Most people can call out an obvious scam or bad real estate deal, but what about the less-than-obvious signs? Today, we’ve got two multifamily real estate experts, Andrew Cushman and Matt Faircloth, on the show to go through the multifamily and syndication red flags that could cost you EVERYTHING. Andrew even went through the painful process of losing 90% of an investment years ago just to walk through his lessons on the show.
David:
This is the BiggerPockets Podcast show, 850.
What’s going on everyone? This is David Greene, your host of the BiggerPockets Real Estate Podcast, the biggest, the best, the baddest real estate podcast on the planet. Today we are joined by two of my friends in the multifamily space, Andrew Cushman and Matt Faircloth. We’re going to be talking about red flags that every investor should watch out for. This is particularly important in today’s market. Andrew, Matt, welcome to the show.
Matt:
David, thank you so much for having us today.
Andrew:
Yep. Good to be here as always.
David:
And before we get into today’s show, I’ve got a quick tip for all of you loyal listeners. Sponsors are everywhere and they are looking to get your money. If you’re finding a sponsor that’s advertising on social media or even dating profiles, that might be a red flag that you want to look out for. Today’s show, we’re going to go over seven other red flags to be aware of. Let’s get into it.
Why are we doing this show right now? Well, we’re seeing operators in the news getting arrested on charges of investment fraud, and my gut tells me that as the market gets tougher, it’s going to be like the tide going out and you’re going to see who’s been swimming naked the entire time. Today’s show will be about something that has even happened with our previous guests.
Now we vet our guests to the best of our abilities, but we have had former guests on this podcast that have gotten into hot water, and that is why this type of show is so important. This whole incident is a reminder that no industry is immune to criminal behavior and BiggerPockets will continue to stress to our audience that they do their own due diligence when investing. Now maybe you’re thinking this would never happen to me, but it’s more common than you think. And as my co-host, Rob Abasolo has said, though he’s not on today’s show, “An investment fund is structured exactly like a Ponzi scheme and it turns into one if it’s mismanaged.” On that topic, Andrew, I believe you have a story that supports that.
Andrew:
Well, so back in 2005, we all like to think we’re smart and we can dig into things and we know what we’re doing, but the reality is we all make mistakes, right? Look at Chernobyl or the Hindenburg or almost any Nicolas Cage movie. Somehow that stuff still happens. So this was essentially a syndication. It was a little bit different spin. It was a group that was developing real estate out in North Carolina and they did have a couple of assets, but what they were doing is they were coming saying, “Hey, we’re selling shares, free Ipo. We’re going to build all this stuff and then we’re going to go public and you’re going to make seven to 10 times on your investment.” So, one mistake I made, I didn’t do my own due diligence. My boss at my employer at the time went and did some, and I’m like, “Well, he knows what he is doing, so I’ll invest also.”
I did a shallow look at what the sponsor was doing. Said, “Okay, it seems like they have an asset here.” Didn’t really dig into, well, where’s the money going? How’s it being used? And then there were some red flags or things that didn’t quite seem right that I overlooked because of FOMO, right? Fear Of Missing Out. And essentially greed, right? Like, dude, I can 10X my money by just investing it with these guys. And so, for example, one of those things that I found and I should have just said, “Nope, I’m out”, is a little bit of research. I found that they already had shares trading on the pink sheets, and I asked them, I was like, “Wait a second. How are you going public if you already have shares out?” And they gave me some bogus explanation. I should have said at that point, “I’m out.”
But I said, “Well, you know what? Actually this just sounds good. It’s too much of a great opportunity.” And so I invested, ended up losing 90% of our investment. I invested and then they were paying dividends and there were some more red flags. And the day before I was going to call and request my money back, the SEC swooped in, froze everything. Three years of special servicer later? We ended up, like I said, I think we got like 10% back or something like that. So it can happen to anybody. There are pretty sophisticated guys out there who can pull the wool over almost anybody’s eyes. Look at Bernie Madoff. He did it for how many decades? So don’t feel bad if it happened to you. It either has happened to all of us or probably will, but we’re going to talk about a number of things that we can do to try to prevent or minimize that.
David:
Thank you, Andrew. Today we are going to cover the biggest red flags to look out for to keep you and your investments safe, after this quick break.
All right, welcome back. We’re here with Andrew Cushman and Matt Faircloth. Andrew is my partner in multifamily investing and Matt is the author of Raising Private Capital, a book with BiggerPockets. Let’s give a quick shout out there, Matt, where do they go to get that book on the BiggerPockets platform?
Matt:
What’s up brother? Good to be here. They can go to biggerpockets.com/rpc to get a copy of that book and if they buy it from BiggerPockets, they get a bunch of bolt-on bonuses, including another small ebook that I wrote on buying apartment buildings and a 90-minute interview with my SEC attorney. So people should watch that. Just get the book just for that interview because that interview would help people avoid a lot of the mistakes we’re going to talk about today.
David:
All right, speaking of those mistakes, let’s get right into it here. All right, when they’re vetting a sponsor on a deal, Matt, briefly describe what a sponsor is and then let’s talk about what they should do. When it comes to looking internally.
