The Top 5 Mistakes People Make in Multifamily Real Estate Investing

Are you interested in investing in multifamily real estate?

Multifamily is a terrific asset with a lot of benefits. But I see people making the same mistakes over and over again. In this blog post, I’m going to share the top five mistakes people make when it comes to multifamily real estate investing.

1. Being too aggressive with your underwriting.

Underwriting is the modeling that you do when it comes to the investment opportunity. It’s the sum total of all your market assumptions and forecasting for that opportunity or property.

Most people tend to be too aggressive in three main components:

A. Being too aggressive with appreciation.

We as investors cannot control how the market appreciates. But we can control the property — how it looks and how it operates through our value-add business plan. So we can’t control appreciation but we control a whole lot of other things.

Where people get it wrong is they tend to get too aggressive with the appreciation when they plug in the numbers into Excel or whichever spreadsheet program they’re using.

Some people will actually bank on the market appreciating six percent a year for the next five years. That is a little bit too generous. We always want to err on the side of caution and really scale back our appreciation forecast because appreciation may or may not happen.

We want to focus on what we can control. If you’re banking on the market appreciating between five to seven percent per year, chances are you are being far too aggressive. You can’t control that. The market could stall and go flat. If you’re assuming that cap rates will be lower or more compressed — maybe a hundred basis points lower than when you purchase the property — you are being far too aggressive.

One should always assume that the market will be softer, so cap rates will be higher when you go to sell or divest of the property. We always want to plan for a worst-case scenario. So if the market appreciates even more, it’s a great day — an added bonus. But when we’re working on our underwriting, there’s a big difference between plugging the numbers on a spreadsheet and actually making them happen in real life.

It’s far too easy to plug in rosy numbers when you’re analyzing your property, especially when you’re competing and it gains multiple offers. But you have to stay disciplined. You can change a percentage point on the spreadsheet, but making that happen in real life is a totally different story. So always be conservative. Don’t bank on appreciation.

B. Being too aggressive with rents.

Far too many people overestimate the upside when it comes to rents. Maybe you’re assuming (in your underwriting) that you can capture a $200 premium through your renovations. But in reality the market will only support $125-150 per unit.

You have to know exactly what the market is today when you’re acquiring the property and underwriting it and evaluating the opportunity. Make sure you are making an apples-to-apples comparison. Don’t compare a 90s build to a 2010 build property, saying that’s a good market comparable. You are only cheating yourself and your investors if you’re underwriting that way and being far too aggressive.

You should always scale back. Let’s say you are thinking that there is $150 upside per unit. Well, use $100-125 instead. Always go less than what you think the market is going to bear. In that way, you will not be disappointed if something happens or if you can’t achieve that rent premium you were gunning for.

C. Being too aggressive with refinances.

Where people get too aggressive is when they build refinances into their underwriting modeling. They make it seem like it is a fact that will happen. But markets can change. Situations can change. Refinances may or may not happen. So if you’re building into your underwriting that a refinance will happen in year three and you will return 100% of investor capital, well, you are being far too aggressive.

There is no guarantee that will actually happen. By removing that refi, that’s going to skew everything else in your underwriting and your modeling. And chances are, you will not hit the targets that you led your investors to expect through your spreadsheets and underwriting. So if you’re planning on going after a refi after your value-ad plan is finished, well that’s great. But leave it as an extra, a bonus, a welcome surprise at the end. Don’t build it into your underwriting because so many things can happen but you're treating it as a fact.

The future is uncertain; we have no idea what will happen. So when it comes to underwriting, be more conservative. Don’t bank on too much appreciation. Make sure you have market rents down to a T. Don’t overestimate the upside. Do not build in refis into your initial underwriting. They are always treated as an extra bonus.

2. Guesstimating your rehab and reno numbers.

On my podcast and TV show, I have guests who are experts in the construction management field. They always say — almost every single one of them tells me — the number one mistake people make is not knowing their true numbers when it comes to construction rehab and renovation.

They’re walking through a deal. Maybe with their property manager, maybe with their partner. They just guesstimate a per unit cost for the rehab, for the construction. Let’s say $20,000 a door. The number one mistake construction managers highlight is people not knowing their true numbers. You cannot just make up a blanket statement — an all-encompassing number — per door of $20,000 without actually going through and itemizing exactly what needs to happen.

Having a true handle on your construction rehab costs is essential. Many people underestimate it and then they run into cash flow issues. They have to raise more capital to finish the renovation project.

Make sure that, from the start, you are working with somebody who has construction management experience with that type of asset. They can give you real numbers based on fact, not from guesstimations from walking in and just taking a peek at a couple units.

Coupled with rehab and renovations is downtime. I’ve seen people do a tremendous job, a bang-up job, figuring out a conservative appreciation, working on market rents, and not working in refi. Everything is good here. They buy the property at the right price, but they forget that as they’re doing these renovations and rehabs, nobody is paying rent in those units because it’s empty.

So their underwriting looks perfect but maybe a unit is going to be down for three months. But they haven’t factored that in and they’re still assuming in their spreadsheets that somebody’s paying the rent. And what if you have five units down at the same time and they’re down for three months apiece? That’s a whole lot of rent not being paid. And unless you actually work that in and build that into your underwriting, you're going to be showing cash flow on your spreadsheet that isn’t actually there.

So always make sure that when you’re doing renovations and banking on having units down, extend it for longer than you think you’ll need to. Coronavirus was a good example of banking on delays in terms of a construction project. Construction sites shut down. Renovations had to stop. If you are assuming that a unit is going to be down for a month and a half in your underwriting, put down three months. Work out three months of no cash flow coming from that unit because delays always happen, no matter the construction project.

