REIA 168 Bruce Wuollet: Why do investors consistently put sponsors out of work?

Welcome to Real Estate Investing Abundance, the show for busy, fulfilled professionals like you to learn how to develop financial independence built on solid passive real estate investments. Now here is your host, Dr. Allen Lomax.

Hello, enlightened investors. I'm your host, Dr. Allen Lomax, and it's a pleasure being with you today as we explore a very interesting question, and that is why do investors consistently put Sponsors out of work? And I'm really interested in knowing the answer to that question. I'm really delighted to have back with us again a returning guest. Bruce Willette has over 20 years of experience with thousands of units bought, repositioned, and sold. The focus is on finding good deals, and he is passionate in serving the underserved, providing them with one of their basic human needs, and that is, of course, housing. So Bruce, take us into the show and share with us a memorable experience from your formative years that helped you to be who you are today.

Yeah, that's a good question. It gave a lot of thought to what would be some of the most impactful. So probably growing up in a large family in the Midwest and working in the family bakery side by side with my father at 11 years old, and just one day a week, and then became 2 days a week, and just working alongside family And being able to spend time at work, at play, and living in the same house was really a great experience. And it's influential for our business today. And now we're also a family business. Most people here are family.

Well, cool. It's nice when all of that can work harmoniously together. And I don't know how many families can actually handle that, but it's good when it does happen there. Well, first of all, just answer our question here. Why do investors consistently put sponsors out of work? And what do you mean by that?

Yeah, it's one of the things that we see more and more syndicators entering the market to find. We see people that are doing a great job capital raising, finding assets, repositioning them, and selling them. And according to the tax definition, investments over 12 months are considered, oftentimes considered passive investing. And to me, 18 to 24-month real estate transactions are not passive. They're very active. Although the investor is passively involved, to me, they're not, it's not passive investing. Where buying cash flow is. So I asked the question for investors that why do you consistently put the sponsor out of work? What I mean by that is if we buy, fix, and sell a property every 18 to 24 months, we are constantly looking for new deals. And the reason I know this is I have done— we're in our 20th or 21st project. We've taken 18 projects, 17 or 18 full cycle. And every time we sell it, there's a little bit of a victory dance and we're excited, but then we gotta look for the next one and the next one. And if you don't have one lined up, you're not doing a 1031. When you go to buy one, now you gotta go find the investors again. Well, in the meantime, you know, they might've invested something else. So every time we sell, we're quote unquote out of work looking for the next job. And so what we're gearing towards, and this is some secret sauce, if you wanna shrink your database overnight, switch from a 2 to 3 year model to a 10 year model, and you'll see who will stay along for the ride. We did that and it shrunk our investor database considerably, but now we're rebuilding with the buy and hold long-term 10 year plus holds is what we're targeting so that we can buy cash flow. And as anybody that's in real estate knows, we're cyclical. There's ups and downs and the market always goes up, right? Until it doesn't. And then how are you protected as an investor? That's a question you want to ask yourself.

Well, that is interesting that you were saying your investor base declined substantially when you went from a, essentially just kind of, I mean, they don't call it that, but just a flipping business in terms of commercial real estate to a long-term hold position. Why do you think that is, that you lost investors instead of gaining investors?

Initially, because of the change, they were liking being passively— I put investors into 3 buckets. One is a passive investor who puts their money out and just gets it, maybe never wants it back. They always want to reinvest it. That is a passive investor. Then the other side of the spectrum, you got an active investor. Active investor is me, somebody that's working the deals, actually managing the projects, and influencing the property that way. So we're very active. And then in between is the active-passive investors. They're passive by tax definition, but they're active in their deals in that they're always moving their money around from one deal to the next. So there's nothing wrong with that business model. You know, it's a good business model. It's just not my business model. And I think it's important to know what is your passion? Where do you want to go? And my passion is that real estate is a long game. It's not a short game. It can be a short game, but eventually when the market turns, people that are in the short game are going to be looking for a new job because it would be very difficult to buy in a falling market. And it's going to happen. It's happened in 2007, '08. Before that would've been, I suppose, what, '99, '90, '91, somewhere in there. It'll continue. And the other thing to think about is there are syndicators who own real estate and then there's operators who syndicate. And we're operators who syndicate. And so we're in it for the long game.

Well, tell us a little bit more about your business model. You tend to focus on the lower middle classes and the upper lower classes, which is, according to the US data, that's one of the fastest growing demographics in the country. And I can certainly understand why that is, but your business model is intended to specifically focus on that particular demographic. Why is that that you've chosen that class and how is it that you are serving them?