Matt:
The sponsor is the syndicator in raising private capital. I talk about the deal provider. That’s the person bringing the opportunity. They’re likely putting in plenty of sweat, contacts, resources, their market knowledge, all the doingness and all the, a lot of time as well. All that stuff put together into a big package. They’re bringing the deal, the opportunity and the intuition, the know-how, the drive, all of that. So that’s the deal provider. That is the sponsor, the syndicator, they have all kinds of different names. General partner, sponsor, syndicator, opportunity provider, all these things all fall into the same guise and they’re providing the opportunity to the people that are going to invest in the deal as limited partners or cash providers.
Andrew:
And going back to some of the things that I mentioned in my story about when I lost money, keep in mind it’s not just the sponsor. The first thing to do is to look at yourself internally because whether it’s a prince from Nigeria or a sponsor with ill intent, they’re praying off human emotions. So what are some of the things I mentioned? Fear of missing out, right? A bad sponsor is looking for somebody who has a fear of missing out, not getting the great returns, everyone else is doing this. Number two, are you investing because you’re following a celebrity? You don’t really know who they are, you haven’t met them, you don’t know anyone else who’s worked with them, but hey, they got a TV show or whatever, or really flashy social media. Are you investing solely because of that? It’s not automatic red flag that they have those things, but internally that’s not good if that is the sole reason that you are investing.
Another one, too, is just are you being greedy? A lot of times we’ll talk to investors and they’re looking at four different investments like, well, this one says it returns 8% and this one says 12%, so I’m automatically just going to invest with a guy who’s promising 12%. That’s greed because just because an investment says 12% doesn’t mean you’re actually going to get it. So take the time to dive in and make sure that you aren’t just being attracted via essentially what is greed. And we are all subject to this to whatever is promising the highest return. Because generally the highest it is, the more risk that might be buried in there and you need to take time to dive into that. Matt, do you have something you want to add?
Matt:
What I want to say is the way that a sponsor plays into all those things altogether is they’re going to provide you with an opportunity, just as Andrew talked about earlier, that is really, really high above the norm rates of return. Seven X in Andrew’s case, right? But you got to get in right now because we’re almost sold out, right? So it’s going to be really, really high rates of return to create the FOMO, really, really high rates of return to create that greed. And also you got to wire the money right now and I’ve been subject to these kinds of things myself and it’s always been above the norm rates of return and I need the money immediately. So you don’t have really have time to vet it, think about it, any of those things. So that’s when you see those things, investors, listeners, just put the brakes on, run the other way. Time will start to allow these things to unfold. And if it’s too good to be true, it probably is.
Andrew:
And another thing that I would add before we dive into some of the actual red flags is keep in mind there’s multiple ways a sponsor can fail. It’s not all fraud. Unfortunately there are some fraudulent actors out there and we’re going to try to help everyone listening and ourselves to avoid those. But there’s fraud. Also there’s incompetence, whether that’s lack of experience, lack of knowledge, the wrong partners. There is incompetence.
And then unfortunately there is also just bad luck. And I know some operators who are of decades in the business, truly put their investors’ interests before anybody else’s and they’ve had a situation where a fire destroyed half the property, their insurance tripled, there was a shooting and all of a sudden the property’s in trouble. So be careful not to broad brush everybody with the same color. Just keep in mind there’s multiple ways to fail and part of what you’re trying to do with these red flags is to hopefully root out all of these and give yourself the best chance of successfully investing as an LP.
David:
All right, so we had five red flags we are going to cover in today’s show, but in just the last few days, events have unfurled that have led to two more being included. So we’re going to be going over seven red flags in today’s show. We’re going to get through these as quick as we can with as much value as we could possibly bring. All right, so, number one, the first red flag, the sponsor has a different partner for every deal.
Andrew:
So you’ll notice this is really popular the last few years, is you would see these sponsors and it would be like, they’d be like the Oprah Winfrey of syndication. You get to be a GP and then you get to be a GP and you’re a GP. Everyone look under your seats. They’re an equity. And the reason that this is and can be a problem is a lot of times what that represented was just someone grabbing any partner they could to get a deal done. And as all of you know, partnerships have a high risk of blowing up and not working. So then the question becomes when it hits the fan, and we get into the market environment that we’re in now, where the Fed has raised rates over 500 basis points, insurance is doubling or tripling, vacancies going up a little bit, etc. When things get difficult, who’s in charge?
Which partner is it? If a sponsor has six different partners for six different deals, who’s going to contribute the half a million to save this deal? Who’s going to step in in place of the property management company that’s maybe not doing so well? If one partner declares bankruptcy and is just like, “That’s it, we’re out,” and I’ve actually seen this happen in the last six months, then what? Right? Because now you’ve got half of a partnership. So that is definitely a red flag.
