Lack of a Business Plan: Operational Risks to Your Business #1 – EP 321

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Creating a 7 or 8-figure portfolio in multifamily real estate isn’t easy. If it was, everyone would be doing it.

If you want to stabilize your assets, ensure constant cash flow, and not be at risk of losing properties, there are certain things you need to do to make your investment strategy pay off for years to come. Especially in today’s market with the cost of debt skyrocketing and interest rates pushing over 7%. 

In my new series titled, Operational Risks to Your Business, I want to share with you some of the hard lessons I’ve learned from my own business, as well as from my friends and clients. I’m going to talk about seven things you need to have under control to achieve your investing goals. 

In this first episode, we’re going to talk about business plans. You’ll learn about the three general business plans for multifamily properties, how to employ them, and why having a solid plan in place is critical to your long-term success.

Key Takeaways with Josh Cantwell

  • The difference between quick flip plays, refi and roll plays, and cash flow out the door plays.
  • Why some business plans won’t help you make the right move at any given time.
  • How to do your due diligence and make sure that your business plan is in line with what’s possible, what your partners want, and what you want.
  • What can go wrong when you lack a business plan–and why a failure to plan, especially in tough economic times, almost always results in selling at a loss.

Josh Cantwell Tweetables

“When you have cash flow risk, you’re talking about a serious threat to a foreclosure, a receivership, or a deal ending up in a really bad situation.”

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Josh Cantwell: So, hey, everybody, welcome back. This is Josh Cantwell, your host of the Accelerated Investor podcast. And today, I want to walk you through and educate you on operation risks in your multifamily deals. And so, this is specifically for those investors who are general partners who are looking to stabilize their assets long term and make sure that their properties are constantly cash flowing and there’s no risk of ever losing the asset.

 

This podcast and this recording is also for limited partners as you vet out general partners to work with, whether it’s working with me or with anyone else. These are some of the questions and some of the things that you’ve got to get comfortable with that we want to make sure that there isn’t a threat to the operation or the cash flow of the building. And that way, the building has a constantly kicking out cash flow, constantly kicking out rate of return, and always having an asset that’s going to help you achieve your financial goals. Obviously, what we’re talking about is possibly losing an asset to foreclosure or receivership. Here we go.

 

[INTERVIEW]

 

Josh Cantwell: So, we’re talking today about operation risks, and as I see the market changing and as I see the costs of debt skyrocket, residential mortgages actually crept over 7% interest for the first time in almost 40 years. Last week, the cost of commercial debt has crept up into the 6.5% range. It’s usually about 200 to 250 bps over and above the 10-year Treasury for permanent financing or bank financing.

 

And so, now, you start to take a look at, okay, well, where does the risk lie for multifamily operators? Whether you’re a general partner, whether you’re a limited partner, where does the risk lie in possibly being maybe you’re a limited partner in deals that you invested in two or three years ago and that deal is supposed to sell or refi soon, and you’re concerned that the operator is not going to be able to hit their targets, or whether the cost of debt goes or whether the cost of debt is going to be prohibitive for them to refinance or sell the building? And then you also look at, well, as the economy changes, if we move closer to a recession, is the tenant base going to be as good? Is the cash flow going to be as good? Is there any threat to the operations that would possibly cause me to lose money?

 

And so, I’ve identified seven specific operational threats that I think you need to be aware of. These are things that we’ve worked through, things that we’ve identified in our own business as threats and things that we have seen in our business that said, hey, we have to have these under control as really good operators. But they have these seven things under control, and if we do, the asset’s going to be a great asset long term, it’s going to kick out cash flow, it’s going to have great resonance, it’s going to have great property management, it’s going to have a very good regional manager. The CapEx is going to be in order. The cash flow is going to be solid. There’s going to be no serious crime. Occupancy is going to stay high, and this property is going to pay everybody – limited partners, general partners, property managers, construction crews. It’s going to pay everybody over the long haul really, really well. And there’s no threat to lose the asset.

