Transcription
What happens when a deal goes bad? Today, I'm going to walk you through a real live deal that I just had fall a contract, costing us roughly 20K of dead deal costs.
This is something that happens all the time in the real estate private equity business. You're pursuing a deal, it looks great, you start digging under the hood during diligence, and major problems start popping up. In this video, I'm going to walk you through what to do when that happens.
For those of you who don't know me, I run a real estate private equity firm with just under $40 million of assets under management, mostly comprised of multif family deals. I post anonymously, which allows me to show you the real numbers and behind the scenes content that wouldn't be possible otherwise. If you want to see more content like this, hit the subscribe button below.
I'm going to start by walking you through why I like the deal initially and then by showing you everything that went wrong and force me to kill the deal. Just as an FYI for this deal, I'm not going to show any exterior pictures because it's one that may end up coming back to a lower price in the future.
So, here's a basic overview of the deal. $5 million deal, 67 units, so roughly 75k unit purchase price. All in after deal costs, renovations, acquisition fee, reserves, roughly 90k a unit here. So, so pretty good basis overall um for a deal like this. Uh especially given the unit mix. It was actually two separate properties, by the way. 130 unit property, 137 unit property. So, a little bit unique there. But the unit mix really skewed heavily towards two and three beds. One of them was actually a litec build. So, it was it was pretty nice product, especially when you look at kind of incoming $900 rents, typically the product's pretty poor. That wasn't the case here. Um, there were actually a lot of town home units. The three bed units were all town home. A lot of the two bed units, over half them were town home as well. Um, so pretty attractive unit mix, pretty good basis overall at 90k unit all in. um and overall a good piece of real estate given the lower income status in a market that was kind of a sleepier Midwestern market and the basics of the deal right in place going in cap rate um based on their 2024 financials 7% stabilizing at a 9% yield so pretty solid numbers there and that's really what I liked about the deal right you have the low basis you have the high going in yield right and you have the high stabilized yield right so it seems like kind of at face value you have a deal that's relatively lower on the risk spectrum um and a decent profit. Right? This is a market where assets were actually trading for around high fives, low sixes, you'd say like between 575 and 625 around there. Um, so I had the exit cap rate a little bit higher here just to be safe. But overall it's a good stabilized yield. You're getting a lot of um you're getting a lot of basis points there of spread, right? So, those are kind of the things that I thought were very interesting initially about the deal.
The other thing is really just the market, right? It's a market that kind of Midwest, a little bit sleepy, really no incoming supply at all, really no risk of rents going down in the future, right? Kind of stable population, no incoming supply. So, you kind of have a place where you should be able to push rents a fair amount. The other thing I liked about the market is that it seemed like there weren't too many institutional owners there and there weren't many owners who had there were a lot of slum lords on one end, but there weren't many owners who had actually gone in there and started pushing revenue, right? And what I mean by that is like a full renovation scope, not just turning units. You'll see this a lot in lower income housing where they're just turning units for like 5 to 7K. um that's not going to get you kind of top of market rents, but it will just get you kind of the next person in the door at maybe a $50 rent bump. And you can see here we allocated a little bit more um roughly 12 grand there um on 67 units. And this deal was sourced, by the way, offmarket um direct to seller on a cold call. So that's kind of the reason for the attractive purchase price and really why we like the deal overall. So, those are kind of all the things that made the deal interesting to start out.
And I could show you kind of a little bit of the numbers here, right? This is kind of the basic underwriting. Here's the 2024 numbers, right? And looking through it, right? You kind of have a 360K and a Y, right? Here's your gross potential rent. You end up with around 636K of revenue. The expense load is definitely a bit light, and you'll see that here, how much the expense load jumps up. Um, this is classic when you're looking at deals in this kind of smaller size range is you'll have a management just an overall fee load on the expense side that is non-institutional and really below market. So, this 7% incoming yield is actually going to drop a lot once you put a real a real expense load on there. Um, and you can see things like payroll, insurance, I'll talk about that in a second. um really start jacking up and and taxes as well and management. So there there's a kind of a few things that really came into play there and I can kind of show you on the scenario tab that I built out, right? Basically why why the deal started becoming unattractive.