Now again, it’s not something where you’re automatically out because on the flip side of this, there’s what you call fund of fund investors where it’s very experienced professionals who will raise money and then from maybe let’s say 50 LPs and then go invest with another sponsor. In that situation, if you’re someone who’s raising that kind of fund, what you’re doing is you are relying on their expertise that they have done all this due diligence and that they have picked the right sponsor and that they’ve done all of this vetting. So don’t confuse the two. It’s okay to invest with someone who’s raising for another sponsor, but you just realize that you are relying on their due diligence and in fact that if you’re a busy doctor, you don’t have time to do all of this, you are going to invest with that fund, then you’re relying on them to do that. And picking the right fund to fund capital raiser can be a great and safe way to invest. Just make sure you dive into it. Matt, anything you want to add?
Matt:
When things are going well, these folks look brilliant. We see people that met at a conference one week and the next week they’re doing deals together, right? And that’s okay sometimes, but also I believe in building businesses together. So maybe it’s okay for people that just met to do a deal, but you should see a plan beyond that. If you’re going to consider investing in something where it’s a couple of operators first time doing business together, it flags. If they’ve all got different email address domains, right? Or if they all have different websites and everything like that. Or if you see them on, I’ve seen sponsors promoting multiple deals at once with different teams and things like that. So that’s really, to Andrew’s point, all well and good, if things are going well. When things start to not go so well, that’s when you’re really going to see the tide go out and see who’s naked, right?
I think that you want to see companies that are building brands, building businesses, building something that’s going to be doing deals over and over again. That should make you comfortable. It’s okay for people to bop around a little bit first and then they should really kind of drop anchor and find a home.
David:
And the logo on this red flag to highlight here is that most people get into trouble when they’re picking a spartner because they are trying to delegate the due diligence. “Oh, you did a deal with him? Oh, I know this person. Oh, Logan Paul is selling that NFT? Okay, I’m going to buy that one because I know Logan Paul.” No you don’t. In fact, the reason Logan Paul makes the podcast is probably just because people like you will buy stuff without due diligence and he can convert the Kardashians have made an empire doing this. Is Kylie Jenner’s makeup better than anyone else’s makeup? No. But Kylie Jenner’s makeup is well-known because it’s her name on it.
Andrew:
I like it.
David:
That’s good. So remember that due diligence is not an area that you want to delegate or give up on it. It is sometimes laziness. I myself have had deals where I tried it out with somebody. Didn’t go well. That’s not a person I want to partner with anymore. But guess what? That person went out there and did a bunch of deals with other people saying he was my partner. And unfortunately other people got into bad deals because he said I did a deal with David Greene. That was a consequence I was not expecting when I did that first deal with him. And now I have to be super careful. Maybe I just don’t partner with anyone anymore. I don’t want my audience to get exposed to, “Oh, you did a deal with David? Well then I can trust you.” And it actually wasn’t the case. I was just trying it out to see if they were a good operator. All right.
Matt:
David, one more thing to throw on the back of it, is a thing that a lot of the cool kids were doing in an up economy was raising capital for lots of opportunities. And since I’m the author of Raising Profit Capital, I should comment on that briefly, right? That was something that happens. A lot of people just all raise half a million for this person’s deal and then I’ll raise a million for that person’s deal over there. That’s all fine in an up economy. But what the problem with that is, as we’ve said before, that if the deal starts going south, the capital raiser that you liked and trusted has no control over the real on goings in the deal. And so when you’re getting in with a fund of funds that maybe is putting a lot more juice, a lot more opportunities into operators, maybe that’s okay. But if you’re investing with a capital raiser that’s contributing a small portion to the capital stack for a real estate deal, I would be wary because the capital raiser you’re working with, your relationship as the investor really doesn’t have any sway.
And I’m already starting to see deals like this fall apart, Andrew. I’ve had capital raisers call me up to say, “Hey, I raised a million for this deal where there was a $15 million equity piece and they’re now talking about giving back the keys to the bank and this capital raiser doesn’t really have any control for these people that put millions of dollars of their hard-earned money into the deal, there’s really nothing they could do because they’re in minority control of the opportunity.” So I would be very leery of sub subcapital raisers in this changing market
David:
And that’s a question that should be asked. Is this your deal or are you raising money for somebody else’s deal? ‘Cos if you think about the fact that money can change hands three or four different degrees here, I raise money to give it to this person who then gives it to this person who then gives it to this person and then puts it in the deal. You’ve got a lot of distance from personal responsibility and nobody is going to be vetting it exactly. It’s like a copy of a copy of a copy. It can easily come out really, really fuzzy.
All right, red flag number two, the sponsor or the seller suggests anything suspicious like inflating the proof of funds, not disclosing material facts, et cetera. Andrew?
Andrew:
Well this one really is kind of a gut intuition thing, right? If somebody is telling you to do something or that they’re doing something that seems unethical or suspicious or maybe something you wouldn’t do, like don’t tell the bank, don’t tell the other investors, we’re going to swap these signature pages at the last second. Those are some things that you want to look out for. And this one, it’s hard to give a list of the 27 tips to avoid. This really boils down to using your gut, right? You hear that a lot. Trust your gut, trust your instinct. If it’s something you wouldn’t do or you wouldn’t want your mom to know you were doing, that might be your good litmus test right there.
