SS286: When to Walk Away from a Deal

SS286: When to Walk Away from a Deal

Making the decision to walk away from a multifamily deal requires discipline and a realistic assessment of the property. In this episode, Charles discusses some red flags that might signal it’s time to walk away.

Watch The Episode Here:

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Talking Points:

  • Knowing when to walk away from a deal is as important as knowing when to purchase. The problem is that investors who have sunk time, money, and energy into a deal might try to make it work by rationalizing certain flaws in order to just purchase the property.
  • With many multifamily properties, the cash-on-cash return, when you account for all expenses, capital reserves, and debt servicing, is usually a single-digit percentage. In other words, the margins are very tight, and investors need to know the deal numbers and readjust their offers as new information emerges. Knowing when to walk away, when that new information comes to light, dramatically changing your underwriting, is the ultimate superpower that is easier said than done.
  • Let’s discuss some critical red flags that might warrant an investor walking away.
    • 1. The Numbers Don’t Work
      • If the expenses have changed once you normalized them to what you will be paying, including the increase in taxes and insurance, and the deal does not cashflow
      • Typically, the income of a property is much easier to confirm because you can cross-reference the rent roll, the trailing 12 months’ financials, and bank statements to verify that the seller is actually receiving the income they listed.
      • Expenses, on the other hand, are much more difficult to verify and estimate. This could be because the seller could have some sweetheart deals with their contractors or property manager that will not be available to you once you close. Maybe they own 5 other properties within a few blocks and enjoy economies of scale that you might not have.
      • If the debt service coverage ratio is under 1.2 or 1.25x, you are cutting it close with paying your mortgage and covering vacancies at the same time. Check out episode SS134 to learn more about what a Debt Service Coverage Ratio is.
      • If you are relying on rent growth or dramatic rent growth early on to break even or have your business plan succeed, this is another red flag.
    • 2. You Start Finding Inconsistencies
      • There is no management fee, no reserves, or no vacancy line.
      • T-12 income does not match the bank statements.
      • If the seller’s story does not add up, or if it is difficult to get information, documents, or explanations. Or worse, you are unable to perform inspections across certain units.
    • 3. Due Diligence Discoveries
      • If newly discovered deferred maintenance is beyond your risk tolerance:
        • Major plumbing issues
        • Cast iron sewer replacement
        • Extensive electrical issues
        • Structural issues like balconies or stairwells
      • If the seller will not renegotiate terms and pricing after the discovery of major deferred maintenance issues.
        • One of the property’s roofs requires immediate replacement
        • The deferred maintenance is much larger than initially anticipated
        • There are problem tenants at the property. Maybe they are creating issues with other residents, not paying rent, or involved in illegal activities.
    • I have realized over the years that if you can initially filter out most properties in 15-20 minutes, then filter those again, it allows you to spend more time on that small percentage of properties that have a chance. Spend the time to actually drive the neighborhood, to see if you should even speak to the owner or broker further. Visit the property at 12 noon and at 10 pm. Drive some of the comparable properties. Ask the broker or owner what needs repair and what is nearing the end of its life expectancy. Check permits pulled for the property to see when work was done. Buyers can do a lot of due diligence online and by phone before ever having to submit an offer, or even walk the property. The more due diligence you do upfront, the more questions you ask, which will save you from having to draft offers, spend money on agreements, and inspections.
  • During due diligence, if your underwriting assumptions seem to only work in the best-case scenarios, it is time to walk away. Most real estate investors, especially new ones, underestimate the time and capital required to reposition a property. If you are pushing a deal forward with the hopes of the stars aligning, you are going to put yourself in a very difficult position, and deals that only work in a perfect scenario will fail when reality sets in.