So statistically, the lower middle class and the upper lower class are permanent renters, meaning they're always, they'll never own a home, but they'd like to live in one. Being that there's a pretty strong base of people who are always going to be renters, it's a base that's not going to go away. So we don't have to worry about what the market shifts, what happens. Well, they're still gonna need a place to live. We can adjust rents accordingly to keep the places occupied. Rents don't typically fall, but we could say we're not doing a rent increase this year, or there might be at some point where you do a small decrease. Or if you have a person that's been in your property for a long time and you wanna retain them, you find ways to make it work. 'Cause empty units don't pay any bills. I did the math and vacant units pay no bills. And so it feels like to me that that is the least, it's the most underserved or the least served. And so how do we serve them? We come in and provide a place that's safe, functional, durable, and clean. At market rents. So we still need to be good stewards of capital and have the rents at market. And then we also need to be good stewards as owners where we keep the places at or above market as far as condition. One side thought I had is recently I was at a conference and I told them that, yeah, I heard the man, the speaker say, you know, you don't need to put granite countertops and shaker cabinets and low flow, and you don't need to worry about those with these residents that they don't need that. And I'm like, well, what's need got to do with it? If the budget fits that you could put granite countertops or some solid surface quartz countertops and shaker cabinets and stainless appliances, why wouldn't you? So we have a property in Southern Arizona that's a C+, B- type of a property. And it's going to have solid surface quartz countertops, shaker cabinets, stainless appliances, because it's not, they don't need it. The wealthy don't need it either. What do we really need those things? The second thing that people do is They say that we put low-flow showers only in our lower-income properties because the higher payers do not like that type of water, the low flow. And I'm like, well, actually poor people like water pressure too. So those types of analogies just don't fit for me. So we just treat them as we'd want to be treated. I think that's very important. Now, would we live in the neighborhoods where we invest? Not necessarily. Some of those neighborhoods would not be a match, but I wouldn't be afraid to. And if push comes to shove, I would want a place that if they say, okay, this is a place that I could live in it.

Well, certainly whatever class you're investing in and serving, there's going to be different challenges and different headaches. What are some of the major headaches you find in dealing with the lower middle class and the upper class individuals?

The biggest challenge that you face is there is a higher criminal factor in the lower class and lower middle class. It does attract more unsavory individuals that seem to slip through the cracks, especially when the neighboring properties may not do the same background checks. Like, can you go rent that property in North Scottsdale, there's a background check. They're going to make sure that you're creditworthy, you don't have a criminal background, and they're very particular about who they're renting to. Where the lower you go in the neighborhoods, the more unsavory even some of the operators are where they're only taking cash. There's no background check, just pay your rent. We make it simple with ours. We do background checks. We make sure that we're not renting to criminals. I have 2 simple rules at our communities, and that's pay your rent, Live in peace. That's it. It's that simple. That's all you need to do. And everything else that goes on is not my business. As long as you pay your rent and live in peace with your neighbor, that— what more do you need, right?

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So the first thing, anybody that is delinquent, you know, if there's delinquencies, people that are not paying, they're dealt with rather swiftly when we first take over a property to set a new sheriff in town, for lack of a better term, that we have these rules that they follow. And then also we're very particular about keeping Consistent in dealing with the residents. Like if they have indoor furniture that they keep outside, we see that a lot in the lower income areas where the property managers and owners don't seem to care if somebody has a sofa outside, things like that. They're gonna be out front. It's outdoor furniture only can be outdoors, if at all. Some of the communities don't allow furniture because the walkways are too narrow. And just being very consistent in that. And then also that there's no belongings that are kept outside. People will bring their motorcycles and their bikes up by their door and lock 'em up to the post right outside their door and it becomes a nuisance. You got to consistently walk the property and get rid of those. The other thing is there's safety issues with barbecue. People have their barbecue grills around outside their apartment. There could be a fire or safety issue. So we want to make sure where possible to install permanent barbecue, a permanent awning, permanent well-built picnic areas where people can congregate. And this is at all levels that you'd put this in, where you'd have a nice area for people to meet outside. You know, we're primarily in the Southwest, so the weather's very favorable for being outdoors as much as possible. So those are some of the major things that you do. And just keeping the peace between the— like I mentioned earlier, between the residents creates a high sense of community. And one of the things we did at one of our properties, which we'll continue to do, is we hired a food truck and the food truck came out and we had a big get-together outside and people could order food and sit at picnic tables and talk to people they never even knew lived in the community. That was kind of fun to do. And we invited the police department and the community action officers We invited some city officials who didn't show, but the police officers were there and the community action officers were there. And it was really nice to have that couple-hour time where we were able to hang out with the residents.

Well, oftentimes clubhouses are a must for a lot of people. In this class of housing, what do you do about clubhouses? Do you bother with them, or have you found them effective, or do you have any?