Matt:
Great point there. I mean the problem is that an LP might not see a lot of the things that are happening behind the scenes, but you got to go with your gut and sometimes if things look a little bit suspicious then they could very well be, right? I would say that if you’re looking to be an LP in someone’s deal, you have the right to ask for things like the contract of sale on the property. You have the right to ask for a lot of the documents that went back and forth between the buyer and the seller on the deal. And if the sponsor is not willing to give you full transparency and give you copies of the agreement of sale, the appraisal, the this or that, they should have actually those documents very easily. And if they won’t give you those things, then maybe there’s a little bit of smoke and you should look for the fire.
David:
All right, red flag number three, no successful track record in the business. This one has been extra common the last couple years with the market being incredibly easy to succeed in. Andrew, what do people need to look out for here?
Andrew:
Think of it this way. If you are on a flight, right, and it’s like, “This is your captain speaking, thank you for flying Syndication Airlines. It’s been noted there’s some turbulence between here and our destination today, but the good news is your captain and copilot covered this in flight school and speaking of flight school, we just graduated yesterday, so we really appreciate you joining us on our first flight. Tray tables and seat backs up. Let’s get rolling.” You hear that you’re going to want to get off that flight and it’s the similar thing if you’re investing in any syndication or sponsorship. If there is no track record whatsoever, it doesn’t, again, doesn’t mean they’re fraudulent, doesn’t mean they’re incompetent. It just, they don’t have the experience, right? And then with that said, none of us would get started if people didn’t trust the inexperienced.
There’s a point where every single investor out there did their first deal. However, how that can be mitigated and what you want to look for is, is that inexperienced person partnering with somebody who is experienced? And it could be a literal partnership, it could be a mentorship, it could be maybe someone who’s really experienced is putting money into the deal. Is the new person putting money into the deal? And then also track record and experience does not always have to be direct. It’s kind of a catch 22, right? It’s like, well, when people who are applying for a job, it’s like, well, you have to have experience to get this job, but you can’t get experience because you don’t get the job. So track record can be somebody who maybe excelled in another occupation for 10 years and has just a stellar reputation for being honest and hardworking.
Or maybe they ran an incredible flipping business for 10 years and made it into a seven figure business and now they’re going to start going into self storage, right? So again, if I was investing with that person, I would be like, “Okay, I like this person’s work ethic and their business skills. If it’s their first deal in another asset class, I might want to see a mentor or some kind of more experienced partner.” But I would still consider investing with them even though they’re technically not experienced. So what you’re looking for is either the direct experience or making sure that the person is partnering with somebody who truly has experience. A lot of the deals that are going bad right now are the ones where somebody went to a bootcamp and in the last couple of years ran out, just went straight into buying 200 units, had no experience managing it, operating it or anything like that and doesn’t have anybody to fall back on, now that things are getting difficult and then those deals are having trouble. So that is why you’re looking for experience.
Matt:
Just to, on top of that, Andrew, I agree. The only thing I would say in addition is that it’s one thing to cite that I’ve got this mentor or cite that I’ve got this experienced person sitting over top of me and we were actually, a brief story. We were selling an apartment building a couple of years ago in North Carolina and we had a bidder that pointed to a mentor that said, “Well, I’m working with this person as my mentor,” and it gave me a lot of comfort, but then I realized after a little bit further investigation, that mentor wasn’t at risk on the deal. All they were, were just sitting over top of the student. The student really just took the mentor’s class and was allowed to point to the mentor as their advisor, but the mentor wasn’t going on the debt as a sponsor. The mentor really wasn’t engaged and a at-risk sponsor, meaning the reputation wasn’t there to lose if the deal fell apart.
So if you’re going to be investing with someone that points to someone above them that taught them everything they know and is going to be bringing a lot of their expertise to the deal, just make sure that that person with the experience is also at risk, so to speak in the deal.
Andrew:
I should stop and clarify that. We’re not throwing all boot camps under the bus. So the education that BiggerPockets does and that Matt’s involved in is the right kind of good education. What we’re talking about is some of the big flashy ones that you’ll see all over social media, on billboards, where it’s more about the excitement of just getting out and doing a deal and not necessarily, well, it’s like the dog who finally catches the car and then doesn’t know what to do with it. That’s what’s happened with a lot of these multifamily deals in the last few years is you have somebody that is doing, I mean their heart is in the right place, right? They tried to get the education, they took action, they raised money, but they don’t have the expertise or the partners to fall back on now that things are getting difficult.
Matt:
So to clarify, Andrew, when you take the BiggerPockets Multifamily Bootcamp, you’re not allowed to say that Matt Faircloth and the Derosa Group are your business partners for every deal that you do. But we do teach quite a bit, but we’re not everybody’s business partner for the BiggerPockets Bootcamp. We have to draw the line somewhere.
Andrew:
Exactly. And candidly, it’s not on the Bootcamp. The responsibility for this is on the individual, right? Again, it’s like, you can’t sue Harvard if you get out and you can’t get a job, right? That’s on you. It’s not necessarily the Bootcamp. Again, it’s just the person who just got an education and ran out and just bought 200 units without building the team and the resources and the bench that’s required to do this successfully.
