,000 a unit and make old completely brand new again and gut the units and make them new. So that capital investment thing is very much a function of okay, if we do these improvements, how much can I improve my rents. No different, again back to single family analogy, you can overimprove your house and make it so nice that nobody will pay you that price in that submarket. You got to be careful that your strategy matches the rent structure of the submarket and can you get paid back for making those improvements in the assets. So there’s a high focus on capital improvements on assets initially and then once you’ve done that improvements then it’s really just customer service time, taking care of the tenants, making it a great place to live, a great community to live in, timely responses to requests for maintenance and whatnot and just being a good operator. So it’s kind of two phased: operational and capital.
Tyler Stewart – There may not be an answer to this, but I’m curious. Is there a most bang for the buck improvement you can make, a low value improvement, but you always see a great return from.
Tim Wallen – You’ll get this one. I think that the easiest, lowest hanging fruits in the multi-family space is being water efficient. Just by changing toilets and shower heads, you can reduce your water bill by 30% and usually you get about a 2 year payback in your operating expenses. For example, if I reduce my water bill and say the water bill was 200,000 per year for all the units now, it’s dropped to 140 or 60,000 per year. That increases the value of my property by about a million dollars and probably costs us something in the range of 120 grand to do it. It’s amazing how much people don’t do it. We look at the properties we buy and I don’t understand why operators don’t do it, but it’s very low hanging fruit in buying any multi-family asset. That’s an easy one.
Adam Hooper – There you got. I know there’s a handful of sponsors that listen to this podcast, so there’s your pro tip for the day. With Northwoods, do you recall any specific challenges that you had that maybe deviated from the plan going in or was it a pretty straightforward execution of the business plan going in, with that one.
Tim Wallen – I think it really gets back to that inherited tenant list. We did have a tenant list we did see turnover. We have certain standards on credit history, income history, crime history. We don’t accept slow pay. So we did have a lot of work to do on that basis and that’s what investors pay us for is to do that tough work and that’s not fun. It’s not fun dealing with those issues. People live here, but yet the rest of the tenants, it’s kind of like you got 30 students in a classroom and one’s acting out all the time and the other 29 are, “Gosh, what’s this guy’s problem?”, the teacher’s job is to clean up that one student. Either they cleanup and stop behaving that way or they’re going to have corrective behavior and the same thing’s true in a multi-family asset. If there’s some characters that are not doing their part and being part of the community, it’s our job to go through the pain of getting them out. Because the other tenants deserve to live in a nice, friendly community and it’s our job to make sure that we deliver on that.
Adam Hooper – Good. So you’ve got in. You executed a business plan. How do you know when it’s time to exit? What was the trigger for that?
Tim Wallen – In this particular deal, we achieved our plan in two years. Most everything we buy we have a five year plan and sometimes it ends up taking six to eight years and sometimes it’s shorter. In this particular one, we achieved our plan in 24 months and the market for selling was extremely strong and very liquid, a lot of buyers that want to buy multi-family and we achieved our plan in 24 months. And any time you do that, it really enhances the returns to the investors if you can achieve your plan in 24 months versus 5 years, because it really pops the annual rate of return that they’re earning when you do that. So we achieved our plan and we said time to go.
Adam Hooper – And what do you think about this deal was it that allowed you to execute at, basically, half of the target five year horizon? Was it because the units, like you said before, was already renovated, there wasn’t much cap ex’s you had to do or what was it about this deal that allowed you to execute so quickly?
Tim Wallen – I think you hit the nail on the head. There wasn’t a big capital plan here. It was really mismanagement on behalf of the prior owner, so we moved the rents up 12% in 24 months and we reduced the operating expenses by about 18% in 24 months and the combination of those two allowed us to achieve our sales price. We bought the property for about 4.7 million and we were looking to sell it for 6.8 million and we ended up selling it for 7 million. Hit the plan in 24 months and so we said time to go.
Adam Hooper – And I guess, when you’re getting those kinds of numbers and returns, it’s a pretty easy decision to sell, at that point.
Tim Wallen – Yeah.
Adam Hooper – Are there some deals where coming to that sell decision is a little bit more challenging? It sounds like this is pretty straightforward great execution, got in there, did your job and were able to realize those gains. Are there situations where that sell decision becomes a little bit more of a longer conversation.