Transcript:

Charles:
What if the best real estate deal you ever make is the one you walk away from? A bad deal does not become a good deal just because you spend time on it. And the most dangerous deal is the one that only works if everything goes perfectly. Welcome Strategy Saturday. I’m Charles Carillo, and today we’re talking about when to walk away from a deal. Let’s get into it. Knowing when to walk away from a deal is as important as knowing when to purchase. The problem is that investors who have sunk time, money, and energy into a deal might try to make it work by rationalizing certain flaws in order to just purchase the property. With many multifamily properties, the cash on cash return when you account for all the expenses, capital reserves, and debt servicing, is usually a single digit percentage. In other words, the margins are very tight and investors need to know the deal numbers and readjust their offers as new information emerges.

Charles:
Knowing when to walk away when that new information comes to light, dramatically changing your underwriting is the ultimate superpower that is easier said than done. Let’s discuss some critical red flags that might warrant an investor walking away. Number one, the numbers don’t work. If the expenses have changed once you have normalized them to what you will be paying, including the increase in taxes and insurance and the deal does not cash flow. Typically, the income of a property is much easier to confirm because you can cross-reference the rent roll, the trailing 12 months financials, and bank statements to verify the seller is actually receiving the income they listed. Expenses, on the other hand, are much more difficult to verify an estimate. This is because the seller could have some sweetheart deals with their contractors or property manager that will not be available to you once you close.

Charles:
Maybe they own five other properties within a few blocks and enjoy economy of scale that you might not have. If the debt service coverage ratio is under 1.2 or 1. 25X, you’re cutting it close with paying your mortgage and covering vacancies at the same time. Check out episode SS134, SS134 to learn more about what a debt service coverage ratio is. If you’re relying on rent growth or dramatic rent growth early on to break even or have your business plan succeed, this is another red flag. Number two, you start finding inconsistencies. There is no management fee, no reserves or no vacancy line. T12 income does not match the bank statements. If the seller’s story does not add up or if it’s difficult to get information, documents or explanations or worse, you’re unable to perform inspections across certain units. Number three, due diligence discoveries. If newly discovered deferred maintenance is beyond your risk tolerance, major plumbing issues, cast iron sewer replacement, extensive electrical issues, structural issues like balconies or stairways, if the seller will not renegotiate terms and pricing after discovery of major deferred maintenance issues, one of the property’s roofs requires immediate replacement.

Charles:
The deferred maintenance is much larger than initially anticipated. There are problem tenants at the property. Maybe they are creating issues with other residents, not paying rent or involved in illegal activities. I’ve realized over the years that if you can initially filter out most properties in 15 to 20 minutes and then filter those again, it allows you to spend time on the small percentage of properties that have a chance. Spend the time to actually drive the neighborhood to see if you should even speak to the owner or broker further. Visit the property at 12 noon, at 10 PM, drive some of the comparable properties, ask the broker or owner what needs repair and what is nearing the end of its life expectancy. Check permits pulled for the property to see when work was done. Buyers can do a lot of their due diligence online and by phone before ever having to submit an offer or even walk the property.

Charles:
The more due diligence you do upfront, the more questions you ask, which will save you from having to draft offers, spend money on agreements and inspections. During due diligence, if your underwriting assumptions seem to only work in the best case scenarios, it is time to walk away. Most real estate investors, especially new ones, underestimate the time and the capital required to reposition a property. If you’re pushing a deal forward with the hopes of the stars aligning, you’re going to put yourself in a very difficult position and the deals that only work in a perfect scenario will fail when reality sets in. I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics at globalinvestorspodcast.com. If you’re interested, actively investing in multifamily real estate, go to syndicationsuperstars.com and join the wait list for our one-on-one mentor and program. Again, that’s syndicationsuperstars.com.

Charles:
Look forward to another episode next week. See you then.

Speaker 2:
Have you always wanted to invest in real estate but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding, and didn’t want tenants calling you? Since 2006, I’ve been buying income reducing properties in great locations that provide us with consistent passive income while we wait for appreciation in the future and take advantage of tax laws while we’re waiting. And unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out investwithharbourside.com. If you like the idea of investing in real estate, if you like the idea of passive income, partner with us at investwithharborside.com. That’s investwithharbourside.com.

 

Links Mentioned In The Episode:

  • SS134: What is Debt Service Coverage Ratio (DSCR)

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