Interested in what is currently happening with multifamily in Los Angeles, San Francisco, Portland, and Seattle? Then this episode is for you.
Max Sharkansky, Co-Founder & Managing Partner of Trion Properties, joined us in-studio to provide an in-depth look at multifamily on the West Coast.
In this episode you will learn:
- What is currently happening in the West Coast market
- Why Max's hold period strategy has changed given current market conditions
- What markets to keep an eye on for future opportunity
RealCrowd - 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 - Tyler, I'm great. Thanks for asking.
Tyler Stewart - Absolutely. I always like to check in and just see how you're doing.
Adam Hooper - I appreciate that.
Tyler Stewart - Yeah.
Adam Hooper - Who do we have in the studio today?
Tyler Stewart - Today, we have Max Sharkansky, co-founder of Trion Properties.
Adam Hooper - Yeah, Max has been a supporter and sponsor of RealCrowd from the very beginning.
Tyler Stewart - Yeah.
Adam Hooper - We did deals with him back in--
Tyler Stewart - 2014.
Adam Hooper - 2014, four deals I think we've done with these guys.
Tyler Stewart - Yeah.
Adam Hooper - Individual assets funds, It was great to have Max here in Portland in the studio. They own a couple assets up this way, trying to buy more. Good conversation with Max, we've got some insights on how they operate, what they look for in markets. Interesting point on where we're at in the cycle that you'll have to listen for, calling this almost a subcycle of the overall cycle, which I thought was pretty interesting.
Tyler Stewart - That was an interesting take, yeah, and if you're interested in what's happening on the West Coast, whether it's L.A., San Diego, San Francisco, Portland, Seattle, Max kind of dove into it all and this'd be a great way to get a quick update on what's happening here on the West Coast.
Adam Hooper - Yeah, talked about a few new markets they're looking at as well and also their thoughts on timing too and looking at things, especially this part of the cycle, looking at things a longer-term horizon, kind of resetting expectations of what returns are going to be where we're at right now and going forward, so it should be some pretty insightful tidbits in there for our listeners and I think another great episode.
Tyler Stewart - Absolutely, yeah, listen for the contrast between a short-term hold and a long-term hold. It was a good take from Max.
Adam Hooper - Yeah, and they've been through that, right. They were buying deals earlier in the cycle with a very different strategy than what they're up to now given the timing so.
Tyler Stewart - Stay tuned, listen on.
Adam Hooper - All right, well, as always, listeners out there, if you have any comments or questions or anybody you want us to talk to or topics you'd like us to cover, send us an email to podcast@realcrowd.com and with that, let's get to it.
RealCrowd - 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 to the podcast on iTunes, Google Music or SoundCloud. RealCrowd, invest smarter.
Adam Hooper - Max, thanks for joining us today in the studio here in Portland.
Max Sharkansky - Thank you for having me.
Adam Hooper - Good to see you as always, we actually got some, you brought some sunshine up for us, which is nice.
Max Sharkansky - Yes, I did.
Adam Hooper - So let's go a little bit back, and we've done four deals together now.
Max Sharkansky - We have.
Adam Hooper - A couple individual assets, a fund. Why don't you take us back before that. How did you get into real estate, what's your story?
Max Sharkansky - I got into real estate straight out of college. I loved the concept of real estate. I loved the concept of real estate development, changing the community, changing the neighborhoods, adding housing, adding retail, adding office space and the creation of communities and the development of communities, and that was, you know, those were my thoughts while I was in college so I got into real estate straight out of college and got a job at Marcus & Millichap as a broker. I was brokering multifamily in the San Fernando Valley and my partner Mitch, who you guys know very well, he was on the debt side working at HFF, and we were best friends from college, from JC, he went to USC, I went to LMU, which is actually how we got the name Trion. Trion is Trojan and Lion.
Adam Hooper - There you go.
Max Sharkansky - So we started, neither of us wanted to be on intermediary side for the rest of our lives. We just we want to own and do that full time. We started buying value-add multifamily in the San Fernando Valley, naturally, that's where I was brokering and had market knowledge. This was in '05 and we continued to buy into '06 and we're doing great with it, we're really enjoying it and it just really opened up a new world for us. So end of '06, we left and we opened up our own shop. We continue to buy through the loss cycle. We aggregated a small portfolio and we sold it in '08 prior to the crash.
Adam Hooper - Good timing.
Max Sharkansky - Yes, yes. That's worked out, we were fortunate to have a good timing. We had a couple deals trickle into the first quarter of '09, but we made it out okay. One of them, we actually sold at a profit because we were able to increase rent so much that it didn't matter that cap rates were up couple hundred basis points. So we did that and then as were selling in '08, we changed our acquisition strategy from buying value-add multifamily to buying nonperforming debt secured by multifamily.
Adam Hooper - Yep.
Max Sharkansky - With what was going on with cap rates going up and rents going down, value add kind of went out the window. People weren't paying extra for granite counter tops. They just wanted somewhere to live and that was also during the first wave of defaults, so we started targeting that and we had a great run during the downturn. That lasted a last few years and then end of '12, early '13, we picked off our last REO first quarter of 2013 and then went back to the value-add space just on a larger level.
Adam Hooper - And now you guys are up to, we were talking this morning, around a thousand units?
Max Sharkansky - Yeah. We're a thousand units in portfolio right now. With everything we have in contract, we'll be a little over 1,200 in the next 90 days or so.
Adam Hooper - Good, and we said you guys are net buyers right now.
Max Sharkansky - We are net buyers.
Adam Hooper - Still selling some projects, but overall still trying to acquire more.