I know a lot of you are struggling with finding deals right now. Some of you are looking to find your first deal and are having trouble knowing where to start. Others of you have bought a few deals and are looking to scale. I've been in both those places before, having scaled from a $2,500 investment on my first triplex to over $30 million AUM. I've created the acquisitions boot camp, which is an 8week one-on-one program where I show you how to solve those problems so you can purchase profitable deals. The results have been insane. You can see some of the testimonials and closed deals flashing on the screen here. Most recently, Matt made a million dollars on a deal in about a year. I made a full video on that on my profile. If you'd like to set up a call to discuss if the program is the right fit for you, you can do that in the in the link in the description.
And the first thing is that when you look at it, right, basically the incoming yield I thought we had, right? Or you'd think you'd have wasn't real, right? So 2024 financials, right? If you look at the cap rate and the stabilized yield, you're coming in at 7.2 cap and a 5.97% stabilized. Once you readjust the expense load, so basically take that same in place revenue, readjust the expense load, you're actually coming in at a four and a half cap and a 3.7% stabilized yield. And this is less common to see when you get into the actually more institutional range. Like let's say this deal was 10 mil plus um just bigger over 100 units. There would be more of an institutionalized expense load on it and you wouldn't see this huge drop, right? Maybe be a little bit. You'd see the taxes adjust a little bit and maybe the insurance, but it wouldn't give this huge adjustment to payroll and management um that we see here.
And to take a step back, right, the payroll and management, this is actually a bit high, right? If you look all in, it's around 100k um which is significant for a a deal of this size. And it was basically a 6% management fee and a let's see here it is 6% management fee and then 55k of payroll on site. Normally, I'd be able to do it for less if it was in the market that I I have actual scale in and that I know, right? I would just do it inhouse for significantly less. I've done 50 unit buildings with basically basically cost me 25 to 30k with an in in-house super. Um, and you can do that, but with this, it's a market I was unfamiliar with. I didn't want to go with a lower fee load on the management side. So, it ended up being a bit higher there. Um, so that's kind of the reasoning for that. You don't need to be doing it this much. You could you can get away with a significantly lower fee load um on the just pure management side if you do know the market better. But the point is really that it it it very much impacted this in place uh yield which does a few things right one is that it's going to affect the debt you're you're able to get right it really affects the debt I mean basically you can see here right the loan amount of 2.9 million that's not much right you look at 2.9 million based on the purchase is that's under 60% levered, right? And when you take it on the total capital stack, that's obviously under 50%. So your the leverage you're able to take on really really goes down. And that's not always a horrible thing, but when you're like sub 50% levered on the capital stack, it's going to start really dragging on your returns. Um, and that started becoming an issue here basically because the way the lender underwrote it is like this, right? Where they said, "All right, real estate taxes they were assuming at 67K." I always assumed they're fully going to reassess. The lender underwriting was assuming that they weren't. I don't really believe in that. Um, but I I kind of kept it just for that case. Um, but they had the insurance kind of at the in place number and I'll talk about the insurance and insurance in a second, but that really readjusted. Um, and they had payroll at a lower number than we were going to come in at. Right? Those were kind of the major items that they had lower. And my concern is when they actually started looking at the numbers a little bit deeper because that's there's always preliminary underwriting there. They're going to adjust it to say, "All right, there's actually a bit of a problem here, right? You add another 60k of expenses and now we're not able to give you what you want from a a lending perspective." So, that was kind of another one of my concerns as we we went through the deal itself.
Um, but just to kind of give a basic overview of what really started going wrong is one there's a sub institutional um expense load and that had to be right sized, right? That's the first thing which really dropped the um the in place income, right? Which did two things. One, it just how we talked about the loan amount, right? It became a little bit dicey in terms of how much debt you could take on, which obviously affects returns. And two is that it actually just increases the risk of the deal, right? If you think you're coming in at 7.2 two cap and stabilizing at roughly a nine or an 8.9 here, that's a good profile. If you're coming in at a 4 and a half cap rate and really a 3.7 higher basis, you need to bring that up to an 8.9, you need to double basically the uh the NOI here, right? It's it's it's not going from 224K essentially up to 500 over 500K, right? So it it becomes a way riskier deal overall. So that's that's kind of the first thing that really went wrong. It just became a way riskier deal.
