Why he sold all his Multifamily Real Estate is a question Jonathan Twombly answers. If so many are buying, why did he sell?
Jonathan Twombly is a former Wall Street attorney who specialized in corporate contract disputes between hotels and property owners. When the Great Recession happened, his employer waited for legal activity that never materialized. Since billings were down, cost had to be cut and Jonathan was turned lose to become a real estate investor.
The Case for Buying Multifamily
During the Great Recession people were losing their jobs and homes as their mortgages came due. Replacement financing was unavailable. What were these former homeowners to do? They still needed a place to live. With their credit trashed, and no financing available, their only hope was to rent.
Nationwide, multifamily is one of the most affordable options for renters. As more and more borrowers defaulted, the demand for rental housing was grew. Multifamily is a proven business with predictable income and operating cost. For a conservative investor like Jonathan, multifamily made sense. The growing demand for rental housing, with predictable income and expenses looked like a good low risk opportunity to make some money.
The First Deal
How can a new investor with no experience get started in Multifamily? The answer lies in syndication. Syndication is when individuals pool their money together to buy a large multifamily property. As an attorney, Jonathan regularly dealt with private placement funding, which works similar to syndications. As he quickly found out, his Wall Street contacts had money and were willing to invest with him.
At first, Jonathan partnered with a syndicator. Together they pursued a couple of deals that did not materialize, primarily due to the difficult lending environment. After the failed partnership broke up, Jonathan considered going back to law. Fortunately, one of his investors committed to back Jonathan solo, and shortly after, he landed his first deal as detailed on CREPN Radio episode #36.
Baptism by fire is what happens to most first time investors. The first deal is where you get the chance to learn all the lessons not taught in the books. This is where all of your theories go to get tested. Simple questions like, will the property and management perform as planned? What will you do if they do not?
Jonathan believes the following lessons are directly related to his lack of experience as an asset manager. He uses these lessons when teaching his multifamily coaching students so that they can recognize and avoid problems like these.
The first lesson was due to his selection of a property management company. He had established a relationship with a frim from out of town that wanted to break into the market where his property was located.
To add to the management challenge, the property management company primarily dealt with subsidised housing and had no experience working with a market rate property. On the surface, this would not seem like a big deal. However, it quickly developed into a problem that kept on giving.
The first sign that there was a problem was that occupancy dropped to 85% compared to the market rate of 95%. Vacancies are never good, and significantly affects cash flow for investors.
On top of the increasing vacancy problem, was the persistent bad debt and numerous evictions. Why was this happening?
Subsidised Versus Market Rate
The difference between a subsidised and a market rate property starts with demand, which reflects the way the property is managed.
The subsidised market has limited supply and overwhelming demand. When a manager of a subsidised property has a vacancy, they merely have to call the next person on their waiting list to offer the unit, and it is filled.
Market rate properties are plentiful. In order to get market rents, each property has to compete for the best available resident. This requires the property manager to advertise and make your property and the unit appealing to your prospective resident. Failure to do so will result in unwanted vacancies.
Bad Debt and Evictions
Bad Debt and Evictions were persistent, but why would they be so abnormally high? There were no obvious signs to point to. Because of this, it took months of investigating to find the root cause of this problem. What they found was hidden in the screening criteria settings used by the screening vendor selected by the property manager to screen applicants.
Given the property management company’s experience was with subsidised housing, the screening company set the standards to the levels used for subsidised housing. The lack of income required of applicants explained why the tenants were unable to pay the rent. Market rate properties typically require 3 times the monthly rent for monthly income to qualify and to ensure rent is affordable.
Once the problem was identified, the solution was simple. Bring the standards up to market requirements. The screening service was instructed to level up the requirements for this one problem property. Instead of leveling the one up, the screening company managed to lower the screening requirements for all three of Jonathan’s properties. Quickly they went from having an isolated problem to problems at all properties. Fortunately, this error was quickly recognized and righted before it got out of control.
The bank took issue with the vacancies when the Net Operating Income no longer met the debt service requirements. When a lender underwrites a property for a loan, it looks for a Debt Service Cover Ratio or a minimum of 125%. This means the NOI must be at least 125% of the annual debt service. Failure to meet this requirement triggers the loan clause requiring Cash Management.
When “Cash Management” happens, the borrower agrees to allow the lender to collect all rents, and then pay only those expenses approved in the operating budget. This protects the banks position and ensures payment of their loan. To reverse this clause, you must improve the NOI to meet the Debt Service Ratio requirements.
The property that provided all the lessons of mis-management, increasing vacancies, and bank problems, was not done teaching valuable lessons the books don’t talk about.
The next lesson was taught courtesy of two fires at the same property. Fortunately, insurance rebuilt the nine destroyed units, and covered the lost rent while the units were under construction. However, as insurance companies do, they refused to offer renewal coverage when the policy expired. To replace his coverage, Jonathan had to pay significantly higher rates immediately after the fires. This negatively affects the NOI.
The Happy Ending
Despite the fact that the one property was full of operational challenges, there is a happy ending. The property never provided any owner distributions while it was held as an investment and provided multiple challenges, management, vacancies, bank, fire, etc.
The happy ending is primarily due to the rising market of the past six years. In a rising market, you can make a lot of mistakes and still come out ok. Jonathan was able to buy at a low price, and sell at a high price resulting in a handsome profit.
Why He Sold
Why he sold, is simple. Recognizing the market is at a high point, and not likely to go higher in the short term, he made the decision to exit all of his properties in 2019. Due to the positive market conditions, he was able to pay all the arrears in preferred returns, management fees that had not been paid while operating the property.
Fortunately, for Jonathan, the lessons he learned only came from one property. The other properties operated with only minimal normal issues. This one property taught him lessons he shares with his students to help them avoid making the same mistakes.
He reminds his students that while getting a deal always seems like a difficult task, the real challenge is to operate the property profitably. If you are not properly capitalized, any one of the issues he faced can be your ruin.
As for passive investors, this is a cautionary tale of the importance to know who you are getting into business with. Do they have the experience and know how to navigate the challenging market ahead? Have they stress tested the numbers for the what if? Have they accounted for the deferred maintenance? Are they properly reserved for capital expenses? What happens if the market changes during the value add implementation?
Each week I ask my guest what is the Biggest Risk they see that real estate investors face.
BIGGEST RISK: The Biggest risk investors face is the Economy. When you are at the top of the market, there is only one direction it can go.
How to manage the risk: Be aware of the cycle, and recognize the risk you face in an economic down turn. Understand the tenants in the class of property and how they will likely be affected in a downturn. While real estate out performed other assets in the crash, it still got hammered.
If you buy at a premium, you have no room for any error. When you suffer an occupancy loss, will you still be able to meet your debt service ratio requirements?
Go in with your eyes wide open. Multifamily is a business that requires good people, and the wind at your back to make money. If you are planning a value add, ask yourself if you can complete the renovation before the market changes. Don’t forget that timing is important.
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