Max Sharkansky - Yeah, we're selling projects right now. We think it is still a good time to buy. We like the fundamentals macro that are happening in the economy, but at the same time, prices, yields are low and they're low on everything, so we're taking advantage of that by selling some of our non-core stuff that we don't want to hold forever.
Adam Hooper - Yeah, that's what--
Max Sharkansky - It's really a upgrade of a portfolio.
Adam Hooper - Yeah, that's what we were talking about breakfast this morning is the expectations of acceptable returns two, three, four years ago are not there in today's markets, right? We're heard that across the board. The financials, the deals, the yield is deafly compressed because there is a lot of capital-chasing deals. There are a lot of good fundamentals going out there. How have of you guys had to reshape or rethink your acquisition strategies now that you're seeing a little bit tighter yields on these deals or have you?
Max Sharkansky - Yeah, absolutely. First and foremost, you'd be a fool not to look at interest rates in that environment, I mean we are now officially in a rising interest rate environment, so we've had to change our underwriting and we're underwriting, in our model, we underwrite everything with year two refi and so we're underwriting the higher interest rate on the take-out debt, and then we're also underwriting a higher cap rate on the exit cap.
Adam Hooper - So let's unpack a little bit, so year two refi, so you put acquisition debt on.
Max Sharkansky - Correct.
Adam Hooper - You go through and you renovate units, you add that value and then you put new debt on in year two. And you're saying that that new debt that you're forecasting in year two is going to be at a higher interest rate than the debt you put on to acquire it today.
Max Sharkansky - Yes, and at a higher, well, no, no, no, no, sorry. That's not true. Actually, the cost of capital may go down, but the way we were underwriting a couple years ago, the cost of that takeout debt is now more expensive than it was a couple years ago.
Adam Hooper - Right.
Max Sharkansky - And we have to factor that in.
Adam Hooper - Okay, so your bridge loan acquisition, so your actual interest rate may be lower than what your bridge financing is going in.
Max Sharkansky - Correct, correct.
Adam Hooper - Because it's permanent financing, which we just talked with Alicia on our last podcast.
Max Sharkansky - Lower risk.
Adam Hooper - Lower risk, lower rate, but the rate that you're taking that loan out is higher than it would've been two years ago.
Max Sharkansky - That's right.
Adam Hooper - Okay, and by how much do you think, what are you guys forecasting in there?
Max Sharkansky - So I would say we're probably popping rates on that by about 50 basis points.
Adam Hooper - Okay.
Max Sharkansky - So that affects it.
Adam Hooper - It's appreciable.
Max Sharkansky - Yeah.
Adam Hooper - Yeah, that's a pretty big, that's pretty bump. How does that affect your acquisitions going in?
Max Sharkansky - Everything's gets tighter, so it really affects the profit margins and I'd say we're still doing deals at IRR threshold that are very acceptable to our investors. We were more picky in the past with our IRRs. We were really targeting IRRs at like low 20s project level, high teens, 19, 20 investor level and we were working on smaller deals so that was easier to find. Now, it's peaking, there's a lot more in the marketplace. We've also gone up market in terms of deal size and deal quality, so you factor all these things in, the rise in interest rates, the rise in cap rate, or projected rise in cap rates. They haven't really gone up yet, and those numbers go down by about three, 400 basis points, so now we're lucky to find a deal in the high teens on an IRR level and mid-teens, IRR project level rather, and mid-teens investor level.
Adam Hooper - Well, since you brought up investors, we were also talking at breakfast this morning about an interesting little connection with an investor that you met through RealCrowd.
Max Sharkansky - That's right, that's right.
Adam Hooper - You want to tell us a little bit about that?
Max Sharkansky - Yes, yes, through the first deal that we ever crowded funded with guys, that was back in 2014. One of our investors is an anesthesiologist at a local hospital and in 2016, when my wife went into labor with our first son, he happened to be the anesthesiologist on staff and he gave my wife her epidural. He administered the epidural and was in the room when her doctor delivered the baby. So I believe the order was as follows: I hugged my mother-in-law, I hugged my doctor and then I hugged him. So that's about, as you said at breakfast, as intimate as it gets between sponsor and investor.
Adam Hooper - That's good. We're making miracles happen here at RealCrowd.
Max Sharkansky - Absolutely, absolutely.
Adam Hooper - That's a funny story, I think that is the most involved, I think, investor story that we've got.
Max Sharkansky - That's great.
Adam Hooper - Yeah. So I mean on the investor side, that's one of the things that we've talked about a lot on the podcast is trying to help reset expectations of returns, right? I think what you just said, you're seeing deals today are three, 400 basis points net to investor tighter than they would've been two, three years ago.
Max Sharkansky - At least.
Adam Hooper - And given where we're at in the cycle, do you guys expect that to continue to tighten, is it going to kind of level out? I mean, again, crystal ball time, but do you see that as a continuing thing or are we there?
Max Sharkansky - I would say that's a continuing thing. I would tell all investors reset your expectations and not only on just projections and what you've seen in terms of projections over the last few years, but performance and a lot of these deals, even though we were projecting 20 IRRs investor level, we outperformed that significantly.
Adam Hooper - Right.
Max Sharkansky - I mean we had a lot of deals 30, 40 because there was this huge tailwind over the last five years, coming out of the crisis, supply-demand imbalance in markets that we're buying, cap-right compression, rent growth. I mean it was just like this Goldilocks phase in the cycle and I think the easy money's behind us and you should set your expectations for a more normalized cycle, subcycle call it. Things have changed, we have a new administration in office, there's new policy, rising interest rates. Things are changing, so I wouldn't say we're in a new cycle, but we're probably in a new subcycle, so just prepare yourselves for, in our industry, low- to mid-teens IRRs and if you're getting a 13 to 15 IRR investor level, that is still a very, very strong return.
