Well Greg, sometimes in life...
Teaching moments – whether you had them as a child or you are now the mom or dad who is implementing your child's missteps to guide them – they can be powerful tools for learning. Sometimes we learn from our mistakes, or if we're lucky, from others. Either way, it is essential to file them away in the critical lessons category. I have heard myself speaking to my son about a poor decision, and I felt like I was channeling Mr. Brady a la The Brady Bunch.
You may have caught wind of Arbor Realty Trust foreclosing on a quartet multifamily property in Houston valued at $229 million. The properties had a combined 3,200 apartment units, purchased by Applesway Investment between August 2021 and April 2022. As an LP, the worst possible outcome is to have your investment foreclosed on. Investors fear pausing distributions, capital calls, or additional loans, which could dilute their investment. While these are not wanted or expected outcomes, they are damage control to do what's necessary and retain our valuable assets. When the bank forecloses on an asset, the investor loses everything, and the mere thought of this can make us feel queasy. What's the #1 rule of private equity? Never lose the investor's money. While capital preservation isn't sexy, it is the most critical element of investing.
So let's put on our Mr. Brady hat and go through some of the teaching moments of this unfortunate event. Trust me when I say this is not to pile on the operator, but valuable lessons can be learned.
Lesson 1: Conservatively underwritten deals. Everyone says they use conservative underwriting, but it is up to you not to be romanced by the glossy numbers and to carefully look under the hood of those numbers. The Applesway offering promised some gaudy numbers. 22.44% IRR and 31% AAR. If a deal is projecting these numbers, ensure you understand how they achieve such high returns. The underwriting on this portfolio didn't account for rising interest rates, property taxes, insurance, or material costs. I have had an investor tell me he will only look at deals above 20% IRR. If you are not looking beyond the returns, then good luck to you. Questions that you can ask: What assumptions are you making here? What rent growth are you projecting (compared to market rent growth)? What are the rents you are trying to achieve compared to the comps? What price or cap rate are you looking to accomplish upon exit? What are your projections for future property taxes and insurance compared to the t12? Lesson 2: These were rough properties in rough areas, bought at high prices, with lofty business plans. Some demographics don't want the gold-plated toilets – they want cheap rent. Make sure the business plan matches the demographic, and if you are taking on a "heavy lift," make sure this is in the operator's wheelhouse. For the record, there were murders, fires, and trash piling up at these properties. No thanks.
Garbage piling up at one of the properties. I am guessing that this photo was not in the investment summary.
Questions that you can ask: What are the local demographics? As an investor, you can find this information quite easily by going to justicemaps.org, city-data, or BLS.com. What are the tract's average median income and demographic makeup, and what is the crime like? If it is a rough area or heavy lift, what experience does the operator have with such challenges?
Lesson 3: Over-leveraged with risky debt structure, and no risk mitigation. This is the one that has me scratching my head the most. How could this loan get approved with no risk mitigation put in place? This property was purchased with 90% leverage, a floating interest rate, with no rate cap! As we have recently learned, rate caps present their challenges (increasing escrow requirements to fund future rate caps). Still, it boggles the mind that the lender turned a blind eye to this interest rate exposure.
Questions that you can ask: How is the debt being structured? Is it a fixed or floating rate? If it is floating, do you have a rate cap in place, and if so, how long is the term on that rate cap? If you don't have a rate cap, do you have ample replacement and contingency reserves?
Lesson 4: Undercapitalized. This team severely underestimated the challenges and expenses of this portfolio.
Questions that you can ask: What are the reserves that you have in place on the project? Check for operating reserves, replacement reserves, financial contingency, and cap-ex budget. Are we well capitalized to weather any storm? Business plans don't always go to script, but how well are we positioned to pivot and survive?
Lesson 5: No local presence. It got so horrible that one of the properties was featured on the local news, about how bad the living conditions were, with roaches, rats, and overflowing garbage bins. From what I understand, it was an absentee owner with negligent property management.
Questions you can ask: Who are property and asset management? Will the property have onsite management, maintenance, and leasing? What is their track record? Are they responsive to tenant needs? How many units have they managed? Are they local and regional? Does management have a local competitive advantage? Do they have the local expertise and a logistical network in place?
Lesson 6: Growing too fast. The team purchased 3200 units from August 2021 to April 2022. 3200 units in 8 months; that is scary. What is the hurry?!
Questions you can ask: How many units has the operating team acquired over the last 12 months? Do you have a track record of success – especially in the local area?
I am not writing this intending to scare you – this is an outlier under the microscope. However, it should influence investors not to be swayed by pretty numbers on the surface and to ask important questions.
Mr. Brady would have put his arm around Gregg and asked him: Son did they have ample reserves on the properties? Did they have attentive, professional property management who will look after the property as if they owned it themselves? Teaching moments - use them to your advantage.
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