Book Review: The Hands Off Investor (Part 2)

(Skip down to the bottom for a link to a recent podcast episode the author of The Hands Off Investor, Brian Burke made regarding the current state of the market)

Section 3: evaluating real estate

Next the book dives into how to evaluate the real estate offerings. Different real estate sectors include multifamily, single-family homes, offices/retail, self storage, warehouses, mobile home parks and land. General real estate strategies include buy and hold (hold periods common for 3 to 7 years), buy and flip, and development (considered most risky). Substrategies, in order of less risk and less return, to more risk and potentially more return, include core (least risky, less return more desirable buildings in urban centers), Core plus, value add (common strategy with moderate risk and moderate returns), and subsidized housing.

There are also different classes of real estate ranging from class A (newer buildings in nicer neighborhoods) to class D (older buildings in rough neighborhoods). The author mentions that syndicators will often state that the property is higher than it really is, and you can look at the median income of the area to know whether what they say is correct. 

Location is important to assess. It’s important to look at the job, income and population growth of an area, these are the “big three” of commercial multifamily real estate. Other indicators to look at are rent growth, vacancy rates and rent to cost of ownership. Things to assess related to the immediate location of a specific property are access to transportation and amenities, crime rates, school districts. It is also important to compare nearby rentals

Next the book covers understanding gross income as well as understanding net income and cash flow. I am not much of a numbers person, and the authors highlights specific numbers for people like me to focus on, but these chapters serve as a good reference when you are looking at a balance sheet, which can be evaluated prior to deciding to invest. Looking at a balance sheet can help to know where the focus should be to improve operations. He gives some expected percentages and tricks that some sponsors may use to make their balance sheets look better. For example if there is a large jump between the year one forecast and T3 (trailing 3 month income) or in place net rental income, it is likely the sponsor will not be able to meet the projected returns because they cannot just switch on higher rents property wide on the first day. It is important to examine the assumptions underlying the projected returns, instead of just choosing an investment based on the highest projected returns, which is a common investor mistake. 

There are primary and secondary performance indicators that we can use to evaluate investments. Primary performance indicators include annualized return, internal rate of return (IRR), cash on cash return and equity multiple (EM). Secondary performance indicators include break even ratios, debt service coverage ratios, expense ratios and physical and economic vacancy rates.

Waterfalls describe how profit is split between the sponsor and the investors. A preferred returned indicates the amount of money that goes to the investor each year before the sponsor gets paid. It’s not a guaranteed return, just a number that indicates whether the sponsors will get any of the cash that year. If not met that year it is generally rolled over to the next year. If the preferred return is met that year, there is usually a cash flow split percentage that indicates how much the investors get versus the GP for example it could be 75/25. Say the preferred return was 8% and the investment was $100,000, and the cash flow profit that year was $10,000. $8000 will be given to the investor and then 75% of the remaining $2000 (an additional $1500) will also go to the investor but then 25% of the remaining $2000 (i.e. $500) will go to the sponsor.

Treatment of the sale proceeds are usually treated just like any other cash flow (for example 75/25 split) of the money remaining after the investors capital has been returned.

However, a waterfall can be set up in different ways, for example return of capital before preferred return. In this case, capital is returned to the investors before the sponsors get anything which sounds good at first but actually may result in a smaller amount of return for the investor as the preferred return is also decreasing each year due to the decreasing amount of capital invested, although the difference is overall relatively small.

Other performance indicators include IRR (internal rate of return), cash on cash return and equity multiple. The IRR takes into account time, i.e. how quickly your money is returned to you and can be calculated on an excel spreadsheet. The cash on cash return is obtained by dividing the cash flow each year by the amount invested. However you would not include the return of capital or profit from the sale in the cash on cash return number. Equity multiple is calculated by adding all of the cash flow received as well as the proceeds from sale and return on capital dividing by the original amount invested.

Lets jump ahead to fees, something we are all wondering about these investments. Regarding fees, of course no one likes to pay fees but the sponsor needs to get paid. Examining the fees is a good way to see whether the sponsors interest or align with the investors interests. Usual fee ranges are given, as well as where to find them on the sponsor documents. If fees are left out of the documents (not uncommon), this would cause the actual performance to differ from the projections. For example:

Upfront fees, which will be found on the "sources and uses of funds" table:

Acquisition fee 1–3% of purchase price (larger properties towards the lower end and smaller properties towards the higher end).

Loan processing fee 1% or less of the loan amount.

Loan guarantee fee 1% or less of a loan amount.

Disposition fee 1–2% of the sales price (Exit costs)    

-should be less than the acquisition fee since it is easier to sell than buy a property. Some syndicators do not charge this fee

Oversight fees: these fees may sometimes not be included in the operating agreement if third-party management is used

Property management fee 3–4% (Income statement)

Construction management fee 3–10% (renovation budget)

Asset management fee: generally 1% but this can be calculated differently. Most commonly it may be the percentage of effective gross income (most aligned with the investors as this is based on performance), the second most common method is one percent of the investor equity. This could also be 1% of the net asset value or gross asset value (larger numbers in general).  

Links below for a recent podcast episode with the author Brian Burke about the current state of the market and for the book (I get a small commission if you buy the book via this page)