Adam Hooper - That's a very good good return, yeah.
Max Sharkansky - You're significantly outperforming S&P 500. You're in a very strong asset class in very strong markets and there is nothing wrong with a 13-to-15% compounded return on a five-year hold period.
Adam Hooper - Yeah, and so are you seeing any difference amongst the markets that you guys are in? I know we talked about you're looking at a few new markets but is that pretty consistent across the board or is it more amplified in certain markets over others?
Max Sharkansky - I think some of the gateway markets are priced through the roof and that's where we've been disciplined, and we have not bought in some of those markets recently so...
Adam Hooper - Which would be your L.A., San Francisco, Seattle.
Max Sharkansky - Right, going more micro, we're, so our four core markets are San Diego, L.A., Bay Area, Portland, Oregon. We have in the last couple years, we have not been able to find much opportunity in San Diego and L.A. just because the yields have gotten so tight. People are, you've got value-add players that are underwriting to a return on cost of say, five to five and a quarter in Southern California, L.A. and San Diego and you've got exits of 4.75. We're just not in the business of breaking even or taking unnecessary risk for very small returns. ut we've been able to find a tremendous amount of value in East Bay, in Portland and in more high-growth gentrifying markets.
Adam Hooper - And then you guys are looking at some new markets for acquisitions this year?
Max Sharkansky - We are, we're looking at Seattle and we're looking at Salt Lake. I have a feeling in Seattle, we might find some of the attributes that we've been finding in San Diego and L.A. and we might have a hard time investing there, although we're looking at some of the outlying markets, not just core Seattle, so we'll see how that goes. Then Salt Lake has just phenomenal fundamentals, very supply constrained, high population growth, high job growth, high quality of life, just everything that we look for as an investor in a submarket.
Adam Hooper - And so the main things that you guys look for are, again, you said employment, jobs, right?
Max Sharkansky - Correct.
Adam Hooper - People growth, supply constrained, are those kind of the big three that you guys are looking for when you look at new markets?
Max Sharkansky - Yes, that's it, when we came into Portland, we were flying up here once every couple weeks and we fell in love with the city itself, we feel in love, the restaurants, the lay of the land. We said, okay, this is a cool place to live. We could see the big millennial draw here. Then we started looking into more of the economic data. Who are the major employers, what is their growth? Are they expanding, and we were able to check all those boxes with Nike, with Intel, with Salesforce, with everything that Nike has been able to create as probably an unintended consequence where Adidas, Columbia, Under Armour have all come in and they're and growing so now Portland has become the sports apparel capital of the world. So you just have these phenomenal economic drivers. Then on the supply side, it's a filled-in market, very supply constrained; it's not easy to just go buy a swatch of land like you can in Phoenix or Vegas
Adam Hooper - Right.
Max Sharkansky - And build 400 units. That'll put us out of business so those are all the boxes that we check.
Tyler Stewart - So you have a market on the surface you like. You go visit that market, see if this is a place I'd want to live and then you really dive into the economics after you determine if it's a place you want to be at.
Max Sharkansky - Absolutely.
Adam Hooper - And then what's the tipping point that says, okay, we're in, we're going to go buy something there? How does that go from market we like to market we're now in?
Max Sharkansky - So we will check all the boxes, right? So we'll have a team meeting and we'll decide do we want to start pursuing this and then acquisitions team will start tearing through the comps, calling the brokers and we start to write offers. Our acquisition strategy is we'll start to write offers on marketed stuff. We typically don't win widely marketed stuff, but the brokers will call us after we see how we behave, how we underwrite, we'll come close to winning but we won't necessarily win, so they know that we're not just low ballers and then ideally, they'll start showing us off-market product.
Adam Hooper - Right, and that's where, again, I guess I'm curious, so everyone says in real estate, you make your money on buy.
Max Sharkansky - That's right.
Adam Hooper - But you have to have an exit for that, too, right?
Max Sharkansky - Right.
Adam Hooper - So in this kind of changing market later in the cycle, what are you guys thinking about exits? Has that changed for you guys based off of how you're looking at deals three, four years ago, what is your exit strategy now? Has that changed or is it going to change?
Max Sharkansky - So with regards to actual just finance underwriting, like I mentioned earlier, we are underwriting higher exit caps because of rising interest rates. We are looking at higher quality product and we're looking at a longer time horizon. We're not really showing anything anymore on a three-year hold strategy. I don't know that I, I don't want to buy anything anymore that i feel isn't really something that I'd want to own long term in case something went wrong in the market.
Adam Hooper - Yeah.
Max Sharkansky - So some of that inferior product that might be underparked or have tiny units are funky floor plans, we'll just take a pass on it. Whereas, a few years ago, we felt that there'd be enough tail wind or that we were not far enough into the cycle, I should say to where we might be able to buy a funky piece of real estate, make it work and then just get out of it, which we've done successfully many, many times.
Adam Hooper - Yeah.
Max Sharkansky - We're actually closing on an escrow today on a property in L.A. that's got 300-square-foot units and the one-bedrooms, the bedrooms are probably 90 square feet so...
Adam Hooper - That's tiny.
Max Sharkansky - And there's no parking, so I wouldn't buy that today.
Adam Hooper - Right.
Max Sharkansky - But we bought it a couple years ago. We're going to do well. We'll make, you know, make mid-teens IRR and it's a double and that's not product we'd look at today.
