How to Go from Fix n Flips to Multi-Family Investing

By Ed Rogan, Owner, Co-Founder

How to Go from Fix & Flips to Multi-Family Investing - LI

Your entry into real estate investing could start any time. For most people, new investments start small. In the case of real estate, it’s common to begin with single family homes before moving on to bigger things.

If you’re looking for options to move away from single family investments, multi-family real estate is a great option for scaling up without jumping too far outside of what you’ve already been doing. It’s decidedly different from single family, but if you prepare yourself ahead of time you can transition successfully.

Going from Fix n’ Flip to Multi-Family

In concept, fix n’ flip single family properties and value-add multi-family are the same. You’re taking a property that’s either renting for or valued below market rate and improving it in a way that brings the values up to or above market, but in practice, the process of choosing a project and improving its value is very different.

Depending on the area you’re searching in, single family fix n’ flip properties could be anywhere from $100,000 in an up-and-coming neighborhood to a few hundred thousand dollars in an upscale area. With multi-family, you’re looking at millions.

Due Diligence

The added weight of a larger investment means more due diligence is needed for multi-family properties. While there is a certain due diligence in every real estate investment, no matter the size, multi-family due diligence is much more involved than single family.

Though multifamily investing is a complicated business to be in when done properly, with many moving parts and nuances, there are some key steps to follow that drive success. Let’s take a look at these most significant parts of the process, starting with due diligence, which should cover 3 categories:

Watch as Percy discusses financial due diligence or read the transcript here >>

Then, when you look into the financial due diligence, typically, you ask for what's called a T12, or the previous 12 months' operating books of the profit and loss statements, cash flow statements. We go through the actual T12, not what the broker is giving us, or not what the seller may have advertised, initially. We look at the actual T12.

One of the steps we take is we try to then track that or trace that to the bank deposits that they have made. We take an extra step, and say, "Hey, okay, you're telling me that this is the revenue that came in, and these were the expenses. Can you prove to me that this was the actual revenue that came in and was deposited into the- cash that came in was deposited to the bank?" We try to trace that; make sure- validate the statements a little bit.

Then, we do our underwriting. We have our own financial model that we've built over the last several years. We stress test the projections based on certain assumptions. So, we look at what would be the break-even occupancy of the property. What's the cap rate, when we are looking to sell the property? We generally increase the cap rate, which means we assume that the market's going to be softer when we sell it. We stress test it at multiple levels to see how much of a downturn we can sustain in the market while still giving a good return to our investors.

Then, we obviously do some forecasting and stress testing around refinancing, as well; like, if we had to extend the refinancing period for a while, or if we get a different interest rate than what we're anticipating, et cetera. Once it passes those key assumptions and metrics that we have, then we go a step further. We put an LOI out, which is a letter of intent.

1. Financial

Looking at the finances of a deal is one of the first steps you want to take. Observe the market where the asset is located. How does it compare to similar properties around the area? Is the market projected to grow or stagnate? Does the future potential of the property fit well into your business plan?

Beyond the market conditions, financial analysis also looks at the T-12 reports (trailing 12 months) including cash flow statements, income statements, and other financials. Don’t take all numbers at face value. Re-do calculations, assess projections, stress test the numbers under different market condition assumptions, and verify everything you read. Sellers will generally paint a property in the best light possible, so your job is to get the full story from the numbers.

2. Legal

Properties can come with a number of legal complications attached. Make sure the title is clean, uncover any existing contracts that would transfer to new owners, look for title restrictions, and generally unearth any hidden legal hurdles. It’s your responsibility to find out these types of issues ahead of time. You won’t have any legal leeway after the sale is complete.

3. Physical

If a property looks okay in the financial and legal categories, it’s time to take a closer look at it physically. Send the seller an LOI (letter of intent) and schedule a tour of the property. Take a trusted contractor from your team (more on your team below). Contractors often notice things you wouldn’t, identifying signs of future problems with the building.

Look at the property itself and the surrounding area. Talk to staff members and residents. Learn whatever you can about the building.

If you’re looking at older buildings in particular, keep in mind that building standards have changed significantly over the last few decades. Renovations may uncover substandard building materials or outdated building techniques that will then need to be brought up to code – a process that can be very costly and through your budgeting off significantly if not included.

Everything you discover throughout due diligence should be included in the final budget for renovations, impacting the price you’ll offer during negotiations. If you’re planning to work with a property manager, bring them into the process and have them draw up their own budget for the project. Compare what they give you to what you came up with privately to make sure their estimates are consistent with yours.

When we evaluate a property, we go through checklists with around 200 items for each category. These aren’t tests designed to disqualify properties, but to make sure we’re investing in something that’s going to give us the right ROI.