Tim Wallen – Because our model is built on buying stuff, fixing problems, creating value and selling we’re not really long term holders, the way we approach the industry. I will tell you on occasion though, you get a legacy asset and it’s a legacy location that you know you can own it for generations and be safe, because of its location and you went through the hard work to reposition the asset and fix it up and it is painful to sell an asset like that, because you know it’s going to continue to improve over the long haul, but our promise to investors is to have your money back in the six to eight year window and our plan is five years and we have to keep our word, so we have to sell stuff like that, even though we love it and love the asset. But on the same token, when you got a situation like that, you’re going to have 30 buyers at your door to buy it and your pricing is going to be over the top. So it’s fun to have that win. The other thing that happens in our industry, unfortunately sometimes is, there are some folks in the industry that … This is a question that really the investors should ask sponsors on their history of holding assets versus planned, because a lot of sponsors, they want to maintain and keep that fee income from their business. So you sell an asset and all of a sudden you’re losing the property management fee income. It’s important for investors to talk to sponsors about you said the plan on all these other deals was five years, did you actually do that; what did you do. So you need to understand on operator’s history,
Tim Wallen – it’s important that people keep their word and investors need to check on that when they’re looking to invest with sponsors. Are they selling when they hit the plan or are they holding it beyond what they told everybody. If they say upfront, “Hey, this is a long term hold guys. Don’t invest with us if you don’t want to do the long term hold.”, that’s great. If they say it’s going to be a 5, 8 year deal then are they doing that in reality and that’s something I think investors should look at when they invest with a sponsor.
Tyler Stewart – Is that always a red flag or are there cases where the sponsor’s still seeing value from the asset and it’s in the best light for the investor too, to continue to hold?
Adam Hooper – Right. It might not be the right time to sell, given market conditions or something like that.
Tim Wallen – Oh, I will tell you this. Let’s go back to 2009 and 10. We had some assets where that was our five or seven year window and you couldn’t sell. It would be foolish to sell. So there’s good reasons why it makes sense to hang on sometimes. I guess there’s two equations. One side of it is 2009, 2010 we have a really deep dive in the economy and the asset class. You really need to hold through that cycle, because you don’t need to take that loss. There’s cyclicality to our economy. You just need to weather the storm. Hopefully you weren’t overlevered, so you don’t lose the asset by being overlevered when there’s a downturn. Then you have the other side. We have a deal up in Minneapolis right now which is a killer asset, a killer location as well as an asset it can be a legacy asset and we talked internally. It was tempting to say go back to investors and talk about holding it. The problem is you need a high percentage of investors to agree that it’s okay to hold longer. I think, as a sponsor, you have a responsibility to go back to those investors and get their buy in: You know guys, we’re at our window of exit, but I really think there’s more value to be had here and we think we should hold longer. I think you should get the buy in. That’s how we look at it. That particular asset, we’d go back to our investor base and look to hold longer and if there was 10% of the guys that wanted to exit, maybe we negotiate a buyout of those 10% that don’t want to hold. I think you have to be real about what you told folks,
Tim Wallen – that you’re being true to your word on the structure.
Tyler Stewart – Is the buyout option, is that common amongst real estate sponsors?
Tim Wallen – No it is not. We give our rights, in the legal documents, to buy somebody’s interest back, if somebody wants to exit and generally that would be a very positive buy for the rest of the investors if that occurs, but we don’t have a liquidity structure where we have the right to buy their interest or they have the right to sell their interest to us. It’s very difficult to structure that in legal documents and get a furnace there. Real estate’s an illiquid asset class. You have to be understanding when you invest in it, it’s illiquid and you need somebody to pay cash for it, to turn it into cash. It’s not like the stock market. But the benefit of it is we create higher returns than the stock market in the long haul, I think. So it’s a great asset class, but it doesn’t have liquidity like the stock market.
Tyler Stewart – So if an investor was curious on buyout options they would refer to the operating agreement. Is that correct?
Tim Wallen – That’s one approach. The way we handle it is if somebody wants to exit then we find out that and we either have other investors within the asset buy them out, if somebody’s interested or we buy it out or the entity itself buys them out. But if nobody wants to buy it, because the guy wants too much then the guy’s stuck owning it. We don’t promise liquidity.