Second thing that went wrong and this was not as of today. This is just where the five-year ended up going when we ended up dropping out of the deal. Um, but the 5-year went up 25 basis points during during the time that we were under contract. And that's obviously a big change, right? And it's been moving around a lot. It's probably back down now. I haven't checked in the last week or so. Um, but that really impacts the proceeds you can get as well, right? If you're at a four, what were we at a 39 beforehand? 389 I think it was, it's a big difference. Um, and that really will impact returns. So that's kind of the next thing that went wrong.
One of the biggest things and I I would argue the biggest thing that went wrong though was really the insurance figure. And you can see here their basic insurance load. And I have it broken out by property in this tab. So if you look at the insurance, one property is significantly more than the other. Um, but they were at like 50k, right? Which if you look at it on a per unit basis, right? You have payroll, sorry. You have insurance divided by 67 units. Right. We're at like roughly 750 a unit, which is about where I thought it would shake out. Right. You're kind of in a Midwestern market. Obviously, it's kind of older vintage 70s8s product, but overall it's there shouldn't be too much going on with it, right? Um, the quotes that we got back were insanely high, right? And it wasn't even like we were getting a lot of quotes back. Most carriers, we probably reached out to like 15 carriers and most just denied coverage overall. We reached out to a ton of brokers as well. Um, they couldn't get carriers. So, we ended up ended up only getting one quote, right? And the one quote was from State Farm at 87K. And if you look at that, right, across 67 units, 1300 a unit, right? That's a lot um for a market like this, right? Obviously, if you're in Florida or something like that, it's that's part for the course and even low. But when you're in a market like this, Midwestern kind of sleepier market, you don't expect it to come in that high. And if you look at it from a just an overall, yeah, you look at it just from an overall um volume perspective, right? A magnitude perspective, let's just say it's a six and a half cap market, right? And I think it's actually lower than that. We're being conservative here. This delta is 600 grand, right? On a $5 million deal, that's over 10% of the deal. And given the equity, right, it's an even more significant portion of the equity. So, we're just losing so much value there right off the bat with the insurance, which was pretty unexpected. I mean, expected to go up a little bit, but I wasn't expecting a 40k increase there up to $1,300 a unit.
And basically the feedback that we got from the carriers and the brokers was that it's a combination of kind of building vintage, right? 70s 80s builds. Um, location, building size, 67 units. They kind of wanted either bigger or smaller. Um, I guess it's just kind of a weird range for them. Wind exposure. Um, they're also specific panels on the property, which we told them we planned on replacing, but for some reason was still an issue for some of them. Um, kind of just a combination of all those things is just death by a thousand cuts, I guess. um and just made the deal, I'd say, significantly less attractive.
The other thing that really came into play, which was almost bigger than the increase, is that once you only get one quote for insurance, you're really kind of screwed, right? Because let's say next year they tell you, "All right, the we're coming back at 120 grand." You have no choice but to pay, right? They can increase insurance 10% every year, 20% every year. You have there's no competitors you can reach out to because everyone else doesn't want to be in business with you. So, it really puts you in a spot with no leverage. Um, and I've actually been in that spot before on another property and it just you just kind of get killed over and over again. So, it becomes pretty difficult to make the deal work because the insurance just eats you alive every year and it can be really significant, right? If this ends up being 2,000 a unit two or three years from now, it's going to really eat into returns and you just there's nothing you can do about it, right? Right? What happens if they decide to drop coverage? You know, there's just there's so many things that can come up at that point. Um, and it was it was pretty clear the market had spoken and said, "We just don't really want to give insurance on this property." So, that was kind of one of the really other major things.
So, it was kind of a combination of all those, right? You have on the one hand just that substitutional expense load. Um, two, the debt market's not really cooperating. And three, really the insurance just coming back and being so surprising. So, it's kind of a combination of those three things that turned the deal from attractive into not attractive. And some of the stuff we knew beforehand, right? Like I don't want to say I went into diligence not knowing that these numbers were going to change, right? I knew that this was going to end up we're going to have put more of a a load on it in terms of expenses, but I didn't think that insurance was going to go up that much, right? Um, and some of these other figures you you'd think you'd be able to get payroll management just a little bit lower. Um, and taxes kind of ended up when you kind of fully underwrite it. But overall, it was it was kind of a combination of those three that just really started eating into the numbers, right?
