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Don’t Invest in Real Estate If You Can’t Handle Ups and Downs

by Jonathan Twombly
Last Updated: May 5, 2017

For months, we’ve been working on a multifamily deal in South Carolina. Since every multifamily property in South Carolina seems to have “creek” or “park” in its name, I will call this deal “Creek Park” to protect the innocent.

Creek Park is a 1970s property that has received about $1.5 million in renovations from the current seller and is in tip-top condition.  It’s in a great location, within a short walking distance of bars, restaurants, and retail, which is unusual for suburban South Carolina properties.  The area is on an real upswing, and we own a property less than ½ mile away that is 99% occupied.  Creek Park would have taken us to an even 500 units in our portfolio in less than three years since we started operations.

We do deals at 75% loan-to-value (LTV) leverage.  We have a great relationship with a major bank, and we expected a smooth loan closing, according to the usual terms.  We prepared all our investor materials assuming 75% LTV, began pitching the deal to our partners, and got a warm reception.

Then we received the lender’s term sheet — 68% LTV!  The bank usually underwrites deals on a trailing three-month (T3) financial statement.  But within the T3, the seller was recognizing bad debt from earlier months and taking it as a charge against income.  While it’s a normal accounting practice to subtract income that you previously recognized but did not actually receive, it made it appear as if the property was doing far worse during those three months than it really was.  Even though this was an accounting adjustment and had nothing to do with the cash coming in the door, the financial statements made it seem as if the property was not receiving enough rental income.  So, the bank decided that the income stream could not support the debt service on a 75% LTV mortgage and offered only 68%.

Crap!  Yields were getting tighter in this market, and we had already pushed our underwriting as far as we felt comfortable going to reach a 7% preferred return, which we thought was the minimum that investors would go for.  At 68% LTV, we didn’t know if we could even get there.  We thought about canceling the deal, but we knew deep down that Creek Park was a solid property for our long-term hold strategy, and we needed to make it work.  We underwrote the deal again at the lower LTV, made some adjustments to the structure, got to the numbers we needed on conservative underwriting, and went back to our equity partners.

. . . Crickets . .  Crickets . . .  Crickets . . .

The investors got spooked.  If the bank doesn’t love this deal, why should we?, they thought.

Thus started a round of calls with the seller and lender, to get the lender to understand the accounting, to get the seller to restate their financials to show the true current situation at the property, and to get everyone back on board.  Finally, after weeks of calls, the lender felt comfortable that the property’s cash situation supported 75% LTV and upped their offer.

We went back to our equity partners.  Hey, everyone, look here!  We’re back where we started!  Happy times are here again!  This is a great deal — come invest!

. . . more crickets . . .

The investors had moved on.  Once spooked, investors stay spooked.  That’s okay, we’ll pass, we heard.  Be sure to keep us in mind for your next deal!

But one potential investor remained, from the West Coast.  They had planned to invest alongside a bigger group from Virginia, whom they had brought to the deal.  The Virginia investors loved the deal, but were closing two others by year-end and decided to pass for lack of time.  (Keep us in mind for your next deal!)  The West Coast investors decided to become the principal investors themselves, providing 75% of the equity; we would raise the remaining funds from our individual investors.

Today, those investors dropped out.  They had come down to South Carolina, liked the property, liked the market and then . . . dropped out.  No real good reason; they just dropped out.  Keep us in mind for your next deal!

So, now we’re throwing Hail Mary passes at new investors who might just happen to have a couple million dollars lying around that they need to invest by year-end.  Other than that, we’re cooked on Creek Park.  What a waste, not just of months of time, but of an opportunity.  And every time I drive past this property on the way to the one we own nearby, I am going to get a lump in my throat about what might have been . . .

So, what’s the lesson here?  You can never have enough equity investors lined up before your deals.  Even when you think you have enough, you will always need more.  If your deals are not over-subscribed, you stand a chance of losing the deal.  No matter how good the deal is.  And Creek Park was a great deal.

Not make-you-rich-overnight great, but steady, dependable, cash-in-your-pocket-every-quarter great; looking-back-in-ten-years-and-being-glad-you-bought-it great.

And now it’s gone.

But wait!  Just got an email saying that an investor wants to discuss the deal tomorrow morning.  We’re not quite dead yet!

Update:  The Next Morning

The investor doesn’t invest in these sorts of deals.  We’re cooked.  Game over.

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