Adam Hooper – I would say that’s one of the things that we’ve always tried to figure out is more liquidity provisions, but again, as you said, the evaluation component of that is incredibly challenging. Just the fact that every deal has its own set of covenants around liquidity provides a bit of a challenge too. So it’s one of the things we’re always looking at, how we can increase liquidity. I think there’s an interesting… actually curious to get your take on this, I think the investor’s desire for liquidity seems pretty well opposed to a sponsor’s desire for stability of that capital, which, I think, is why it’s usually fairly onerous to have any kind of liquidity in these projects.
Tim Wallen – Yep. It’s part of the nature of the asset class.
Adam Hooper – Getting back to the exit of these deals. We’ve talked about, on prior episodes, how do you make that acquisition attractive for the buyer coming in. Do you leave a little bit of meat on the bone? Do you leave some capital improvements that they might be able to do or have you changed the risk profile, so now it’s a core buyer that’s coming in to do that? How did you approach that on Northwoods and then how do you approach that, generally, to make your assets, when you now have the seller hat on, how do you make those attractive to buyers coming in.
Tim Wallen – A high percentage of the time, we’re hiring professional investment firms like CRBE, DLL, ARA. We think that’s the best way to sell assets. There can be an occasion where an off market sale can make some sense. As far as leaving food on the bone per se, we want the max number. It’s kind of funny, on the buy side want the lowest price, on the sell side you want the highest price. We’re like everybody else. We want that max number, so we think the best way to achieve that is by hiring investment sales firms to do so, but we do accept off market deals, on occasion. Actually Northwoods was an interesting situation. We actually took it to market with investment brokers and through the process, we didn’t get the price we wanted. We didn’t get that 6.8 million dollar number that we wanted and then about 7 months later we had a buyer show up that was willing to pay us 7 million off market. So we took it. We had been through the process, full marketing. We fell short of 6.8 number, so we said, “We’ll get this up and grow our operating income a little bit more. “We’ll bring it out in the next year.”, but then somebody showed up and I don’t remember if they were a trade situation or what, but they wanted the asset bad at seven million, so we sold it to them. On occasion it can make sense to sell off market, but not commonly.
Adam Hooper – Did you give him 60 or 75 days to buy it?
Tim Wallen – We only gave him 60.
Adam Hooper – There it is. It’s an interesting point, right? You have to wear both hats, depending on where you’re at in the cycle. Does it give you any different leniency when you have your seller hat on, you’re a seller through and through and that’s for the buyer to figure out how to get it done?
Tim Wallen – Again, we look at the buyers, what’s their ability to close, do they really have the equity, do they have a history of buying, do they have a history of retrading, have they really underwritten the capital issues? We know our assets, if there’s something still wrong with the asset that needs to be fixed, roof issues. If we’ve got a roof that’s got only four years left on it and we’ve told them that in the due diligence process, before they wrote the offers, I don’t want them coming back to me saying, “Awe, the roof’s going to be bad in four years. We want a purchase price reduction.” We told you that before, so don’t bring that back as an issue. So we work the buyer to make sure they’re qualified and able to close. Also price matters. If somebody’s offering an extra million or two bucks and they want 75 days versus 60 days and they have a history of closing, I’ll wait 2 weeks for a million bucks. It depends on the buyer and their history and their story. Ability to close is important. And at some point, sometimes if a guy’s materially above everybody else, you’re concerned on their ability to close, but sometimes you’ll take a risk on that, because it’s so materially above everybody else. You’ll take that risk.
Adam Hooper – And as an investor in deals through a platform like RealCrowd, how much visibility do you typically have into the nuances of these processes? Is it just what they’d get through quarterly updates or is there a more involved process when it’s time to exit, of communication with the investors, typically?
Tim Wallen – It is a balancing act of being excited about we’ve achieved plan, we’re looking to sell and then creating expectations. They’re ready to go spend the money they’re going to make.
Adam Hooper – Right. Once you tell them it’s on the market, the dollar signs are already in their pocket.
Tim Wallen – All of a sudden they want to buy that second home in Florida with that money and they’re all excited about that and then you disappoint them, because you didn’t achieve the price you wanted. So typically we tell people we’re thinking about selling it. If we’re putting it on the market, we’ll tell them it’s up for sale now, but say, “Don’t spend your money yet, because we actually have to get a buyer that’s willing to pay us the price we want.” And then obviously, we’ll communicate that we went from a selling process to signing a contract and we’re expecting a close in 60 days or 75 days. We’ll communicate that to our investment community. We do quarterly reports, on all of our properties and all of our funds, that are very detailed and we do a detail of each asset on that. So if we’re in the process of selling that will be in the quarterly report and then we’ll also do some email blasts to communicate as well.
