Passive Investing Red Flags In Under 10 Minutes

For today’s episode, we will be discussing the 3 red flags to look out for before they smack you in the head.

We will go over assumptions, cap rates, organic growth, and expense growth. That is just the first red flag. 

We will talk about these things…and more in another episode of Multifamily Investing Made Simple in under 10 minutes.

Tweetable Quotes:

"we should say that advertising the potential upside of a deal is perfectly fine. What really you should be looking for is the lack of transparency with what the potential downside could be." - Dan Kreuger

"Better is to say, let's peg this to inflation at about two to three percent. So holding it pretty much steady at zero." - Anthony Vicino

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Transcript

Anthony Vicino: [00:00:15] Welcome to Multifamily Investing Made Simple, the podcast where we take the complexity out of real estate investing so that you can take action. Today, I'm your host, Anthony Masino of Invictus Capital, joined as always by my partner, Dan. I got a brand new shiny camera, Kruger. Now, don't get too excited if you're watching. Yeah, you can't see the nice camera right now. But if you're following Dan, I think it's D.G Kruger at Kruger on Instagram and Facebook, then you can see his brand new fancy camera and he looks great on it. So just give me a little bit of a plug there. So we'll follow Dan. Not today. Not today. In under ten minutes, we're going to be talking about three red flags that passive investors need to be on the lookout for. You need to be on the lookout because if not, these red flags are going to jump out of the bushes and smack you over the head and you'll lose all your money. Right.

Dan Kreuger: [00:01:09] I don't know. Yes, I don't know and I would like to have that they just have to look at ominous and flapping in the wind.

Anthony Vicino: [00:01:16] Yeah, I guess they're kind of an inanimate threat, but it's what they represent. That's so scary. OK, here we go. So here's the number one red flag to be aware of when looking at a passive investment. It is rosy assumptions, not like a rose Bush, but like, I actually don't know, rosy

Dan Kreuger: [00:01:37] Domestic

Anthony Vicino: [00:01:38] Optimistic assumptions. So let's break that down. What assumptions are we specifically trying to be cognizant of?

Dan Kreuger: [00:01:45] Yeah, and we should say that advertising the potential upside of a deal is perfectly fine. What really you should be looking for is the lack of transparency with what the potential downside could be. And we've seen this left out of a lot of operators deal tax that they distribute where they look at the best case scenario and it looks all fantastic and everything's great and does make a ton of money. But you're not really sure exactly how bad things can go before that deal starts to lose money. So there are a few big factors, few variables that have a really major impact on the performance of a deal. And we've talked about it a lot, but we've got to do it again. Cap rates, that's a big one. That one probably has one of the biggest pulls on a deal relative to how a minority adjusted. And really it's just because it impacts the valuation of the property. So if you notice that the operators have their cap rate moving favorably, which would be moving downward, might be counterintuitive, but cap rates going down actually means properties are going to be worth more. So if you see a cap rate dropping consistently and operators underwriting package or deal package, that's that's something you want to dig into a little bit and see what that looks like. If it inverts, if the market gets softer, that cap rate goes up or if it's just flat.

Anthony Vicino: [00:02:59] Yeah. The other two things that we really want to keep an eye on in cap rates is the big one, because just a tiny little tweak of it has massive ramifications. But to other ones that you really want to be aware of is your rent growth, your organic rent growth assumptions and your expense growth assumptions. And so organic rent growth is just the appreciation that you can expect the market to demand over the next couple of years. Generally, we want to peg that as close to inflation as possible. And our markets say here in the Twin Cities, over the last couple of years, we've been seeing rent growth of around seven, five to seven percent. So that's really strong. But it's not a good underwriting practice to assume it's going to continue being that strong. Better is to say, let's peg this to inflation at about two to three percent. So holding it pretty much steady at zero. And then we are going to force depreciation, which is an entirely different thing. But and that wherein that world then you're not going to be caught off guard should the market soften? For some reason, rent growth doesn't grow how you think it will. And the same way with expense stress, always assume that expenses are going to grow and probably grow more than you think they are. They just have a way of doing that. Utilities never get cheaper. They're only ever going up. And so you need to adequately budget for the worst-case scenario. And here's my general rule of thumb. When it comes to predicting the future and guessing metrics and they have to plug these metrics in to get your return, projections always assume the worst when it comes to numbers that could help you and always assume the best when it's numbers that can hurt you. So best be like they're going to go up.

Dan Kreuger: [00:04:41] It's very good practice. And if more people did that, there would be fewer deals out there. But then you'd also notice that all the deals out there are performed really well. So it's really important to look at that stuff. As we said, a lot of operators will focus on the upside. But if you don't see it very clearly laid out what the potential downside is and how much a cushion there is in a deal, then you definitely want to ask about that.