Adam Hooper - I think that's, we've talked about that before. What you just said there I think is really insightful, buying things today that you're okay holding long term because we are again in the cycle, right? So so you can't guarantee a two- to three-year takeout like we would've been able to back in 2012, '13, you acquiring those deals, so looking at a longer-term horizon and being okay holding something long term, if there's any fluctuation in the market, if anything happens, you're okay operating that asset on a long-term basis, which, I think, is, again, from a risk-adjusted standpoint, makes a lot of sense.
Max Sharkansky - Absolutely and we saw firsthand because we were extremely active and did a lot of transactions during the downturn. We saw what went back, we saw what didn't go back. The great product in great submarkets was fine, I mean vacancy went from 3% to 8%. Rents went down by 10, 15%, if you weren't over-levered, you're fine, you make it out of there. You have light cash flow for a couple years and then it trends back up. But if you had too much debt on the property, if you've got under-parked assets in markets that aren't very supply constrained like the Vegases, the Phoenixes, they just got crushed and it's very difficult to the cycle out of that.
Tyler Stewart - Now we have some listeners who would say wait a second. A shorter-term hold, isn't that less risk? What would you say to that given this market?
Max Sharkansky - I don't know that a shorter-term hold is necessarily less risk. If you stabilize an asset with great tenants and great improvements and you don't over-lever it, I don't know that you've got a risky asset on your hands.
Tyler Stewart - Yeah.
Max Sharkansky - Especially if it's in a great submarket, part of the reason we came into Portland, that's one of the other boxes that we check is how did this market do during the downturn? And our philosophy is we're going to buy in markets that do well when times are bad, not in the market when times are good. So we're fine and I think all of our investors are fine owning and operating in strong markets like the Bay Area and Portland and Southern California when times are bad. So if your cash flow goes from 12 to four for a couple years, but then cycles back up to nine and then your asset value goes back up and you can refi again and take some cash out tax free, there's nothing wrong with that.
Tyler Stewart - Yeah, so will longer-term hold, you can ride the greater trend, the underlying trend. Shorter-term holds, that's more about timing the market.
Max Sharkansky - Correct, correct.
Tyler Stewart - Yeah.
Max Sharkansky - Maybe selling some small stuff, we'll do that too, like we're buying a portfolio right now here locally in Portland and one of the properties is on the smaller side. So we'll do like value add and probably flip out of it in a year, not because it's a bad asset, but just because it's on the smaller side and just inefficient for us to manage long term, so we'll do stuff like that.
Adam Hooper - So when you guys acquire new assets, what's your typical timeline in terms of being able to get in and do the value add?
Max Sharkansky - It's typically--
Adam Hooper - It depends on deal-by-deal basis, probably, right?
Max Sharkansky - Sure, of course, of course, depending on the size. So it's typically taking us 13, 14 to as long as maybe like 18, 19 months. We really try to refi by month 18, 19, especially now that I think this is where timing can not be your best friend is that in a rising interest rate environment, you definitely want to refi as fast as possible. So that's where we really try to put the pedal to the metal and execute as fast as possible.
Adam Hooper - And so when you're looking at new markets, or I guess even your existing markets, walk us through a little bit of your acquisition process looks like, so there's any number of deals that are marketed, any number of deals that are presented to you guys off market, can you kind of take us step-by-step for listeners out there? What does the acquisition process look like from deal hitting your desk through to diligence and closing?
Max Sharkansky - Sure, so our director of acquisitions will usually source the deal on or off market. We'd give it to the underwriting team, the analyst and associate to underwrite, pull up all the most recent rent comps, pull up the most recent sales comps. Oftentimes, we're writing our own portfolio because we're just transacting in markets where we already own. Size up the deal, submit an LOI, go through that process, offer a counter, strike a deal, issue a PSA, then we go through our due diligence process. Our due diligence process is very thorough. We are not just hiring, a lot of sponsors will just hire a third party to do one PCA and they'll use that as kind of their source document and source due diligence for the physical condition of the property and for those of you who don't know what a PCA is, that's...
Adam Hooper - Yeah. I was writing down some acronyms--
Max Sharkansky - Yeah, yeah.
Adam Hooper - So LOA, letter of intent.
Max Sharkansky - Letter of intent, that's an offer.
Adam Hooper - So before you actually have a deal under contract and in escrow, you submit a letter of intent that says we want to buy this, these are the terms. We're going to base our eventual sales contract on the terms of this LOI negotiated.
Max Sharkansky - Correct, yes, correct. Or oftentimes we'll put, if the broker feels that we should put it into a contract, then we'll just write the offer similar to what we do on a house. You just write it on a contract and then you go back and forth that way.
Adam Hooper - And that was PSA that you said, Purchase Sale Agreement.
Max Sharkansky - Correct, Purchase Sale agreement.
Adam Hooper - And then we get to a PCA.
Max Sharkansky - I get to a PCA, not to be confused with a PSA. That is a Property Condition Assessment.
Adam Hooper - Yeah.
Max Sharkansky - And we do that as well. That's a very high level document and just gives you sort of a high-level bullet points of what needs to be done with the asset.
Adam Hooper - Physical condition of...
Max Sharkansky - Physical condition of asset, right.
Adam Hooper - Yeah.
Max Sharkansky - But then we're also, we're really focusing micro and we're getting a mold and asbestos person out there. We're getting a roofer, an electrician, a plumber and we're focusing. We're having a specialist tell us what was really under the hood, so that's a big part of it. We're ripping through all the leases, all the utility statements, every single document. I mean you live and you learn, right? We've done 40-plus deals and we've missed stuff during due diligence and we've done enough deals now where we've learned not to miss stuff, so we'll go as micro as looking at a tax bill so that we can catch any special assessments that are on a tax bill.