Adam Hooper – You mentioned you bought this one 4.7, sold it 7 million. That sounds like, in 24 months, a pretty darn good return. What did that end up at net realized investor level returns?
Tim Wallen – The projected returns on the front side was a little over 15% IRR to the investors. That’s assuming the five year hold. And the investors ended up achieving a little over 28% on the money, that a 1.83 multiple on equity in 2 years. We sold it 46,000 a unit, when the projection was 45 a unit. Obviously greatly enhanced the returns. What was really cool about that, now they can take that money and invest in something else and multiply that again doing something else. It’s very, very powerful in the investment mathematics.
Adam Hooper – Yeah, that’s a great return. To temper listeners out there: those deals are not as readily available these days, going forward, as they were back when you guys acquired this one, right?
Tim Wallen – It is really hard to find deals that achieve that. That is not the normal of our industry. I will say it’s kind of interesting in our fund too though, we’re literally taking half the assets and putting them up for sale right now and we’re three years into the fund and we’re achieving our five year thing in three years. But it’s hard. In fund 3 we’ve bought 15 properties in the last year. It really comes down to now is you got to find somebody who’s making a mistake with their asset. It can be their expense is too high, rents too low, there’s a missed opportunity that they’re not fixing up their asset. You can’t just buy anything and expect the market to take care of you like it has the last five years.
Adam Hooper – Especially at this point in the cycle, right?
Tim Wallen – Yeah, this point in the cycle you’re really looking for somebody who’s making a mistake on an asset that you can fix.
Adam Hooper – And that’s, as we’ve talked about before, one of the things that we’re trying to do in educating investors is helping their expectations of what a realistic return in this asset class stay in line with the reality of what the market is right now. I think that’s a key point you just made, get those deals where you’re really able to unlock that value; you have to, at this point in the cycle, find something that somebody has missed for one reason or another. The early days it was hard to find some bad deals. A lot of people made a lot of really good money in this last 5, 6, 7 years of the cycle, but you got to be more prudent and find a little bit something extra, to be able to get those outsized returns, where we’re at in this stage of the game.
Tim Wallen – The reality of, take the Atlanta market. They’re seeing a rent growth of 6% a year for a couple of years there. That’s not sustainable. You could have bought anything in Atlanta and you were going to make money and we saw deals that we passed on, because you had to assume 6% rent growth and you weren’t even doing property improvements. It’s like how can you assume that. But people bought those deals and it worked out for them, because the market delivered above historic norms as far as rent growth, but that’s not sustainable. We are definitely in a stabilized environment and you really have to reduce your expectations on returns, but you still can find the needles in the haystack and it’s, again, driven by somebody else making a mistake.
Adam Hooper – You just got to look at 60 deals a month to get there.
Tim Wallen – That’s all. A little work.
Adam Hooper – Thank you. That’s a great rundown of what happened at Northwoods. Again, there’s a number of investors that were in that deal and we appreciate the opportunity to have worked on that with you guys.
Tim Wallen – Thank you. I appreciate it as well.
Tyler Stewart – Tim, I know a lot of investors ask, what’s the process on the investor side when you exit a deal. What’s timing look like for when investors see that return? What are the tax documents involved? Can you just kind of go over the process for the investor?
Tim Wallen – Sure. You do all your work. You do your due diligence. You put your offering documents together. You raise your capital. The investors have to sign a subscription document, typically, committing to a certain dollar amount. They provide the capital maybe two weeks before closing. You close the purchase. Each shop’s a little different on how they do it. Some shops send out distributions monthly. We send our distributions out quarterly and we send out financials and post them and have a lot of transparency on that. Again, there’s a variety of tools out there that allow investors to get good information, so each firm’s a little different. Most firms provide good data, transparency on the financial statements, show some pictures of the improvements that are being done and giving good communication on the performance of the asset, whether they’re ahead or behind on their plan. We, inside our shop, do send out projections of taxable income, usually by the first week of December, so when they’re doing their year end tax planning, they have an idea of how much taxable income if any that they’re going to have flowing through to them when they file the personal tax return. Then we look to have K-1s … K-1s are the tax form to show your share of taxable income to show on your personal tax return. And those K-1s we look to have to investors by no later than March 15, so that the investors don’t have to extend their tax returns. I will say, doing this for 30 years, that investors get very annoyed if you delivered you K-1s past April 15.