Matt:
I agree.
David:
And that’s a good point there. And there’s analogy here where maybe you look at partnering with someone is like betting on a fighter. Well, you can lose your money if the fighter throws the fight. That’s someone operating outside of integrity, doing something illegal, but that’s not the only way you lose. You might just bet on a terrible fighter and they just go out there and get beat. Either way, you lose your money. So don’t assume it’s only getting ripped off by illegal activities or unscrupulous behavior. It can also just be a bad operator. Now on the topic of bad operating, that leads us to our next red flag, which is lack of focus. Is this investment their core area of expertise or just one of 27 different things they do and they’re a part-time operator, not a smooth operator. Andrew, what do people need to look out for here?
Andrew:
Again, this is another one where it’s not an automatic no, it’s just something to dig into. There are a lot of sponsors and syndicators out there that, for example, have done 10,000 units of storage or 10,000 mobile home communities and they’ve gone an inch wide and a mile deep on that asset class. And odds are when things get tough, they’re going to know how to handle it. They’re going to know how to steer the asset through tough times. What seemed to get prolific in the last few years is we had a lot of groups that their thing they were best at was raising money. And then the problem became, man, I got all this money raised, what do I do with it? Okay, well I’m going to go over here and I’m going to invest in this and I’m going to put this in here and you know what? I got this stuff in Venezuela that I heard has just great returns.
And so all of a sudden you’ve got a sponsor who has got, like you said, 27 different asset classes. And so again, the reason that’s a red flag is because you need to ask yourself, well, are they an expert in any one of them? Now there is the situation where they have partnered with an expert in one of those, and then what you need to do is you need to find out who that partner is and then go do due diligence and vet that partner. And if that partner is an expert in that asset class, then you might want to go for it. That might be fine. But what you want to be careful of is, if it was just Andrew and I’m in self storage and I’m in mobile homes, I’m in apartments, I’m in a crypto farm, all this different stuff, I’m probably not really good at any of those. So that’s what you’re looking for.
Matt:
To add on to that, Andrew, is that if I’m involved in a lot of different things, I don’t have the time availability that I might need to turn the asset around. There are times, and you and I have both been here in our careers that we need to go and put ourselves on an airplane and go get boots on the ground at the asset to go and address a specific issue, whatever that may be. If you’re working with an operator that everybody in the operations team has a day job. Or as you said, they’re involved in a crypto farm and a self storage facility and a resort and they’re too busy with those are the things that they can’t put the time into the multifamily asset. The multifamily assets could just languish a bit from the attention.
We looked at buying a multifamily asset in the southeast recently that was owned by a consortium of doctors. None of them were full-time active. They all were trying to own this thing passively thinking they could just buy the apartment building and wish the property manager the best and tell the property manager where to send the checks when they’re ready, right? So all well and good, but sometimes there is the need for daytime availability and if they operator you’re working with doesn’t have that, that they can’t just go parachute them into the property and get in the face of a contractor or go and look at the property manager dead in the eye and find out what’s going on, you might not be in the best boat.
David:
In Pillars of Wealth I talk about one of the mindsets to avoid if you want to become wealthy, which is what is the easiest, shortest, fastest way to make a bunch of money. It’s people looking for the downhill road. And in this space when they hear about Matt, Andrew, some other multifamily operator raising money and making a bunch of money with it, there’s a lot of people that go, “Ooh, that looks easy, I want to do that.” So they start saying, “How can I raise money and then give it to someone else to go invest?” Or, “How can I raise money and throw it in a deal? How hard can it be?” And so the person investing, they don’t know the difference between a person who’s done this for 10 years, 15 years, really the captain that’s seen the stormy seas or the person that’s only sailed in the harbor, which would be like the last eight to 10 years of rents increasing and cap rates decreasing, and almost every single thing that could go right in multifamily has gone right, and everyone’s doing well.
So you start to hear this confirmation bias of, well, they’re doing it and they’re doing it and everyone’s doing well, so what’s the risk? And maybe you even put some money into a deal and it goes well. So you’re like, “Well, I’ll put more money in the next one. I’ll put more money in the next one,” not knowing why it’s working out. So just those are elements of human nature you want to be aware of so that maybe you sniff out if something doesn’t seem right, versus what you’re saying here, Andrew, is you’re looking for the operator that has done this for a period of time and they’re doing this full-time. They have seen the things that go wrong and they know when A happens we have to do B. They’ve got some clever solutions in mind versus someone who doesn’t have the experience that won’t.
All right, the next red flag is a sponsor that is new to that market or MSA. Why is this something that people should look out for?
Matt:
So David, in the multifamily bootcamp, one of the main core strengths that we talk about you need to have on your team is market knowledge. We call it the market hunter. And the reason for that is that there’s such unfair advantage you can create for yourself as an operator if you get to know a market like no one else. You get to know the brokers, the good property managers, the bad property managers, the property managers that everybody knows. If you’re from out of town, that’s the property manager you use. But if you really know the market, you use the other property management company. You get to know who the acceptable vendors are in the market, who the good roofer is, who the not so great roofer is. All those things. Those happen through market infiltration. If you are new to a market, you’re not going to have all those great contacts.
