In school, you are often taught to solve multiple choice problems through a process of elimination. The idea is to look for things that are obviously wrong with an answer in order to reduce the number of answers that you must choose between. Reviewing investment deals is another place where a process of elimination can be useful. Understanding some of the common warning signs that are often present in poor performing deals can help you as an investor to avoid them. Today we will discuss just a few of these signs that can serve as a warning as you are reviewing investment opportunities.
1. Lack of Experience
Every multifamily investors has had a "first deal" in their career as a general partner. However, the lack of experience that comes with a sponsor doing their first deal can often be mitigated by having other more experienced partners on a general partnership team. Sponsors who are doing their first deal without an experienced partner simply are at a higher risk of having problems on their deals. Similarly, sponsors who are in multifamily part time or lack business acumen also run a higher risk of having unforeseen challenges.
2. Deal Structure That Doesn't Protect LPs
Deals that include a preferred return or similar structures offer investors peace of mind that the sponsorship team has confidence in the deal and that investors are protected in the event of a downside. While most every sponsor will charge an acquisition and asset management fees, unusually high or additional fees can also be a sign of a deal structure where the general and limited partner's interests are not aligned.
3. Predatory Debt
The past year in the multifamily investing world has clearly demonstrated that deals which are highly leveraged with floating rate debt and that have short loan terms are significantly higher risk than those with long term fixed rate debt. Bridge loans serve a place in the multifamily industry to fuel high value add deals until they can refinance over into long term debt or be sold, but should be avoided for stabilized deals with less value add potential.
4. No Skin In The Game
This point probably needs little explanation, but general partnership teams with minimal to none of their own funds invested in a deal is a warning sign. Even with the best of intentions going into a new deal, personal funds invested always serve as a motivator for sponsors to do their best in executing a business plan.
5. Opportunistic Underwriting
We have written a number of articles about what to look for in the underwriting for a multifamily deal. As you consider each of these items (i.e. exit cap rate, rent growth, occupancy, etc.), think about whether these are conservative or opportunistic assumptions. A good deal might be fine if one of these items is opportunistic, but if multiple are too sporty it will be hard to meet projections particularly if everything doesn't go as planned.
There are many important considerations when evaluating a multifamily deal and we make it our mission to careful vet each of these items. If you would like to learn more about passively investing in multifamily, please check out our free ebook "Achieving Financial Freedom Through Multifamily Investing."