Anthony Vicino: [00:05:03] Yeah. And this gets to what you mentioned before about the stress testing is like being able to see where does this deal, when does it start falling apart? Where where is the cap rate have to be? What do the rent growth assumptions have to be? Which at what's the intersection where this thing falls apart? Because even if it's unlikely to ever find that intersection, it's helpful to know where it is.

Dan Kreuger: [00:05:23] Yeah. And eventually got to a point where it starts to lose money. So it's not a bad thing. It's just how far is that from the current place? And, you know, how how how much do things really need to go the opposite direction than what the operators think they're going to go before people start to lose money? It's just you want to see a big, nice, big gap between where you lose money and where things are projected to be.

Anthony Vicino: [00:05:46] I like big fat margins of error. Now, number two, the second red flag that somebody just did, the first one, don't go anywhere near that red to be really careful. A second red flag is an operational red flag. It's specifically the operators. What's their track record? A lack of track record is a significant red flag. Now. I'm not saying don't invest with people who have never done a real estate deal before in their life, there are some people who have maybe never invested in real estate who would be uniquely qualified to step into real estate and really crush it. Maybe they're coming from another entrepreneurial background or finance background. They really understand how to operate a business and to have that skillset and they can just apply it to real estate. OK, that's fine. If your operator is coming from a different background and they have never done a deal before, they have only done a few deals. You need to tread very carefully because experience and time in the game is a significant indicator of competency. Unfortunately.

Dan Kreuger: [00:06:52] Yeah, and something I also know, too, is there's there's so many different categories are there's so many different asset classes and different types of deals that could be done in real estate. So even if somebody has been, let's say, an active multifamily syndicator for many years, lack of track or good could be the case. If they're all of a sudden switching to industrial and they're doing the first industrial deal they might have had, they might have 10 years of experience, real estate, but they'd never done industrial deals. So that's something you want to watch out for as well. Like not only has this person been in the business for 10 years or however long you want to see them in the business for, but have they been doing this thing that they're going to be doing with your money in the past, or is this their first go around? Because there's a lot of things that people could be doing. There's a lot of new flavor of the month out there that people are focusing on. So want to make sure that the operators have done whatever they're pitching to you in the past and not just on real estate stuff of the past,

Anthony Vicino: [00:07:47] Then you can even get more granular with this and go see the property management team. If your operator outsources that to a third party company and you want to be sure that that property management company has experience executing the business model that is being presented, like if the property management company focuses predominantly on single family homes and now you're going to be handing them a two hundred unit apartment complex with heavy value add? Well, maybe they're not the right fit for that. Yeah. So Traxler's track record, what's a third red flag that we need to be aware of? Yes. I don't want to be bamboozled by any red flags. Show me them all inaccessible operators.

Dan Kreuger: [00:08:26] Really what this means is does the operator you're thinking about working with communicating in a way that aligns with your personality? Right. If you are trying to find deals to invest in and you're contacting different operators and they can't give you the time of day to sit down and chat or at least happen resume call if they're not local and walk you through what it is they're doing and what they've done in the past, that's a red flag because if they don't want to give you the time of day while they're wooing you, wooing, you're trying to get you to invest in their deal, what's going to happen after they have your money and you know they're not trying to close you anymore? What happens then? I could only imagine it would get it would at least stay the same if you're lucky. If I get a little bit worse.

Anthony Vicino: [00:09:08] Listen, if I'm a cheapskate on our first date and I won't splurge and buy a dessert, then I'm never going to be a cheapskate. You're never getting the dessert. So yeah, yeah, yeah. Honestly, in the very early days of your relationship, that's a great time to tell. Like, how invested is this operator in me? Do they see me just as a dollar sign or just another number, or do they see me as an individual? Do they understand my unique goals and trying to find the right fit? That's super key because, at the end of the day, nobody wants to be treated like a no. It's one of the great things about investing in these private placements is that you get to know the operators. You get to have that relationship in a way that you don't when you invest in the stock market. And so I would say if you can't get the time of day from your operator, go find another one. There's plenty of great ones that are going to make you feel like a king and a queen. That's how you deserve to be made to feel unrepresented. So that's how I feel about it. I'm sorry.

Dan Kreuger: [00:10:06] So we got rosy assumptions, lack a track record

Anthony Vicino: [00:10:11] And inaccessible operators. No red flags. That's it. You stay on the lookout for those red flags. You're going to be fine next time. Maybe we'll talk about some yellow flags. A lot of girls like Superman and a lot of girls like that are going to do it for us here this week at Multifamily Investing Made Simple. Guys, we appreciate you taking your time to join us. And we'll see you next week.