And so it’s okay to invest with an operator if it’s their first time in the market, but you do want a little bit more due diligence and ask them, who did you select as your property management company and why? What else do they manage in the market? Because the PM company when we did our first deal in Winston-Salem, for example, Winston-Salem, North Carolina? That PM company was the one that introduced us to the roofer that we ought to talk to. And the roofer then said, “No, no, don’t call that other roofer because they’ve really messed up a few of our other properties, right?” So you want to know who they’re relying on to help them infiltrate the market. And a lot of times it’s a PM company or maybe a fellow other real estate investor that’s on the operations team on the company, but whatever it is, make sure that they’ve got some good boots on the ground that’s helping them infiltrate very quickly.
David:
I love that and here’s why. In my own experience, when I’m new to a market, I don’t know it that well or new to an asset class or new to anything, I don’t like rushing into it. I have this analogy that when I was in the police academy that we were learning how to drive the cars on a course and basically they set up all these cones and you have to drive it in under a certain period of time and it was very difficult. They don’t give you that much time and if you hit even one cone, they say that’s hitting a pedestrian. So you fail immediately if you just touch a cone, at all. So people made two different mistakes. They would either drive it too fast and run over the cones or they would drive it too slow and not make the time.
And I think at the first run, like 70% of our class failed. It was really hard. The only way you could do this was you had to study the course and anticipate when I’m in turn A I know what turn B is going to be. So you’re actually thinking at least one step ahead. Ideally you want to think two or three steps ahead. So when you’re in a sharp turn, you’re not just staring at what you’re doing, you’re like, “All right, I’m about to come out of this. I need to get on the accelerator for half a second, build up some speed because I’m not going to break for a minute and there’s a straightaway coming and I need to be bringing speed into the straightaway, right?” So what I would do is drive very slow until I learned what to expect and then when I was anticipating the next step, I would go a little bit faster and I would just run that back and forth until I could do the whole thing quickly.
Moral of the story here is when you’re new to a market or new to a strategy or new to anything, you don’t want to smash on the accelerator. That is what raising money is, it’s hitting nos. You go way faster when you raise other people’s money than yourself.
So when you’re putting together a team or an area, when you get a great contractor, a great property manager, and I know it’s the same for you guys, you start thinking, oh boy, I could do more. Now that I finally have this person, I could scale, I could have two projects at one time, I could take down a deal I normally wouldn’t have been able to before because there’s some more margin here. That only happens when you find the property manager that you trust, the contractor that you trust, a marketing system, all of these pieces give you the confidence to go quicker. So I think that’s great advice. If you’re talking to the sponsor, you want to ask, what do you think about turn three? And if they’re like, “I don’t know, I just wait until I get to turn three before I do turn three.” That’s a red flag. You definitely don’t want to go down that path. What do you guys think about that analogy?
Matt:
I love your analogies. That’s what I think.
Andrew:
I love that. I don’t think I can top that. The only thing I would add is, just be careful of the sponsor who is picking markets like they’re swiping on Tinder and just stopping on, “Oh, this one looks good on the surface, right?” Because odds are, they don’t have the depth and the resources. The two most successful types of sponsors that I’ve come across over the years and when it comes to market selection are either the huge national guys who’ve got maybe 10/20/30,000 units and they have the resources to go into a new market with power and understand it and bring in their own management and just really take it on big time all at once or, and these are the guys that most of us and the listeners are going to know, is the sponsors that live in and invest in one market and have been doing it for a long time.
I know sponsors in San Antonio and Atlanta and Houston. They literally know every block and street and which one you should invest in and which one you shouldn’t. And if I’m giving out money, I’m going to go with someone like that.
Matt:
The only comment I have here is I love David and Andrew’s analogies and I listen to this show so that I can laugh at the phenomenal analogies they come up with and making real estate relate everything to driving courses, to Tinder, to basketball, to everything else that I hear about. So, that’s my thoughts on the matter.
David:
Keep an eye out for BiggerPockets episode 851, which is how to improve your Tinder game while making money through real estate.
All right, the next red flag, other than trying to use Tinder to find love, that’s a red flag in and of itself, but the next red flag for real estate is going to be the sponsor only pushes one return metric. I love this one because this is a clear sign of deception when people are trying to pull your attention away from areas and into others. And before I turn it over to you, Andrew, I have another example for this.
My mom told me when she was a kid, she was in this group called 4-H where they raise animals and she had a pig and she would take the pig to a competition where it would be gauged on how good of a pig it was. I have no idea how this works, it’s a weird thing. But my mom said her pig had a lazy eye and a droopy face on one side of its face and she knew the minute that they see this really jacked up pig, I’m out. So what she did was every time the judge was starting to walk to that side of the pig, she would just point something else out or she would say, “Oh, I forgot to tell you about this.” Or she would start talking about herself. And actually she used it the entire timer and the judge never made it to that side of the pig and she ended up winning with a less than ideal animal. And that is something people do to deceive. So can you explain how this would look within a multifamily deal?