 

So, these are the seven threats to operations, number one is a lack of a business plan. When I look at business plans for multifamily properties, we’ve done now 19 syndications. Matter of fact, yesterday, I just made two offers on two new buildings. I want to make another offer and another one next week. We do expect to get all three of those. So, that will put us at 22 syndications, 22 purchases, and that’ll be over 4,500 units of multifamily.

 

When I look at it, number one, the first threat to the operation is the lack of a business plan. So, when I look at business plans, I look at three general business plans for multifamily properties. Number one, a quick flip play. Number two, a refi and roll play. Or number three, a cash flow out the door play. And when I say that, here’s what I mean.

 

So, let’s go back to number one. The first business plan is a quick flip play, meaning it’s going be a 24-month hold, give or take. We’re going to buy it in order to push the rents, replace the bad tenants, increase the leases heavily, meaning $200 per month, per unit or more. We may do some heavy CapEx to achieve those rent increases. Then we’re going to get to 95% occupied for about two months, which is going to mean that our T3 is very healthy. Then we’re going to put the property on the market through a broker network. We’re going to turn around and sell the property in 24 months or less. We’re also going to have to get primarily bridge or bank debt that has no or very little prepayment penalty, and that’s going to yield an extremely high rate of return or internal rate of return for us and for our investors. So, that’s one type of business plan.

 

It’s a great business plan. We’ve done it several times. Matter of fact, I have a property closing next week. That’s exactly that. We held it for roughly 24 months. We’re going to sell it and make about $1.5 million on it. And it’s a quick flip play. The challenge with that is in this rising interest rate environment is that when your buyer goes to secure their financing, the buyer has to have enough debt service coverage from the cash flow. And so, right now, they might not be able to get a very high loan-to-value. So, the buyer has to not only secure a loan that has lower loan-to-value, but they also have to be in a situation where they recruit more capital or bring in more of their own capital, which could reduce their overall return.

 

So, the first thing is a lack of a business plan. And if the business plan is a quick flip play, we’re going to have to make sure that the exit is conducive to the new buyer buying the property at the right price. We’re going to quick flip it. Obviously, a low-interest rate environment is helpful. An environment like 2019, 2020, 2021, 2022 has been very good. However, now, in the second half of 2022, interest rates have gone up so high, so fast that a quick flip play, if that was your plan a year ago, you’re going to be in probably some trouble executing that.

 

The second business plan that’s out there that you could be trying to execute would be a refi and roll play. That typically means for us a 42-month hold. We’re going to buy the property, we’re going to push the rents, we’re going to replace the bad tenants, we’re going to do a heavy lease increase of at least $200 or more. We’re probably going to be executing a fairly high CapEx program where we’re turning units, $7,000, $8,000, $10,000 per unit, to put a new product out there and have a very nice product. We could be buying C class, 1970s, 1980s construction and we’re going to make it look like it’s brand new.

 

Again, the idea is to get up to 95% occupied for at least two months, have a very healthy T3, and then apply for a refi loan. Now, when we do that, we typically start to tee up the refi six months or nine months before it actually closes. I’m in the middle of a refi right now on one of my properties called Sunnyslope Terrace. And I’ve been working with my broker partner, my lender/broker, for probably six months looking at the T12, looking at the rent rule, looking at the T3, trying to get expenses down, trying to get income off, trying to keep collections up because, again, we want to refi at 42 months and then we want to hold it forever, which means we want to get bridge or bank financing out of the gate. That also does not have a large prepayment penalty or defeasance or any kind of essentially prepayment penalties. We want to achieve a high internal rate of return and a high cash-on-cash return for investors.

 

But because this is such a heavier lift and it’s not as quick of a play, these are the deals that I typically do, the refi and roll play. And we typically keep more of the equity for general partners because we’re not feeing the deal to debt, we’re not adding fees, fees, fees, fees, fees. It’s just 60/40 or 70/30 split, but the GP is keeping 60%, 70%, the LP is keeping maybe 30% to 40%. And in that case, we’re targeting a 20% to 25% annualized return.

