A broker sends a deal. You read through it and it looks nice. Now you're getting a little excited.
That's the moment to slow down. Here's how we read a deal package, in the order we read it, and the oversights that cost investors real money.
Start with the pictures
The photos are usually what catch the eye first, so that's where we start.
Some investors like ugly. They see a run-down property and smell the chance to turn ugly into pretty. That's not us. If we're not seeing attractive features in the photos, it's a tentative no. Taking a property from ugly to attractive is usually too much of a stretch, and the budget to get there tends to grow.
Then read the story, and question it
Every package has a narrative. We like a good story, but we know how easily a story gets embellished.
The broker says the owner is a terrible operator. Why would he say that when he's working for the owner?
The broker says all you have to do is lease up the vacant units and you'll be in the money. Then why couldn't the current owner do that? What else is going on?
Sometimes the story is straight up compelling. They can't refinance, the partnership dissolved, they ran out of money for capital projects. That can be legitimate. The point isn't to distrust everything. It's to ask why before you believe it.
Assume there's a hand grenade in the numbers
This is the part that brings out the detective in us. We start by assuming something is hidden in the numbers and that our job is to find it.
We cross-check every expense account in the seller's trailing twelve months, the T12, against our own list. Everything has to be accounted for. The most common problem we find is the one you don't see: a missing account.
- Insurance. Left out because it's paid from a different account, or blended into a master policy with other properties, or paid annually and this year's payment hasn't been made yet.
- Property taxes. Paid through an escrow with the lender, and the escrow got lumped in with debt service, which sits below the line where you're not looking.
Was it an oversight, or were they hoping you wouldn't notice? It doesn't matter much. Either way, you have to put it back in.
Those are the easy ones. Repairs and maintenance is harder because it's so easy to manipulate. Push repairs off for a year and the T12 looks great. The next owner pays for it.
When the owner's own numbers are handwritten
Not every package arrives polished. Sometimes you like the property, then the owner sends you something handwritten. They even have a broker, but what's a broker going to do about their mess? The best the broker can do is explain all of the other good qualities.
That does not have to be a deal killer. Start with the leases. Are they signed? Work with the owner to get signatures on any that aren't, because you have to know what the tenants actually agreed to pay. That gives you gross scheduled income.
Get the owner's bank statements too. That tells you what the owner deposited over the last several months, not necessarily everything they were supposed to collect. When the systems are loose, there may be tenants who are delinquent, and you plan for having to address that after you take over.
Use rules of thumb, but know their limits
Nearly every expense line has an expected range. A few we use:
- Repairs: roughly $500 to $700 per unit per year, adjusted for deferred maintenance, the age of the buildings, and whether there are pools, flat roofs, or chillers and boilers nearing replacement.
- Property taxes: get an accurate figure straight from the county. Call them if you have to.
- Insurance: get quotes from multiple providers. This one moves around more than almost any other line.
- Landscaping and pest control: smaller line items, but unless there's truly nothing to maintain, they aren't zero.
- Marketing: plan for at least some real spend beyond the free listing services.
If you don't know what to expect for a line, ask experienced people. Commercial real estate brokers, mortgage brokers and property managers are usually happy to help because they want your business. Just make sure they're experienced with apartments.
Be most skeptical of the projections
When the package says these are the rents after you do the work, verify them yourself. Focus on the assumptions:
- Rent growth
- Expense ratios
- Exit cap rate
- Renovation timeline
Small changes in those assumptions create large changes in the outcome. If rent growth comes in a point lower, does the deal still work? If the exit cap rate lands half a point higher than projected, will you wish you'd passed?
The question isn't what are the returns. It's how fragile are those returns. We underwrite with worst-case rent growth and stress-tested exit caps for this reason, and only the deals that survive that process move forward. In underwriting, optimism is cheap. Reality isn't.
What we do after closing
The deal package only tells part of the story. Some of the worst surprises show up after you take over operations, not before. We've seen keys that were missing or didn't work, units listed as occupied that were actually empty, and tenants with proof of work orders the seller never addressed. None of that shows up in a T12. It shows up on day one of ownership, which is why the package review has to be thorough enough to limit what's left to discover.
If you're looking at a deal package and want a second set of eyes on the assumptions, schedule a call with John. We're happy to walk through how we'd read it.