Adam Hooper - And so then physical due diligence, I mean you guys, like you said, you're on site. You're with these individual specialists and that's what you're up in Portland here today, right? Doing some diligence--
Max Sharkansky - Correct.
Adam Hooper - On some acquisitions.
Max Sharkansky - That's correct.
Adam Hooper - Prior to that, are there any or I guess what are some of the red flags that would just immediately dismiss for the review of a deal, or are there?
Max Sharkansky - I don't know that would necessarily dismiss it, but it would have us come back for a credit, which might not, well, with the seller that would dismiss it. There was one property, for example, that we had under contract here in Portland about a year ago where there was so much physical deferred maintenance. We came back for a massive credit 'cause that was the only way we would've done the deal. There was a spring underneath the building. There was mold everywhere.
Adam Hooper - Yikes.
Max Sharkansky - Yeah, there was we discovered that all the balconies and all the decks to be replaced because of dry rot and the seller had put virtually no capital back into the property over the last 20 years that they owned it. It was hazardous, it was hazardous for their tenants and not something they should have done and that's not a liability that we were going to purchase or pay for at that level, so we came back for credit and that didn't work out.
Adam Hooper - And so seller said--
Max Sharkansky - They walked.
Adam Hooper - No thanks.
Max Sharkansky - No thanks and yeah.
Adam Hooper - Yeah, and that's, I think we've been, gosh, at 160 deals we've done, there's been may be a handful that haven't actually closed but it does happen, right?
Max Sharkansky - Absolutely.
Adam Hooper - So where--
Max Sharkansky - That's why you do the due diligence.
Adam Hooper - Typically, I guess, timing wise just feel for investors that are listening out there, it does occasionally happen where you'll go through, you'll get deal docs signed and the deal doesn't close, right? So someone will get excited about a project, do their due diligence on the manager, on the deal, get excited about it and then all of a sudden, doesn't close. That's as part of business, unfortunately, right, I mean that just happens. At what point in that cycle are you raising capital or what is your investor communication throughout that process on those deals that don't come to fruition, how do you mitigate that or how do you can communicate that with potential investors out there?
Max Sharkansky - That's a that's a great question, so we'll do most of the due diligence prior to taking out to our investors. We would went and make a couple calls to our larger investors just to gauge their interest and see if they'd want to move forward, assuming everything checked out okay. We're not actually going to draft a PPM and start marketing it to investors until we know there's a 90%-plus chance that we're going to close on this deal.
Adam Hooper - Right.
Max Sharkansky - So we don't want to spin our own wheels, we don't want to spin our lawyers' wheels. We don't want to spin our investors' wheels, so we're going to do all of our due diligence up front.
Adam Hooper - And then on those deals, I mean you're coming out-of-pocket for all those costs, right? I mean that's a fairly--
Max Sharkansky - That's right.
Adam Hooper - Spendy process to go through the diligence and get all those reports done.
Max Sharkansky - That's correct, that's correct.
Adam Hooper - What would you, off the cuff, what would you guess a typical diligence process costs for an acquisition?
Max Sharkansky - Between 15 and $25,000.
Adam Hooper - Okay. Just for third-party reports and all of that.
Max Sharkansky - Yeah, well, because again, because we're very thorough. We used to do it for under 10, but you live and you learn. You miss stuff and like we had a building here in Portland where we missed the plumbing. We knew the plumbing was bad and we didn't realize it was as bad as it actually was and we had huge cost overruns. Everything worked out okay and ultimately, the deal will be okay, and everybody will do well on it, but we should've caught that up front and what we are doing now that we didn't do back then is we'll actually hire a plumber to get in there and check that the plumbing is still functional. Ssame with the electrical and same with the roof and HVAC.
Adam Hooper - All the stuff.
Max Sharkansky - All the stuff.
Adam Hooper - So when you're going to new markets do you have, are there additional steps that you you guys would do for diligence if you're looking at a market for the first time or is it pretty much diligence is the same in San Diego as it is in Seattle?
Max Sharkansky - I'm going to make a lot of phone calls. I would probably call even some of our friend, in the business, call them competitors and asked them, we're all friendly and ask them what they do differently in a Salt Lake versus a San Diego and there's going to be an answer. There are going to be quite a few things that are different because of the weather. Transacting in Southern California and operating in Southern California is like playing a video game in novice versus a cold-weather town, it's like expert.
Adam Hooper - Right.
Max Sharkansky - It's like playing Madden and Madden, so it's so really, really easy to operate in California. We had a drought for five years, so I didn't have a roof leak for five years and in Portland and Seattle, that's not going to happen.
Adam Hooper - Right.
Max Sharkansky - The number one most important thing I would say, and I don't think many people would argue this is, is moisture. So we're checking the windows. We're checking water intrusion. We're checking the roofs. We're checking all that stuff to make sure that we don't have mold issues and other issues where that are going to drive cost overruns.
Adam Hooper - So all that checks out, you're good. You get the equity financing from investors. You've got debt lined up, closing the asset, then what?
Max Sharkansky - Then we start the process. We start to increase rents. We start to renovate the exterior of the asset. We really try to get to the exterior as quickly as we can. The common area is the exterior because that's curb appeal. That's what people see. If we had an existing tenant that's on the fence between paying their rental increase and staying on as a tenant of the community, as a resident of the community or moving out, that could be the difference. So it's retention and new leasing and then from that point on, we'll have some vacancy because not everyone's going to want to pay market rent and we'll start with interior renovation. We'll try to do, if we're going fast, we'll try to do seven to nine units a month.
Adam Hooper - How do you phase that, is it just based on what units are unoccupied at that time or do you shuffle people inside the project to do big blocks? How do you phase that interior renovation process?