Andrew:
That’s a trend that we’ve seen in the last few years is, if anyone who’s been getting solicitations from sponsors, the last five years you’ve typically seen equity multiple, and I’ll explain what all these are, or internal rate of return IRR and then all of a sudden the last six to 12 months, all everyone’s talking about is AAR and oh, okay, sure. All right, sounds good. AAR, I like that, it says I’m going to make an average annual return of 18%. So I’m going to define these each really quickly and run through what you need to look for and then why the key thing to take away here, if you miss all the details, but the key thing to take away is when evaluating a sponsor in their investment, do not rely on any one of these metrics.
You need to know all four to determine if that investment is Number One, good for you. And Two, knowing all four will help you ferret out the different risks and levers that are being pulled to generate the returns. Because any one of these four is easily manipulated on a spreadsheet. And if all you look at is the one that’s being projected to look good, you might miss what’s showing up on the other factors that will reveal what’s going on.
So, internal rate of return, IRR, that is basically a way of looking at your compounded return over time. And then basically it says, “Hey, money today is worth more than money tomorrow.” The second one, AAR, that is average annual return. And that’s exactly what it sounds like. Just take your return, divide it by the time and that’s your average. So here’s the difference. Let’s say you have two investments. They’re both five years. You put $100,000 in and it’s a great investment. Five years later you get $200,000 out. For one of them, you get $10,000 in cash for every year and at the end you get $50,000 back.
The second one you get zero for five years and then you get $100,000 back. Which one’s the better investment? It’s the one that gave you $10,000 a year upfront and then $50,000 at the end. Well, if you evaluate those two investments with these two metrics, the IRR, internal rate of return is going to be higher for the one that gave you $10,000 a year because you got your money back sooner. And if the IRR on the second one where you had to wait five years to get anything, it’s going to be much lower. So what’s happened recently is that as cashflow has gotten more and more difficult to generate with new assets, everyone has switched to AAR to, I wouldn’t say hide the fact, but maybe not fully disclose the fact that almost the entire return is on the backend and that until you get there, not much is going to be happening.
So that is why you want to look at both IRR and AAR. The other two are cash on cash. I think most listeners are probably pretty familiar with that. It’s just does the investment generate 4% a year, 5%, 6%, 7%? The key thing here is to make sure that the cash on cash is actually being generated by the asset and is not just extra money that was raised up front to give it back to you and call it a distribution. That’s a whole ‘nother topic, but that’s something to look out for.
And then the fourth one is equity multiple. This is really just exactly what it sounds like. You put in your equity or your investment. How many times over is it going to be multiplied at the end of this thing? If you put in a hundred thousand and five years later you get a total of 200,000 back, your five-year equity multiple is a 2.0.
And so by looking at all four of these together, you can again determine if it fits your investment goals, but also figure out if and where the sponsor may be hiding something. And then again, it may not be intentional. They may be using, for example, really high leverage, like 80% or something in mezzanine debt or preferred equity to get a high IRR. If all you look at is the IRR, this is going to look exciting because it’s at 20%, but then you go look at these other three that I talked about and they’re not going to look so good because of that. Bottom line is look at all four of those together. Matt or David, anything you want to add or that I missed?
Matt:
I just want to say that first of all, thank you Andrew for summarizing those things because they get thrown around a lot and it’s assumed or maybe hoped that people don’t understand what those things are or maybe assume that people do. So I’m glad that you went through and defined them. The only thing I would say on top of that is as an investor, what’s your duty to do is to look at how they calculate the IRR, the cash on cash, those kinds of things. Because there’s levers that the syndicator, the operator, the sponsor can pull to make the IRR look really, really good. We’re going to sell it five years from now at today’s cap rate. Or we’re going to sell it and double our money, whatever it is a year or two from now or five years from now, whatever it is.
There are factors that they can use to not so much manipulate the numbers, but to make the numbers shine in the best light on the deal. And you want to look at what the assumptions that they made because every syndicator is being asked to look into the future. And so if they look into the future with super rosy colored glasses, well we’re probably going to sell into a booming economy and we’re probably going to sell when interest rates are going to be back down to 3%. We’re probably going to refinance and get a 4% loan. Well, given today’s standards, you might not. And so it’s important to make sure the operator made conservative assumptions when they present those metrics to investors.
David:
You can see why AAR is going to be a more popular metric because it doesn’t account for the inflation. If inflation is 5% a year and it’s a five-year deal, that’s actually a 25% pad that they’ve been able to work into what their numbers would look like versus the IRR, you’re getting your money right now and it can’t be inflated literally by inflation. So, you can see this is the tricky way that people can adjust what they’re saying to make it look better than it is.
All right, last red flag. The sponsor is not transparent about where the money’s coming from and where it is going or if there are strings attached.