 

Well, for that to work, again, you have to be in an environment where the end refi loan, the interest rate can’t be too high because the higher the interest rate, the lower the debt coverage. So, we’re going to be hamstrung in the next year or so, probably going to be handcuffed a little bit from doing a number of refis because the cost of debt might be punitive, might be penalized for the cost of that debt to the point where it doesn’t cover. If it doesn’t cover on the debt service, like a 1.25% debt-service coverage ratio or 1.3% like the banks or Fannie or Freddie want, we can’t refi. That means that if it does get approved, our loan-to-value might be very low because the debt-service coverage is low.

 

The third business plan that we like to execute in number three is what we call a cash flow out the door play, means the day we buy it, it’s already cash flowing. We bring in debt, we bring in limited partners. And this is typically a five to seven-year hold. We’re going to do here more organic rent increases. We want to stay heavily occupied. The CapEx program is probably going to be a lot less. We’re going to be investing small amount of money into make-readies and quarter turns or half turns on the units. We’re not going to spend as much time or money on the landscaping or the commons or adding amenities. We’re just going to let the environment push the rent.

 

And right now, obviously, in our country, we still have a very big problem with affordable housing. So, that problem with affordable housing is helping keeping our rents up and occupancy very high. So, in that scenario, we may be giving up more of the deal to limited partners because the cash flow out the door, we’re not really pushing the equity, we’re not really pushing the end sale price as hard as fast. And when that happens, we have to give our limited partners probably a lower preferred return. And in that scenario, we have to give the limited partners more equity to make it attractive, to make it something that a limited partner would want.

 

So, the first threat to operation is, number one, a lack of a business plan. And when I think about this, whether the business plan is a quick flip play, 24-month hold and sell, whether it’s number two, a refi and roll play where it’s a 42-month hold and refi, or whether it’s a cash flow out the door play where it’s a five to seven-year hold and then sell, the challenge is that you have to know out of the gate which of these three that you’re going to execute. Which one of these three?

 

And so, if you’re changing as the general partner, as the CEO, as the leader of the organization, you have a property manager that wants to know what your plan is. You have capital improvement CapEx managers, construction guys, contractors that want to know, out of the gate, what’s the plan. You want to have a regional manager that might work over and above your property manager that wants to know what the plan is. You may have a banker that funded your original acquisition loan. You might have a lender or broker who wants to know what your long-term plan is so they can help you prepare for a refi or a sell. You have a lender/broker that’s going to secure financing for you upfront. You want to make sure, depending on what the plan is, obviously, what’s the prepayment penalty. What’s the defeasance? What are the charges if you get out of the deal? Those types of things.

 

You, obviously, also have limited partners. Those limited partners want to know how is their return going to be created. How is their return on investment crafted? And then when are they going to get their money back? One of my commandments for multifamily investing is to get the principal back quickly. And so, we want to get the principal back quickly. In my case, if it’s 24 months to 42 months, I feel like that’s the sweet spot. Investors love that. Limited partners love to be able to get their money back in about two to three years, two to four years.

 

And so, really, the quick flip play and the refi and roll play, that’s the two that we’ve been focused on. But if I flip flop back and forth and here’s where the threat is to operation, if I flip flop back and forth between the two, and I think I’m going to start with the refi and roll play, but then I move over to a quick flip play, and then I change my mind to a cash flow out the door play, and if I change my mind, I’m going to head this threat to operation because if I have a cash flow at the door playing, let’s say a five to seven-year hold and I’m going to do organic rent increases, I want to stay heavily occupied. I want every dollar of cash flow because it’s added to the bottom line for general partners or limited partners.

