New passive investors often ask me what to look out for when reviewing deal pitch decks and the first thing I always say is that nobody is going to show you a bad deal. In multifamily, the pitch is a marketing tool that should compel you to invest and often these are fancy professional documents. However, as a prospective investor, you must be able to evaluate the deal based on your own criteria and investment philosophy. This comes down to first understanding and educating yourself on the business. Then you need to not only understand the information presented to you but also identify the information that is not presented. The following are some key red flags that I have seen upon reviewing several hundred investment pitches.
1) Historical T12 / T3 Details Not Provided
It is a red flag when a value-add multifamily pitch does not provide the trailing P&L information and only provides the sponsor’s proforma. Proforma’s are important since they drive the projected returns but as a prospective investor, your job is to evaluate the likelihood of the sponsors hitting these proforma’s. In a sense, sponsors are asking investors to jump onboard with them and as an investor, I want to know how far we need to jump. These properties are usually occupied and have a current income stream and being able to compare its current income stream to the proforma is very important. Without this information an investor is unable to evaluate:
- The probability of attaining the projected Rental Income growth in year 1 and if business plan (e.g. unit upgrades) can support the needed rental increases.
- How much income growth is attributable to increases in Other Income, which is often very discretionary for tenants and can suffer in a tough economy.
- Whether the Operating Expense decrease is practical based on the proposed cost reduction initiatives.
There may be circumstances where the T12/T3 is meaningless, like when buying a vacant building, but otherwise the historical’s are relevant. As an investor, I don’t expect sponsors to share their analysis spreadsheets as these are proprietary. However, I do expect to be given information on the current operations of the property so I can evaluate how the sponsor plans to take the property from A (current) to B (proforma) and if I feel good about jumping in on the ride.
2) No Mention of Risks and Mitigation Plans
In the consulting world, most pitches have a description of the potential risks and mitigation strategies. The SWOT (strengths, weaknesses, opportunities, threats) analysis is commonly used in big business settings especially when pitching new ventures. In multifamily, however, I do not see many decks mentioning the risks of investing. Like any investment, there is always risk and the key is to understand how that risk has been mitigated. Some sponsors may argue that the risks are outlined in the Private Placement Memorandum (PPM), but I’d argue that those risks are broad strokes legal disclaimer and good sponsors should be able to a) acknowledge the specific deal risks and b) convey their proposed mitigation strategies. The following are some areas I commonly see missing in multifamily pitch decks:
- Income Restrictions – There are many properties that have stipulations placed on them to provide affordable housing to low income residents in exchange for certain government tax credits/grants. The restrictions include ceilings on maximum rents that can be charged and on maximum income tenants can earn. Some restrictions are property-wide and some may only impact a small % of units. Nonetheless, this type of property is different from a market-rate one as it takes more qualified management, there will be a smaller buyer pool on the exit and the income potential can be capped. As such, these risks must appropriately be accounted for on acquisition. I’ve seen several deals that had income restrictions but had no mention of this on investment decks to investors.
- Physical Attributes – Most deals do describe the vintage of the property and the high-level characteristics (e.g. brick vs. hardi, flat vs. pitched roof, etc.) but many do not provide details on whether it’s a chiller property, type of plumbing (PVC vs. galvanized), type of electrical (aluminum vs. copper), etc. These may not be deal breakers, but knowing this information is critical to assessing whether the property has enough Opex/Capex to handle repairs and maintenance.
- Prepayment Penalties – Most standard agency loans have very punitive prepayment penalties if the loan is paid off early. Typical loan terms are 10 or 12 years, yet most business plans I’ve seen are between 3-5 years. Though having long-term fixed rate debt is a good risk management strategy, it is not as flexible and could create challenges upon exit. Investors should be informed and understand that this could impact capital events in the future.
3) No Mention of Roles & Responsibilities
Lately there have been a lot of deals that have 6-7+ general partners on the sponsorship team. There’s nothing necessarily wrong with this but it doesn’t take more than 2-3 people to asset manage an apartment community especially if you have 3rd party management running operations. As an investor, you are banking on the team to execute and when there are a lot of people co-sponsoring a deal it would be wise to understand the roles and responsibilities of each to ensure there is good chemistry and ensure the deal won’t fall victim to ‘too many cooks in the kitchen’ challenges post-acquisition.
4) Lack of Transparency on Sponsor Compensation
The pitches all do a great job of articulating the projected investor returns, but not all of them clearly outline the sponsor compensation. I believe that sponsor compensation should be commensurate with experience. Sponsors take on significant risk pre and post acquisition and those that continue to build a solid track record deserve to get compensated for it. Though the high-level sponsor compensation and fees are included in the deck, I’ve seen several instances where the operating agreement (which is the legally binding agreement) has a lot more fees included than described in the deck, which doesn’t speak well to the sponsor’s integrity.
Summary
The above are just some examples of some of the items I’ve seen missing from the hundreds of investment pitch decks I have seen over the past years. I encourage passive investors to review as many decks as they can so that they can see the similarities between some and identify outliers. Furthermore, it should be noted that the pitch decks have no legal binding and that all passives should thoroughly review the legal documents such as the operating agreement, PPM, etc. before investing.
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