Max Sharkansky - That's a good question. So right now, we have a property in East Bay where it's pretty wide open, low density garden-style community and we're phasing it building by building. When we bought it, the entire rent roll was month-to-month, so it was really easy to do. If it's a more vertical interior hallway property, then we'll still try to do it in sections of the building, but if you're buying it from a somewhat decent operator, they're not going to have an entire rent roll that's month to month and people are going to be in lease, so you're just going to have to do it as leases are expiring.
Tyler Stewart - What are some of the common interior renovations you'll do?
Max Sharkansky - That also market to market, right? Because something that we'll do in the Bay Area where the rents are $3 a square foot will probably be a little bit higher end than something we'll do in Portland where the rents are $1.65 a square foot because we can't monetize those additional improvements. So typical what we're doing right now was we're doing the full wood vinyl plank flooring. If it's a '60s or '70s vintage asset, we'll usually tear out the kitchen as opposed to improving it, so we'll tear the whole thing out. We're putting in brand-new kitchen cabinets, quartz countertops, stainless steel appliances, under-mounted sink which looks really clean and more typical of what you see in a condo than a rental apartment because the labor on that is a little more expensive. We're tearing out the bathrooms. We're tearing out the sinks, we're putting in new vanities with brushed nickel finishes. We're doing the tub surrounds and were fully modernizing the asset. In the common area, we'll try to find some space for a fitness center. That's a huge selling point for the millennial tenant base. We're trying to just, we're fully upgrading the asset to a 2018 experience is what we're trying to do.
Adam Hooper - And then you said that sometimes you'll go and raise rents though even before you've done some of those improvements. Obviously, it's much easier to raise rents after you've done the improvements.
Max Sharkansky - Sure.
Adam Hooper - But when you're acquiring assets, you acquiring them because the rents are below market, right?
Max Sharkansky - Correct.
Adam Hooper - That's what creates the opportunity to add the value, so you go in on day one. You can start bringing those rents up to market and then as the units become available to rehab, renovate those and then get those all the way up to market.
Max Sharkansky - That's correct.
Adam Hooper - That's the strategy.
Max Sharkansky - Yes, and then as we're getting into phase two, phase three, phase four of the renovation, further along into the renovation, we're getting a lot of transfers. There are people who see what we're doing and that we care and that we're strong operators and they want to be a part of the community, so what we'll have, a lot of the times is we'll have people transfer from an unrenovated unit to a renovated unit...
Adam Hooper - Within the same project.
Max Sharkansky - Exactly.
Adam Hooper - Got it.
Max Sharkansky - And pay market rent, it's a little bit difficult for them to do that early on because they're not really seeing the vision. You can't blame them for that because they're not in our corporate office on a daily basis so they'll typically move. Then once we get further along, it's much easier for us to retain the tenants. Getting back to what Tyler asked in terms of our improvements, not only are we improving the physical plant of the asset, we're also improving the technological aspect of it where people aren't going to the leasing office to pay us rent with a check. They're not dropping off their rent check. They're not making a phone call for a maintenance request. Everything is done online. Right when we close escrow, we build out website for every property that has a tenant portal. Tthe tenant portal has online rent payments. They can make a one-time payment via ACH, via credit card or they can set it up for recurring payments where they never have to deal with it again. It just hits their account every month, the first day of every month, that's a win-win situation.
Adam Hooper - Right.
Max Sharkansky - Tenants don't have to worry about the rent and we get paid the first day of every month. There's much less bad debt.
Adam Hooper - Yeah.
Max Sharkansky - There's much less chasing your residents so everybody wins.
Tyler Stewart - And so after you've done some this value add, how do you know when's the right time to recap, to look for replacement financing?
Max Sharkansky - We'll refi and always shooting for around month 18, month 20, we're putting on permanent debt and we're holding. Sometimes we'll hold samples for a couple years, three, four years and we'll sell after five years. If the asset's performing very, very well and the submarket's only getting stronger like what we're seeing here in Portland, then we'll hold in perpetuity.
Adam Hooper - And then the trigger though for that refinance, is that based off of certain amount of occupancy, a number of units renovated, just purely financial based off of cash flow? What triggers that decision to do the refi?
Max Sharkansky - The number of units renovated and the increase in net operating income.
Adam Hooper - Okay,
Max Sharkansky - Because we don't want to be in a situation where we prematurely refi and we don't get much cash out of the refi and we have to refi again because we're further along six, seven months but we can't because of penalties. There are plenty of assets that we've refinanced multiple times, but it's really just through organic rent growth.
Adam Hooper - Okay. And then how much, when you do the refinance, do you typically have a target of proceeds that you're looking to return to investors at that point in terms of percentage of original cap invested or is it just whatever the market will bear at that time?
Max Sharkansky - Yeah, we're typically trying to get into a range of 25 to 40%.
Adam Hooper - Return of capital.
Max Sharkansky - Of original capital contribution, that's right. Then we'll try to get some interest-only financing for the permanent debt so that we can get some really strong cash flow those first couple years as we get more rent growth and then the loan will switch to principal and interest fully amortizing, sometime in year three or four.
Adam Hooper - Okay, and then you mentioned, again, if the market's doing great, comfortable holding it for long term, what triggers a sell decision?
Max Sharkansky - There are a few things that trigger a sell decision: how the property's operating, are there issues with the systems. We've got one property right now that we thought were going to hold 10-plus years, but we're starting to have some, it's an older asset and we're starting to have issues with some of the systems and it's going to be an extraordinary amount of money and undertaking for us to repair some of those systems, so we might just sell it.
Adam Hooper - And then the new buyer coming in would see that as a potential for them to add some value too.
Max Sharkansky - Correct, correct.