And if you if you look at the 25 bips plus the insurance increase and the overall risk profile of the deal, the increase, I mean, you're basically between seven losing between 750K and a million dollars worth of value on a $5 million deal. And now the risk profile is elevated because your imp place income's lower and your risk profile is elevated because no one wants to give insurance on the property. So it was just a kind of a tough spot to be in overall. And that's what led the deal from being very interesting, right? You have a deal where you think I have a great basis. Um, it's good real estate, right? It's actually biotech build. There's kind of town homes. Um, it's mostly two and three beds. Uh, it's in a market that's pretty stable. You're coming in with high incoming yield. You're stabilizing at a nine, right? All those things were just very positive. But once you kind of went under under the hood and really dug a little deeper, it just became a lot less interesting over time.
So that's kind of how a deal can go from a screaming buy to something that you don't really want to touch. Um, and this deal may end up coming back, right? We were looking at kind of in the low fours range, maybe going back and forth with the seller there. I don't know if it's going to come back. Obviously, that changes the risk profile a lot. And the other thing we really told the seller too was we can change the risk profile by if you're just able to over the next few months just kind of increase the in place income, right? If you're able to take this rent roll here, bump every rent 50 bucks or so, um that really changes the in place income for us, boosts the amount of proceeds we can get from the lender, and just helps out the entire deal. Kind of alleviates a lot of the concerns. But for me, that the insurance is really also a sticking point, right? There's at a certain point the market's kind of spoken on it. Um, and you just don't want to be in a zero leverage situation where you have one carrier and every year they can just bang you over the head. So, that's kind of what ended up happening with this deal.
Um, obviously there are a lot of deals that you kind of end up losing during diligence. And that's why I think it's so stupid. You have all these people online who are like, "Oh, you never uh you never renegotiate uh once you're under contract, blah, blah, blah. You can never retrade." It's like it's not a retrade if something came up during diligence, right? That's the point of diligence. If there was no point of diligence, you just wouldn't have a diligence period. You just accept the purchase price, right? Which is the dumbest thing ever. Um, so if something comes up during diligence, you say, "Hey, look, I need a price reduction or I'm walking," which is what we ended up doing here, right? So it I would never feel pressured by those people because I think it's the dumbest thing in the world. And they all they do is site like reputational harm. There are dozens, if not hundreds of firms in New York City who have probably screwed over every person they do business with. And everyone there is loaded. So, I'm not gonna say screw people over, but I think people really overrate the reputational aspect of it. Um, and I think you look there's no point in in eating money when you don't have to, right? If something comes up during diligence that you didn't know beforehand, that is the reason for due diligence and you're able to walk from that deal and you shouldn't feel pressured to do otherwise. So, um, that's really how I'd look at it, but this is how you kind of things kind of change over the course of the deal.
And in this case, it ended up being I think we spent 20 grand in total between lender fees, right? There's lender deposit, um, inspections and just random stuff, lights out and everything like that. So, it's not too big of a deal, right? You have other ones that you other deals that you you kind of recoup it all. And but that is the other thing about the acquisition fee that people get on you for charging acquisition fees. It's not only for that deal that you're doing, right? It's you had other deals that didn't work out, right? Eight 820 grand on this this deal, right? The next deal if you get 100k acquisition fee, you're really only making eight. So, never feel kind of, I guess, influenced to drop your fees either, right? I'd say a 1 to 2% acquisition fee in a deal of this size is more than reasonable. Um, and people don't see that you end up eating money on other deals. So, that's really how I look at that as well.
Um, I know a lot of you are struggling with finding deals right now. Some of you are looking to find your first deal and are having trouble knowing where to start. Others of you have bought a few deals and are looking to scale. I've been in both those places before, having scaled from a $2,500 investment on my first triplex to over $30 million AUM. I've created the acquisitions boot camp, which is an 8week one-on-one program where I show you how to solve those problems so you can purchase profitable deals. The results have been insane. You can see some of the testimonials and closed deals flashing on the screen here. Most recently, Matt made a million dollars on a deal in about a year. I made a full video on that on my profile. If you'd like to set up a call to discuss if the program is the right fit for you, you can do that in the in the link in the description.