Out of every few LOIs we send out, we may only move on to completing the full due diligence on 2 or 3 properties, and from all of this, we typically only acquire 1 property.

Successful due diligence keeps you out of bad deals more often than it finds you great deals.

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Watch Percy Nikora discuss why having a good team is important, or read the transcript here >>

When you fix and flip a property, there are some similarities with large-scale multifamily, and there are some differences. We'll touch on both. The first similarity that comes to mind is having a good team because when you're doing fix and flip, at least at scale, you want to have a good broker on your team who is helping you find and source good deals or he's getting you access to those properties, so you can take a look at them.

You want a good contractor, and that's probably one of the key roles there; somebody you can trust; make sure they're doing good work; also giving you good prices; they're sticking to their schedule - a trustworthy contractor. You want a good attorney - making sure that you cross all the T's; dot all the i's. Then, if you're doing a lot of properties, you want a good property manager taking care of those property or at least making sure that you have those processes in place.

Those same things apply to multifamily, as well. It's just on a much larger scale. When you're flipping houses, it's generally - depending on the area you're in - it could be anywhere from, let's say, $150,000, $250,000, $300,000. With apartments, you're flipping $10 million, $15 million, $20 million, $30 million deals, so it's just a different magnitude.

You have to make sure that you do your due diligence before getting into the deal. The underwriting is super-critical in multifamily deals. Yes, it takes some time to find those assets but analyzing markets, knowing which markets are the right markets, analyzing the specific financials of the particular property are key. We'll get into more detail on that.

If it's a Value-Add project, where you're doing a significant amount of improvements to the property, you want to make sure you have a good contractor or team of contractors, really, to work on the property to make sure that you can get the work done in the budget and on schedule. Then, a good property manager to make sure that you're leasing the property; operating it well; the current tenants are happy in the property. Just to help you continue to improve the net operating income of the property, which is really the entire game when it comes to multifamily properties.

Forming Your Team

Good multi-family deals depend on you being backed by a good team. There are generally at least 4 parts to your investment team:

Broker

Brokers help you find properties in a local market, sorting out the properties that fit your strategy the best. When you have trusted brokers on your side, it’s much easier to find great deals. Working with a broker on a regular basis gives you some advantages, such as access to private sales you wouldn’t have known about otherwise.

You should also source deals yourself by using public and private databases of owners and contacting them to ask if they will sell. This laborious process of finding properties that are not already on the market, the ‘off-market’ transactions, is attractive because it can uncover some really great opportunities, but it requires considerable time, energy, and persistence to find the good deals. It is an approach we have adopted here at Penn Capital with great success.

Contractor

Arguably the most important person on your team is your contractor. This is the guy who’s going to be taking care of your renovations and value-add projects. You want to make sure you’re working with someone with a good track record you can really trust. They need to demonstrate not only that they can keep to budget and deliver on time, but also that they can adapt to circumstances on the ground in real time. Seldom do value add deals not uncover surprises once demolition starts; your contractor needs to be able to keep moving no matter what the issues that arise.

Watch as Percy discusses his insights into finding a good contractor or read the transcript here >>

When you're finding a contractor for multifamily, at a high level, you have some of the same tenets that you want to have in place, when you find a contractor on single-family, such as do you trust the person? Are they constantly coming back with change orders, once they give you a quote? Because, quite often, you'll find contractors will try to get their foot in the door by giving you a very low quote, but every little thing, then, they want a change order, and then, that's how they really make up their margin. You want to make sure that it's a contractor that, when they give you a bid, they're generally within that. There's always some change in scope; I've never seen a project that has been exactly on scope, but that they're not coming back for every little change.

You also want to make sure that they are familiar with multifamily building and what's needed there because the quotes are a little different. You want to make sure they have a good relationship with the government officials where they're working. When you're applying for a permit, they know who to talk to. Quite often, you have to- if it's a market that's seeing a lot of growth, those people are very busy. So, you want to make sure the plans presented to them meet all the requirements; they can sign off easily; or they know who to follow up with, if you need some follow-up, et cetera. Having some existing relationships in that market certainly helps.

Then, having great references. If they do a good volume of work ... We work with- generally, we work with contractors who specialize in multifamily, or in the commercial space, so they have a lot of relationships with, let's say, flooring vendors, or lighting vendors, or people through whom they buy in such bulk that they have really good discounts in place. You could leverage that relationship, or their relationship with some of these vendors to get deeper discounts than you may be able to get. We do that, as well.