Andrew:
This is another one where we could almost do an entire podcast on it, but essentially what you’re looking for as an LP here is there’s a couple of different things. Number One, sources and uses, right? So if they’re raising $8 million, how much of that is for down payment? How much of that is for fees? How much is for renovation? How much is for reserves? How much is for maybe a rate cap or all of those things? And that gets into how you vet a deal. I actually just talked to somebody unfortunately today who had a situation where, whether it was their, they didn’t understand or it seems like this maybe not have been disclosed, but an additional capital partner was brought into the deal and they were a large capital partner and that large capital partner came in with a clause that said, if certain targets aren’t met, we have the right to arbitrarily buy out the entire LP position at a value we determine.
Basically, let’s just say that investors getting zero. Because, you ever seen those contracts where it’s like, for a consideration of $1 seller does … this. That’s essentially what happened where this large capital partner said, because of this, this, and this, we have the unilateral right to buy out the limited partners for an amount we determine and the amount they determined was effectively zero. And unfortunately this is really common. These kinds of clauses and strings are common with mezzanine debt, with rescue capital, with institutional capital. So it’s not that this situation was completely out of the norm or even fraudulent, it’s just that it doesn’t seem like it was fully disclosed to the investor and/or the investor didn’t fully understand the ramifications of it.
So make sure that any investment you’re doing that you fully understand the capital stack. And when I say capital stack, think of it like literally a stack of pancakes, right? The debt, maybe a big juicy layer preferred equity, and then the LP equity on top of that. And however you want to stack that up, make sure you fully understand not the structure of it and then the rights that come with each piece of that structure. Lenders are not the only ones who can come and take over a deal.
David:
All right, thank you for that Andrew. Matt, to close us out, can you give us some common sense principles for people to keep in mind when choosing a sponsor?
Matt:
Thank you, David. So guys, here’s some common sense principles for you guys to take home and take to heart when you’re looking at deals as either a investor or even as an operator. A great sponsor can turn a bad deal into a good one, just like a bad sponsor can turn a great deal into a terrible one. Good sponsors can have deals not work out, and they are willing to tell you about them. So good sponsors, guys, are transparent, good times and bad. Look for asymmetric risk, meaning the amount of money you could make on the upside of the deal is much, much more than you could potentially lose on the downside of the deal. Use your gut, guys. Listen, a lot of times your gut’s right. There’s some Spidey senses, if I may use a superhero analogy. There are some good things in your intuition.
So use those when considering a deal. And if your gut says slow down a little bit, maybe do a little bit more diligence, do that. If you don’t understand, don’t invest in it. That’s a great analogy for anything. Don’t invest in anything that you can’t comprehend or explain to somebody else very easily. And if you guys want a lot more thoughts, as in from an LPs perspective on how to select the right operator, consider all of our good friend Brian Burke wrote a book called The Hands-Off Investor. And it is a great book about selecting operators. And at the very end of that book, there is, I believe, 72 questions that I’ve had investors ask me to answer all 72 of them. So maybe don’t do that to an operator, but pick maybe the top five you like and send them over to an operator you’re considering investing in because Brian put a lot of hard work into that book and it’s intended to help you guys select operators that are really going to be there for your best interest.
David:
All right, so several good book recommendations on today’s show. We mentioned my book, Pillars of Wealth: How to Make, Save, and Invest Your Money to Achieve Financial Freedom. Brian Burke’s book, The Hands-Off Investor. Matt Faircloth’s book, Raising Private Capital, and I’ll throw a bonus one in there for you. You can also get this at the biggerpockets.com/store website. The Richest Man in Babylon, which covers investing principles. And one of them is don’t invest in anything that you don’t understand.
A quick recap of our seven red flags. The sponsor has a different partner for every deal. The sponsor suggests anything suspicious like inflating proof of funds or not disclosing material facts. The sponsor does not have a successful track record in the business. They lack focus, meaning that this is not their core expertise, it’s just one thing that they’re doing. The sponsor is new to that market. The sponsor only pushes one return metric. The old smoke and mirrors. And the sponsor isn’t transparent about where the money is coming from and where it is going to.
Matt, Andrew, thank you so much for joining me on this show. This is very valuable to our audience, which hopefully we could help people save some money. I’ve said it before, the old flex was bragging about how many doors you got. The new flex is holding onto what you have accumulated during the good years.
All right guys, thank you very much for today’s show. This has been fantastic. Appreciate you all being here. I’m going to let you guys get out of here. If you’re listening to this and you enjoyed our show and helping save you some money, please consider giving us a five star review wherever you listen to podcasts. Those are incredibly helpful for us. And share this show with anyone you know of that is considering investing in someone else’s deal before they send their money.
And if you’d like to get in touch with any of us, you can find out more in the show notes.
Do I look like a Shar Pei when I do this, in my head?
Matt:
A little bit?
Andrew:
Actually, you kind of look like one of those Sega characters that had the lines on there.
Matt:
Yes, the bad guy. And Sonic the Hedgehog.
David:
Dr. Robotnik. That’s right.
Andrew:
You know what, quick side note, I think pigs should be man’s best friend instead of dogs because three quick – Number One, highly intelligent and trainable. Two, easy to care for and Three someday when they pass away? Bacon, right?
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