Tim Wallen – So I would say if you’re investing with a sponsor, you should ask them how timely are they on delivering K-1s, because that can be an annoyance if you’re forced to extend, if you don’t like extending. Some people don’t mind, but some people really do mind and you should ask about that and the process for getting K-1s out on a timely basis.
Tyler Stewart – And then on the actual exit, so when you sell the property, say you officially closed on the deal with the buyer today, how many days out until the investor sees the full return from the investment?
Tim Wallen – We close an asset today. We probably would be wiring out 95% of that cash within a week’s time, max, usually a couple days. We do hold some cash back for those bills that trickle in post closing, because you, as a manager and owner of an asset are responsible for operating expenses incurred prior to closing. So do that, hold back some cash for those anticipated expenses. So we hold back, obviously, a surplus with a reserve beyond what expect, to be careful. We pay those remaining bills and once we pay those remaining bills, we send off the balance of the cash out to investors, which typically is more like … It’s typically 30 to 60 days after the close, because you got to make sure you got all the bills in and it’s hard to get the money back if the bill comes in later. So we hold a nice reserve to do that.
Tyler Stewart – Is that common, an investor would receive 90 to 95% of the return almost upfront and then over time, as you close out the remaining costs, then they’d see the full benefit of the return?
Tim Wallen – Yeah, that’s very common in the industry, very common.
Adam Hooper – So what’s next for MLG? What are you guys seeing here, as 2018 plays out? Are you guys looking in new markets or keeping disciplined with the markets you’re in and how does the landscape look for you guys, going forward?
Tim Wallen – Obviously we’re operating in a more stable investment, but we’ve been doing this for 30 years and most of the time you’re in stable environments. 2009 is the exception. It’s not how it normally is. Last time we had a material event like that in commercial real estate was late in the 1980s, coming out of the savings and loan crisis. So it’s not common that we have events like the last seven years. So we’re in a stable environment. You have to work hard, chase hard. We’re focused on markets that have good population growth, job growth type markets, other than my state of Wisconsin where we’re local. We don’t really have a lot of population growth and job growth, but we still do deals here, because we find people who make mistakes in assets. The main thing for us is we find smart deals, deals that make sense, assumptions that look real. Our goal’s still to buy roughly 300 million in assets per year. We have not reduced that, because the market’s tighter or flatter. It just means that we have to work harder and that’s why we expanded the number of states that we’re chasing in, because we have to increase the deal flow coming at us, so we can source the volume of deals that we want to actually close. Got to keep hiring great talent. You need people to do this business, so we’re always hiring great talent, smart people got good personalities. It’s critical to what we do.
Adam Hooper – And we’ll give a little shout out to Andy Sinclair. I know he’s in the room there with you and he’s the primary interface, I think, with a lot of investors in RealCrowd. Thanks.
Tim Wallen – Andy is great one. We talked about those thousands of real estate folks around the country, Andy is very active with a lot of those folks himself personally. He does a great job doing that.
Adam Hooper – Perfect. Well Tim, is there anything else that you want to add that we didn’t touch on that you think would be important to get our there today or you think we did a pretty good job of covering Northwoods from start to finish?
Tim Wallen – Yeah. I would ask me your question did I learn anything from this experience, because I got a little plug for you guys, so you should ask for that.
Adam Hooper – So Tim, did you learn anything from this experience?
Tim Wallen – Yeah, you know, I was really surprised. I think RealCrowd’s done a great job with bringing the investment community to private real estate and allowing real estate companies to be able to attract capital for their deals. Honestly, I was skeptical that people would invest over the internet and I’m so used to the most people that invest with real estate folks, there’s such a trust decision there that they really trust that person, they know them from school or kids’ activities or the country club or wherever they met these people, there’s a high degree of trust that goes into investing with real estate folks. So I was really skeptical that that could be accomplished over the internet on a material basis, but it’s working and it’s happening, so I congratulate you guys at RealCrowd for making that happen and we certainly appreciated the relationship and working with you with the three different things we’ve done so far.
Adam Hooper – Thank you. That’s a very nice complement.
Tyler Stewart – Yeah, that was actually a great question and a great answer by you. Thank you.