There are always surprises that happen as soon as you start doing any type of work. So always overestimate the amount of time it's going to take. I would rather overestimate the cost rather than underestimate because nobody wants to be in the position of having to raise more capital once you’ve already closed on the deal to finish off renovations.

3. Not raising enough of the needed capital.

Here’s a mistake I see a lot of capital-raisers make when first getting started. They’ll go out and speak with their investor database about a potential opportunity. Let’s say they need to raise five million dollars. They’ll talk with their investors. They’ll get soft commitments — verbal commitments — from a bunch of investors saying “Yeah, I’ll invest x amount” totalling five million dollars. Then they think, “Oh great! I’ve got my soft commitments. I’ve raised enough capital. I can now go out and acquire the deal and the money will be there.”

Well, reality will soon set in. Pretty soon, that capital raiser will find out that even though those investors said they will invest five million dollars, only a small portion of those investors will actually fund the deal. Because life happens. Other opportunities happen. Maybe the investor needs the money for something else. Maybe they had a change of circumstances.

So whenever you’re raising capital, always oversubscribe. Always raise more than you think you’ll need. So if you need to raise 10 million dollars, raise 20 or 30 million. Because anybody who’s raised capital before will tell you that things get in the way with the investors. Life does happen like it does with everybody else. So if you’re raising capital and you need to raise a certain amount, always double or triple the amount — the more the better.

Never bank on soft commitments. You can’t rely on just a soft commitment. You have to rely on hard money that is actually wired into your entity’s account, ready for closing. That’s the only capital that you can absolutely count on.

4. Not being conservative with your debt terms.

We all know that bad debt can sink a great deal. So it’s really important to have the right kind of debt. I’m talking about the term of the debt.

So let’s say you are in your underwriting. You’re assuming a 4-5 year hold for you to implement your business plan and then put yourself in a position to sell once you’ve hit your return target. What a lot of beginners do is they’ll say, “Okay, well I want to sell in year four.” So then when they go out and acquire debt, they’ll just acquire a debt with a five-year term. This is a very, very poor decision. Nobody knows what the market’s going to be like in year four and year five. So you’ve basically handcuffed yourself that you have to sell.

Let’s say the market takes a dive. It’s the worst selling market that we’ve seen in the past 100 years. So the world is ending. You can’t sell. Nobody wants to finance the deal. Your term is running out. You are in your last year. Nobody wants to finance you. What happens? Well, you have to sell at that point.

Nobody wants to be placed in the position where you have a gun to your head and you are forced to sell because you can’t refinance and get different debt on the property. The buyers, the market, will chew you up and spit you out so fast. There goes all your investor returns and all your hard work over the past four to five years.

So when talking about debt and the term of the debt, always go for more than you really need. So if you’re planning on a 4-5 year hold, get a 10-year term on your debt. If a worst-case scenario happens and you can’t sell because of market conditions or unforeseen circumstances, you can hold for another five years until conditions improve. You are not pressured to sell. Your investors’ money is safe. You’re able to hold the asset that has produced the cash flow that you have manufactured through your value-add process. You are not under pressure to sell and make poor decisions.

Where poor decisions happen is when you have extreme pressure, whether you know it’s a financial pressure. You don’t want to be placed in that situation. You don’t want to place yourself and your investors in that position. So when you’re looking at debt and considering your options, always go for a lot more than you really need because that’s going to buy you time if something does happen. Like I said a couple times in this blog post, nobody knows what the future will bring. Nobody has a crystal ball. So always be conservative.

That’s the theme of this blog post. Be conservative in your approach in your underwriting. Be conservative in your debt terms. In that way, you are planning for a worst-case scenario.

5. Assuming you don’t need any partnerships.

If you’re interested in improving your underwriting — if you want to have a better handle on construction and rehab, if you want to raise more capital, or improve your capital-raising skills — do a better job at assessing debt. And do partnerships better...

By the way, I want you to come out to the Multifamily Conference next year, 2022. It’s being held May 14-15 in Toronto. We’ve got investors coming from all over North America. We have a star from Shark Tank as a keynote speaker. Go to multifamilyconference.ca. I really hope to see you there. It’s going to be an amazing event — everything to do with multifamily.

So let’s talk about partners and partnerships. The mistake people make when they first get started is thinking they have to do things on their own. That’s the mistake I made when I first started investing in real estate.

The truth is, multifamily real estate is a team sport. It takes a team to effectively take down, manage, and turn over a multifamily deal. So partnerships can come in many different forms:

●    Raising capital. Partners can bring capital. Maybe you need 10 million dollars to complete a deal. But you can only raise five. Instead of passing on that opportunity, partner up with somebody else who can bring in the other five million. In that way, both of you can prosper and benefit from having that deal done than not having the deal in the first place.

●    Construction rehab. Having a handle on rehab and renovations is especially important. If you don’t have those skills, partner with somebody who does. Trust me, the project will go so much smoother, your investors will be in better hands, the project’s going to be on time, and your modeling is going to be much more accurate because you have somebody with the experience on your team guiding you. So partner up with somebody with construction management experience if you don’t have it.

●    Deal flow. Maybe you have lots of capital that needs to be placed but you don’t have the deal flow. Somebody out there has the deal but they need the capital. That is a great partnership. Both of you can get together, make that deal happen rather than not have a deal on your own.

Partnerships are incredibly powerful. So many people don’t think about getting involved in a partnership because they’re thinking like I was when I first got started investing — I assumed I have to do everything on my own.

The Bottom Line

Just to recap, these are the top five mistakes people are making:

1. Being far too aggressive with their underwriting.
2. Not having a handle on their construction rehab.
3. Not raising enough capital — just getting soft commitments for the capital they need.
4. Having the wrong debt terms — putting themselves in a bad spot in case something does happen in the market.

Not exploring partnership opportunities.