Adam Hooper - And so do you usually try to, when you sell a property, do you usually leave a little bit of meat on the bone for the next guy or do you try to sell it just as a fully stabilized property to someone who's just going to it long term?
Max Sharkansky - We do both. If it's the business plan going in that we're going to flip it in two years, then we're not going to rehab every unit and we'll leave a little bit of meat on the bone for the next guy. That typically gets you the best return and is the easiest way to sell it, so we'll renovate 50 to 60% of the units and then we'll sell it to the next guy 'cause you just a little larger buyer pool for that to move an asset and it makes it much more liquid. Liquidity is key in this business.
Adam Hooper - Right, on the exit, right.
Max Sharkansky - On the exit, yeah.
Adam Hooper - Options, optionality.
Max Sharkansky - Yeah.
Adam Hooper - So you mentioned a couple projects where there's maybe some things that you found out midway through that were a little bit more challenging necessarily than thought going in.
Max Sharkansky - Absolutely.
Adam Hooper - It happens.
Max Sharkansky - Absolutely.
Adam Hooper - How do you forecast for that, do you build in some kind of a some slush in the budget, in the projections or do you just kind of address as it comes? What are some of the biggest challenges getting from closing on an asset to taking it full cycle?
Max Sharkansky - Surprises. In our business we're opening up walls and once you start opening up those walls, you see surprises. Also, there are going to be things that you don't catch during due diligence, like the story I told earlier about the plumbing. And we are fortunate enough to have a record where we've never had an actual capital call from our investors and my partner and I have just funded the overruns ourselves, but we do build in a pretty good contingency for these surprises and so we'll build in a hard cost contingency and we're also, we have a quote, unquote working capital budget, which is an automatic extra cushion. So we try to be as careful as possible, as conservative as possible with the budget.
Adam Hooper - And so physical surprises, right, condition of the asset. Financing surprises, I mean does that ever happen where you're trying to to refi? Maybe the loan proceeds aren't what you anticipated coming in, what are some of those other challenges that come outside the physical asset of it?
Max Sharkansky - Well, we haven't had that situation yet because interest rates are just starting to come up and it's very rare for us not to hit our rent projections. That's one thing we're very, very consistent. Even if you have some cost overruns, you should be able, we were always able to refi. Some of the surprises that you see outside of physical can be legal, you know, you have some tenants. There are some areas that are very sensitive like parts of the Bay Area where people don't like to be displaced and they will raise a big stink and a PR nightmare can ensue.
Adam Hooper - Yeah.
Max Sharkansky - So that's another thing that can cost some cost overruns and we've had that happen. The way that can cause a cost overrun is you've got low-paying tenants in their units much longer than you expected and you've got a loan where your negative cash flow so you've got more negative cash flow than you anticipated, so your interest reserve winds up going up pretty significantly. We've seen everything.
Adam Hooper - And I mean that's again, that's part of the nature of the beast, right?
Max Sharkansky - That is.
Adam Hooper - When you're coming in to add value, naturally, you're going to be raising rents and that's just part of the process.
Max Sharkansky - Yes, it doesn't sit so well with everyone.
Adam Hooper - Yeah, yeah. So what's next for you guys? Much the same, change in strategies, looking at new markets? I mean is there anything huge on the horizon that you see that's going to change materially for your business or the industry in the whole?
Max Sharkansky - Yeah, some of things we already talked about macro level. We talked about rising interest rates. With us as a group, we are looking at the new markets. With our underwriting, we're just continuing to underwrite more conservatively. We're, like I mentioned earlier, we're just continuing to upgrade the quality of our acquisitions and dispose of some of our lower-quality assets, which by default, upgrades our portfolio and puts our investors in a stronger position. We are launching our second fund. Our first fund, so far so good, going great. We did have that first fund up on RealCrowd and you guys did a great job for us and hopefully now, we'll be doing a great job for your investors, our investors. We're about to have our first distribution actually tomorrow or next week. It's key one distribution from this point on. We'll be making distributions, we hope, almost quarterly and as well as specialty distributions with sales and refi, so it's going well, everything is going as planned.
Tyler Stewart - And so you guys going to be primarily acquiring assets in funds or individual asset-level capitalizations going forward or both?
Max Sharkansky - It's both, it's both. In a perfect world, in an almost utopian world, you can raise the fund overnight and just acquire assets in the fund, which would just be seamless and a dream of mine but that's never the case and raising a fund is a long arduous process. So we never have, I shouldn't say never, but it's rare that we have enough capital in the fund to just take deals down in the fund exclusively, so we're typically raising a sidecar investment, which is, a sidecar investment, for those of who don't know, is just a separate LLC that is alongside the fund in buying a property. So we're forming an LLC and putting some of our investors into that LLC and we're doing a lot of that, and then we're doing a lot of joint ventures with institutions and small opportunity funds and some interesting companies out there.
Adam Hooper - Yeah, you mentioned you're looking at one right now with Institutional Capital Partners. Is that a new area for you guys, I mean most of your capital has been syndicated equity before, right?
Max Sharkansky - Most of our capital has been syndicated equity, but we've done plenty of quasi-institutional joint ventures with a lot of family offices, foreign family offices, so still some small opportunity funds out of New York, so we've worked with all the different types of investors. We're familiar with the joint venture process.
Adam Hooper - And foreign capital, that's something we've touched on the podcast in the past, what are you seeing for foreign capital activity right now?
Max Sharkansky - For us, we have done a lot of business with Asia. It's a learning experience as a sponsor because you have to learn the culture of your investor and what that culture, what that investor based on their business culture wants to see in terms of reporting and asset management and what they're expecting differently from an American investor.