 

And then let’s say, all of a sudden, I go and change my mind, I want to refi it. Well, now, I might not be pushing the rents hard enough. I might not be able to get a high enough value to refi. Or let’s say, I change my mind and go to a quick flip play, and all of a sudden, I go to sell it. Well, again, if the market’s not right for that, if your end buyer can’t get attractive financing, then you might not be able to sell it.

 

So, in almost every deal that we go into, we choose number two, the refi and roll play, because that will allow us to pay our investors a 6%, 8%, 10% pref return because we’ve baked it into the operations, we’ve baked it into the cash flow. But if we decide to sell it quicker, we already have a bridge or bank debt on that property that does not have a very high prepayment penalty. If we decide to keep it longer, cash flow it longer, well, we can just get more cash flow and then pay the limited partners more money over and above their pref return. Maybe they’re getting an 8% pref. Well, now, they’re going to get additional cash flow over and above the 8% pref. So, now, they’re getting a 10%, 12%, 13% cash-on-cash cash flow return that’s attractive.

 

The problem is, is that a lot of guys that I’ve seen get in trouble, and you’re going to see more of this over the next 18 months, you’re going to see more and more guys get in trouble who they didn’t pay attention to their CapEx, so their property manager, or there was serious crime taking place that they were unaware of, or occupancy drips and drops below 85%, and they were a cash flow out the door scenario or they were a refi and roll scenario. And now, they have to quickly sell it. And that’s their only way to get out of it.

 

Well, guess what? If interest rates continue to rise, property values are not going to keep going up. So, that’s the threat to operations, lack of a business plan, lack of an upfront business plan that you can all agree on. Your property managers, your CapEx guys, your regional managers, your lender, your limited partners, everybody agrees on that. And then the execution becomes critical.

 

So, which business plan are you picking? Which business plan, if you’re a limited partner, do you prefer? You’re a general partner, which one do you prefer? If you get into a pinch, can you sell it? If you get into a pinch, can you refi it? If you get into a pinch, can you recruit more capital to it? Can you bring in more money, bring in some more money from limited partners to stabilize your operation? But the lack of a business plan or the changing of a business plan is our very first threat to operations.

 

And what I want to do in this next week or two, I’m going to release a number of podcasts around different threats to deals because of the timing of what’s going on with the Federal Reserve and them raising interest rates. I think this is an important discussion point for all operators, general partners, but I think it’s also very important for limited partners for them to understand, look, if they got into a deal two, three years ago, when that deal was predicated on a refi or a sale this coming year, we got to make sure that operations are tight because I don’t know that that refi or sale can happen when interest rates are getting so high so fast.

 

So, now, it becomes about how do you operate the building through the peak in valley? This, of course, is one of those valleys. How do you operate the real estate through the valley? Get to the other side when interest rates come back down. That’s exactly what we’re focused on at Freeland Ventures.

 

So, this is podcast number one in a series of at least seven. It might turn out to be eight or nine, but at least seven threats to operations and threats to your deals. On the next podcast, I’m going to be talking about the capital improvement threat, and then I’m going to talk about the property manager threat. Then I’m going to talk about the regional manager threat. Then I’ll discuss the serious crime threat. Then I’ll discuss the occupancy below 85% threat, and then I’ll talk about the refi or sale at the wrong time, the timing threat.

 

So, we’ll discuss at least those seven issues coming up on this next series of podcasts. I’m looking forward to talking about it with you and being really transparent about what I think the risks are to operations. Operation risk ultimately means cash flow risk. We have cash flow risk. Now, you’re talking about a serious threat to a foreclosure, a receivership, or something like that, where a deal can end up in a really bad situation.

 

Let’s get ahead of that stuff. Let’s understand what the threats are so everybody can continue to win and operate in this volatile market. I hope you enjoyed this podcast and I hope you enjoyed the transparency that I’m trying to bring to the table here. If you enjoy it, please subscribe. Smash the Subscribe button. Leave us a like, leave us a comment, rating, and a review. And I’ll see you next time on Accelerated Investor.

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