Adam Hooper – A lot of why we started this company was to help people build relationships. As a real estate person, there’s still a huge reliance on the relationship side of the business and I think that’s why we’ve approached it as we have with that direct relationship between the manager and the investor versus some of the other models out there where there is that buffer, that insulation and the investor doesn’t ever get to really build that relationship or have the opportunity to have that connection or even just the underlying security of investing in the actual asset itself. So that’s very reassuring to hear. Thank you for that compliment. That’s very nice.
Tim Wallen – Happy to share it.
Andy Sinclair – Hey Adam, can I add something.
Adam Hooper – Sure. And that’s Andy Sinclair right there.
Andy Sinclair – Adam, I think one thing I would compliment your group on in particular you’ve done is trying to find good sponsors that are doing deals with safe assumptions that might make economic sense. I think it’s easy to put anything on the internet and let assumptions get swept into the internet very quickly, so I would compliment your team for being on the investor’s side to look out for what’s the right type of deal, but also the sponsor group as well. So I think RealCrowd’s done a very good job. It’s something that MLG focuses on. It’s not just the numbers, but it’s also the people that are involved and the right deals.
Tyler Stewart – Man, I’m glad we opened this up for more comments.
Adam Hooper – Thank you. I agree and that’s very core to what we do is making sure that the groups that we’re working with are best caliber, best in class and we’re always doing work on our side. We’ve got some products and announcements we’re going to be rolling out here shortly on that side, to help investors make the right decisions. I think a lot of people that are coming into this asset class for the first time, they’re not real estate experts, so they are kind of coming into this with a bit of a knowledge disadvantage. That’s a lot of why we do the podcast and helping educate people to make better decisions and having the right groups to partner with and the right managers to make those decisions on their behalf is something that we’ve always taken great pride in, on our platform, the caliber of groups that we work with, so thank you. All right Tyler. Well that was great from Tim. What else do we have for listeners today?
Tyler Stewart – We have Woody, a listener who has gone through RealCrowd University and is going to share his experience with the course. Woody, thank you for joining us. You have a pretty interesting background. Could you describe it for our listeners.
Woody – Okay, well thanks for having me. Honestly, I don’t think my background is interesting as some people might. I’m actually retired now. Been retired for about four years. I did spend about 30 years working for a couple different banks in the financial operations management area. Prior to that I grew up in Tennessee, went to college in New Orleans, Tulane University. I got a degree in economics there, MBA in accounting and finance. After I got out of college, I went to Texas, which is really where I got into bank operations and really pretty much built my career on that, a lot about managing people. I didn’t really work in the financial analysis part of banks. It was more about the managing and the transactions that go on behind the scenes.
Tyler Stewart – So a financial background, now in retirement. How come you signed up on RealCrowd?
Woody – That’s kind of an interesting story. Having retired a few years ago, one of the things I tried to do was get caught up with some old friends, people I kind of lost connection with over the years. One guy in particular who I was talking with, we kind of gone our different ways after college. We lived in different places and we didn’t keep up. Got a chance to catch up with him. We talked about some of the investing that we’d each done over the last 30 years and I talked a lot about investing in stocks, about all the different experiences I’d had and he talked quite a bit about investing in commercial real estate. For me, that’s kind of when the light bulb went on. It’s a whole asset class that I had never really paid any attention to and I though this sounds pretty interesting, because I took note that a lot of these kinds of investments tend to go on for quite a few years and I think of myself as a long term investor. When I buy stocks I buy them for some time and I research the companies and I buy the companies and hold them. I don’t trade. So I found real estate to be interesting and really just hit the internet and started looking at all the various real estate investment websites that are out there today. When I came upon RealCrowd, I guess you might say I kind of got hooked on it, so I’ve spent a lot of time in the website doing various things.
Tyler Stewart – Now you’ve been going through the educational material that’s part of RealCrowd University. What are some of the keys you’ve learned from the course?
Woody – I think as starters, for me, it would be that I’ve learned some of the standard terminologies that go on when you’re talking about real estate investment, things like: cap rates, capital stack, cash on cash return, hurdle rates, IRR, equity multiple. And those aren’t terminologies that I don’t really understand what they are. I know what an IRR is, but how is it used in real estate specifically and what is IRR composed of. As a for instance, there’s an annual cash component and then there’s sort of an exit value component and that you have to look at those different pieces of IRR. So that’s what’s really been valuable is to look at those terminologies and understand how they’re used, what they consist of and what you need to be looking for. Another thing, I think, is about diversification. I’m familiar with sector and style diversification. That’s common to stock. With real estate you get a little bit more into geographic concentration. You also have to think a lot about what’s your position in the capital stack, what’s your diversification there. And then another piece that I thought was very interesting that I heard in one of the podcasts the other day was about vantage risk, putting all your money into some real estate investments at the same time such that they might all mature near the same time and if that sort of thing happens, you could be caught at a not so great point in the economic cycle where you’re coming out of all your investments and then maybe having to go back into stuff and redeploy your cash at the same time.