Adam Hooper - Back to the crystal ball, where are interest rates going? And I guess also, we did a couple episodes on the tax bill. Have you guys seen any impact from that or do you see any long-term impact from that? Two questions there.
Max Sharkansky - On interest rates, I'm just going to follow the herd and I think that the Fed will probably raise, I think that 2018's projections for the Fed are already baked in to current treasuries...
Adam Hooper - Pricing, yeah, yeah.
Max Sharkansky - Yeah, I don't see the 10-year moving up that much in 2018, unless there is an unexpected rise, unexpected bump, which a lot of people think might happen. We'll probably see another 50 to 75 next year and I think that's where it levels off. What was part two of the question?
Adam Hooper - Tax bill.
Max Sharkansky - Tax bill, tax bill. We're bullish. We think that the reduction of the corporate tax rate, the repatriation of capital is going to spur tremendous investment and tremendous job growth and these are all good things for our business. There all good things for the economy and the American people, so we're extremely optimistic and extremely bullish.
Adam Hooper - Anything else that you want to cover? Anything we didn't talk about?
Max Sharkansky - I think that's pretty much it. If you want to about maybe some of the deals that we've done with you guys on RealCrowd, 4620 Slauson--
Adam Hooper - Yeah, we've had a couple go full cycle, yeah.
Max Sharkansky - Yeah, well, we haven't sold any of them, but they've gone full cycle in terms of a refi, so we've executed...
Adam Hooper - Return to capital, yeah.
Max Sharkansky - Yeah. We've executed on the business plan and we've returned quite a bit of capital, 4620 Slauson, that's great. We actually just closed another refi, so we've returned almost all the capital on that one. We locked up seven-year debt because of the rising interest rate market, so we actually refinanced into a higher debt loan, a higher interest rate loan, excuse me. So it's more expensive, so we went from a coupon of the mid-threes to the low fours, but it was about to go from fixed to floating in a year and a half, so we took advantage of where the market's at today and our relationship with that lender, and we've locked up new debt at seven years fixed.
Adam Hooper - Which has also been an asset for the buyer coming in if that loan's assumable.
Max Sharkansky - Correct, correct, correct, but this has been a great asset. It's performing extraordinarily well. We've had organic five, 6% rent growth every year, which is just tremendous, which has allowed us actually to refinance it a couple times now, so it's just been a phenomenal asset.
Adam Hooper - And are you seeing, what are your rent-growth projections? Are you guys keeping those bullish like that or are you going to see some pull back in rent-growth projections, I guess again, kind of market by market?
Max Sharkansky - Market by market. We're definitely underwriting less rent growth than we were a couple years ago. A couple years ago, we were underwriting, for the most part, 3% give or take, now, we're underwriting, for the most part, mid twos.
Adam Hooper - Okay.
Max Sharkansky - 2 1/2% rent growth, 2 1/2 expense growth and that works. That, over a seven-year, 10-year horizon, any kind of horizon, that works and if it does not work, then you shouldn't buy the deal, that's how we look at it.
Adam Hooper - It's pretty simple.
Max Sharkansky - Yeah.
Adam Hooper - Keep it simple.
Max Sharkansky - If you need 5% annual rent growth to make a deal work, don't do the deal.
Adam Hooper - Don't do the deal.
Max Sharkansky - For the investors out there, don't invest with that sponsor .
Adam Hooper - Yeah, I think that's a great point, right? One of the things we've tried to try to touch on is how, as an investor, how can they sanity check these numbers, right? If they're not experts in that market, they're trusting that sponsor to underwrite things thoughtfully and hopefully, relatively conservatively, are there any resources out there that investors can go to to fact check some of these assumptions?
Max Sharkansky - Probably resources that they, not resources that they have access to at their fingertips, like we use Reese as an example and we spend five figures a year on that and that's economic forecasting, rent-growth forecasting, that tells us new construction coming to the marketplace, so that'll give us a pretty good gauge of supply, new jobs coming into the marketplace and it makes forecasting a little bit easier for us. What I would tell investors is look at what your value-add sponsor, if you're investing in value add, look at what they're underwriting to as an untrended return on costs, so that's your pro-forma cap rate on total cost of the project, so what is your untrended return on cost? So without factoring any growth, what is that number relative to exit caps and then then look at your trended return on cost and how are they trending, outward growth. What are they using for rent growth and what are they using for expense growth? And I would, as kind of a good rule of thumb, you want your trended return on costs to be about 100 basis points at least higher than your exit count, so for us, we're looking at trended return on cost of let's say, six and a quarter here in Portland, 6 1/2 and we're exiting at a low- to mid-five cap. So you've got a good 100, 125 basis point delta between your trended cap rate and your exit cap rate.
Adam Hooper - Yeah, and that's where the value comes.
Max Sharkansky - That's right.
Adam Hooper - Okay.
Max Sharkansky - That's everything.
Adam Hooper - And if anybody has questions about that, feel free to reach out and we'll connect them with you if you want to dig in.
Max Sharkansky - Absolutely.
Adam Hooper - Yeah, good. Well, I think that's a good overview.
Tyler Stewart - Yeah, that was great.
Adam Hooper - That was. Thanks for coming in the office.
Max Sharkansky - My pleasure, thank you for having, yeah, it's been awhile.
Adam Hooper - You'll have to stop in again next time you're in Portland, bring the sunshine.
Max Sharkansky - Absolutely, absolutely, I'll try to do that.
Adam Hooper - Perfect, well, I think with that, we'll wrap it up for today, as always, if you have any questions or comments or anything you want us to cover the podcast, send us an email to podcast@realcrowd.com. And with that, we'll catch you on the next one.
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