When we put out a scope of work, we get different quotes, but then sort of lean on them to make sure that they're getting us the best price. We have a good idea of what certain things are going for in the market. We always get- no matter who, even if you have a good relationship with certain contractors, we still get two or three different bids just to make sure that they continue to stay competitive, and there isn't something in the scope of work that maybe one contractor oversaw, or interpreted one way, versus somebody interpreted it somewhere else. It's amazing how that tends to happen, as well. By getting multiple quotes, you sort of normalize that playing field, if you will, and get a good idea of the prices to make sure that you're getting the right price, and the schedules, and all of that.

How do you find a good contractor for multi-family?

Building trust is a big deal. Start with someone who comes recommended and who has experience with multi-family projects. See how the experience goes and make a decision from there. Pay attention to a few details:

- Are they familiar with multi-family buildings? The quotes for these types of projects are very different than single family, so you need someone who understands the nuances.

- Do they have a good relationship with local government officials? Projects go more smoothly if they know who to talk to when applying for permits or seeking further information.

- Do they have good relationships with vendors? These relationships allow you to get better prices when buying in bulk.

Attorney

You have to ensure you’ve dotted all your “I’s” and crossed all your “T’s”. This means working with as many attorneys as you need to get the paperwork right. At minimum, you’ll want to work with a real estate attorney who has experience in multi-family deals. If you’re doing to leverage any part of the property, it’s also a good idea to have someone who can work closely with the lender’s attorney.

For anyone considering syndication, you’ll need a competent securities lawyer also, to guide you through all the solicitation and disclosure regulations.

Property Manager

If you’re not planning to actively run your multi-family property, or if you have multiple properties you want to manage simultaneously, a property manager is essential. The right property manager can help you increase the NOI (net operating income) of your building.

A good team is behind every successful multi-family investment. While you might have a similar team for single family acquisitions, everything is scaled up for multi-family.

Legal Considerations

If you’re used to dealing with single family properties, you need to adjust your expectations about the legal framework governing each type of investment.

Single family

The legal definition of a single-family property is 1 to 4 residential units. These are consumer class properties, even if you’re buying them as an investment. Because they’re classed as B2C transactions, there are more disclosures on the property and regulations that protect you as the consumer.

Multi-family

Multi-family properties are residential properties with 5 or more separate units. These are considered to be commercial properties, are treated as such by lenders, and have fewer disclosure requirements for sellers. The expectation is that as these are business to business deals the burden of responsibility for uncovering issues is on the buyer through their due diligence process.

This applies as much to the physical inspection of a property as it does to the examination of documentation, from title insurance issues, to possibility of liens, and the terms included in any sale agreement.

Buying a multi-family property puts you in a different league to single family housing, and doubly so when you start to scale up quickly, as we have done at Penn Capital, so having competent legal counsel can help navigate what can be a complicated landscape, filled with potential landmines.

Watchas as Percy shares his insights into apartment investing or read the transcript here >>

When you start looking at multifamily, that's a whole different ball game. You've got to make sure the due diligence is done. When you start getting into having these- building out the team, it takes a little more time. Like I said, it took us, I'd say, a good two years to get to a point where we have relationships with all these different trusted vendors - the lawyers, the contractors, property managers - and understanding what works in one market versus the other.

What I mean by that is there are certain amenities in the multifamily space that you may have to provide to the tenants because all your competition is doing the same. In single-family, amenities are not that big of a deal ... Whether you have a swimming pool; whether you have a gym; whether you have a library in your multifamily property may make no difference; whether you offer assigned parking garages, all of that ... Those are all the additional revenue streams that could make a big difference.

In multifamily, when you're doing fix and flip, the end game is to say can I increase the value of the property to get it to a level that some of the comps in the area have sold? Versus, in multifamily, what you're trying to do is increase the revenue or, really, the net operating income of that property. Once you increase that, you get a 10-fold, 15-fold, 20-fold return on that money. You're really looking at what are ways in which I can increase my income streams or decrease expenses so that the bottom line of the net operating income goes up. It's a slightly different focus, and you just have to make sure that you continue to operate the property where you're maximizing the net operating income.

Benefits & Challenges

Single family and multi-family properties both have their own benefits and challenges. It’s a trade-off, no matter which choice you make. However, multi-family can be a better option if you’re looking to scale up your residential investments, enjoy benefits of scale and get a higher return on your investment.

While single family generally has more consumer protections, multi-family requires more due diligence on the part of buyers. Building out your team takes more time, because you need to form trusted relationships.

Even with all these considerations, multi-family is a great option for any investor looking to build a sustainable pathway to building wealth over the long run, while enjoying the benefits of income distributions along the way. You can buy a large number of units in one go and improve the property value through NOI increases, accelerating your equity returns much more quickly than you ever would with single family properties.

It’s not an ideal investment for everyone, but it might be a great next step after single family fix n’ flips and is a pathway that has taken the team at Penn Capital from zero to six hundred and seventy units in under eighteen months.

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