Woody – So that was something really valuable to think about as well. I think the last one that’s really been drilled into me, as part of the training in RealCrowd U is you need to read the PPM. No matter how boring it is, there’s going to be something in there that’s valuable to you to decide whether you want to invest in this deal or not.
Tyler Stewart – Absolutely. On that note, do you have a method for reading the PPM or are you pouring a beverage and going through the PPM all at once? What’s your process for reading the PPM?
Woody – Well, I’ll have to be honest with. I bore easily, so when I start reading a PPM, there is going to be a lot of boilerplate language in there and I know it’s boilerplate, but a lot of times, within that boilerplate language, certain things are layered in there that are specifically relevant to that deal. So you have to be looking out for that. So yeah, I will sit down and try to get focused and start going through it page by page and I’ll try to highlight what I think are the special things that are really specific to this deal, that are very relevant, there not just standard terminology, they really tell me something about this deal. Then when I’ve done that highlighting, I go back through later, because I don’t do all this in one sitting. It could take me several shots at it to get through a PPM. As you well know, they range on up to like 100 pages. And I’ll come back, I look at what I’ve highlighted, I’ll see if I see anything else and then I’ll start making notes, because those are the questions I really want to ask to the investor relations person before I go into an investment. What can you tell me more about this, because I want to understand a little something more about it. As an example, if I see an exit cap rate that’s substantially lower than the entry cap rate, how do they justify that? It is a value add project that you can see something that’s going to be added there that will lower that cap rate on exit or is there some other reason that you’re not aware of? And you can also look at those things relative to the kind of deal that you’re reading about.
Woody – So like if you see a really high IRR on a core plus deal that means there is probably a lot of exit value anticipated there and you don’t normally see a huge amount of exit value on a core plus deal, so that would be something to ask about.
Tyler Stewart – Well that’s great Woody. And what tips would you give to listeners who are looking to learn more about commercial real estate?
Woody – I would say really, to everybody that would listen to this is, really RealCrowd and RealCrowd U just have a huge number of reference and learning tools available. When I really stop and look at what you guys have on your website, I think that this is really a … It really is, RealCrowd U really is, for me, kind of some college level teaching about how to invest in real estate and the great thing is it’s free. We talk a lot about wanting free education. Well this is a free education and it think it’s one that is likely, if you really go through it, to put some more money in your pocket down the road, because you’re going to learn something that will tell you about what you should or should not be investing in and it will help you ask the right questions. So it probably is going to either put some money in your pocket or save you the loss of some money, potentially, later, if you really do all this learning and there’s a huge amount available. For me, it’s been very high quality, especially the way you guys have sponsors on there and they go through … They’re not selling their stuff. They’re going through explaining to you here are the tricks of the trade, here’s what people do, here’s some of the kinds of things that happen when PPMs are put together and here are the things you should be looking for, because these are the risk points. So I just think it’s extremely valuable and it’s something, like I say, once I got into RealCrowd U I’ve just been pretty hooked on it.
Tyler Stewart – Wow. I couldn’t have said it better myself. Woody, thank you so much for joining us on the podcast. Listeners, if you want to learn more about RealCrowd University, head to realcrowduniversity.com. Thanks Woody.
Woody – Okay. Thanks Tyler.
Adam Hooper – All right listeners, that’s all we’ve got for you today. Thanks for listening to another episode of the podcast. As always, if you have any questions or comments or feedback, if you want to rate us go to iTunes, Google Play, SoundCloud, wherever you listen or send us an email to email@example.com and to sign up for the course that you just heard about from Woody, you can go to realcrowduniversity.com. Thanks for listening and we’ll catch you on the next one.
Real Crowd – This podcast is brought to you by RealCrowd, the leader in online real estate investing. Visit realcrowd.com, to learn more about how we provide our members with direct access to commercial real estate investments. Don’t forget to subscribe the podcast on iTunes, Google Music or SoundCloud. RealCrowd, invest smarter.