The properties that we have are typically under 100 units, and they wouldn't have a clubhouse or a meeting area like that. oftentimes have pools and they might have, uh, you know, outside ramadas where people can meet. But there hasn't been clubhouses or fitness centers. Now we're doing a conversion from Quality Inn motel. We're changing that to an apartment building in southern Arizona, and that one there does have a fitness center and does have a meeting area in the front of the building. So how we're going to utilize that is still up for discussion, but we'll probably use it for a community. People can meet, maybe get on their computers or things out in the open there.

Well, it'll be interesting to see how that compares to other properties, because I'm assuming you're still planning to serve the lower middle and the upper middle class in terms of this conversion. Is that correct?

Lower middle and upper lower class. Yep. Correct.

Well, that would be interesting to learn more about that conversion and why you're doing a conversion rather than keeping it as a hotel. So can you just fill us in on that just real quickly?

The reason is in Sierra Vista, there's a high demand for housing and the rents do not support new construction. So you'd have to come in with with pretty significant government tax credits or some type of other grants to build a new property to supply the housing. It's a heavy military town and contractors that cater to the military and then a retirement community. So there's not a ton of high-level jobs. So the rents are under $1,000 a month and you can't build for that anywhere really. And so we're able to buy this property at $38 a square foot, which is a fraction of replacement cost and convert that from a 100-key motel. When we get done, it'll be a 65-unit apartment building. And so we'll have 1-bedrooms, studios, and a couple of 2-bedrooms.

Sounds like an extensive renovation project.

Yeah, it is.

Yeah. Well, I hope that goes well for you. Well, talk to us about interest rates. They're certainly going up. Materials are stuck in the supply chain and inflation is sky high and labor pools are seek— are shrinking. So how are you preparing for all of those socioeconomic changes?

I think in the current economic conditions in the country that the, we won't see a shrinkage in the values. I think the values will continue to tick up for the foreseeable future, at least the next couple of years because of the demand for housing, the increase in certain pockets where the population growth is far exceeding the units being delivered to the market. So I think we have a couple of years of that left. So as interest rates are going up, we're seeing a slight drop in the cost of equity and the capital stack. You might be able to find some preferred equity institutional for a pretty reasonable rate to come in on top of your loan. And then your common equity is even that rate of return. We'll see that drop down a little bit, still be in the double digits. For the type of investing that we're doing, but we're going to see a slight drop in that. And then the raising rents will cover some of that. But eventually, where those numbers start to get too close together, the investors will turn the tap off and say, okay, now we're getting a little bit risky. We're not going to invest. And when we see investors shift from real estate to some other segment, then we're going to see some changes in the real estate market. It might be longer to fund a deal. It might be longer to to get that loan in place. So we get rising interest rates eventually would squeeze out equity because the savvy investors will say, okay, that's enough risk. Now we need to have a higher down payment, which means more equity, which means you better find some more partners. So there's going to be some of that challenges, I think, coming up. It's been relatively easy for the last 7 or 8 years to get capital. And then as far as the supply chain, one of the things that we've been doing now is the— before we turn a unit, Into a full update. Like if we're gonna leave it classic, then it's not much. You just, you clean it up and rent it out again. But if you wanna get the next level of rent, you might be replacing cabinets and appliances, flooring. Well, you wanna make sure you have all those supplies on hand in your building before you vacate that unit or before you turn that unit. It's probably been vacated through a lease, you know, people moving out after a lease and they've left. So now it's vacant. You do your full rehab, but we don't wanna do a full rehab unless we have confirmation that the supplies are actually available. The last thing you want is something to stop you from renting and having a vacant unit that is down because of a supply chain challenge. So we've been doing that on our properties now and it seems to be working pretty well. And as far as rising costs, one thing that I'd like to warn other operators is to double-check what they're putting in for their expenses, for their annualized expenses on their pro formas, because we're seeing people are increasing rents and they're increasing values quite substantially, but I don't see much bump in the increase in expenses. And that's a dangerous place because they're going to be surprised when their operations operational expenses go up 10%, 15%, 20% over the next year or 2. Yeah.

And I don't see how they could possibly not with the inflation that we're facing here.

Correct.

So you had mentioned that most of your properties are less than 100 units. So what are you looking for when you're going out and looking for new properties? And how is it that you are interesting equity investors in these smaller properties?

We have pursued larger properties, but there's high competition. And if there's a bidding war, we don't win. We don't pay that. And people are buying right now, they're buying appreciation, which we buy cash flow. So there's a big difference and it's very difficult. It's very hard to find cash flowing properties in day one. And I get that. Unless you buy a high-performing Class A property, that's not a value add, or even a Class B property, that's not a value add. You're buying somebody else's operation. You can get some cash flow from that. But if you're doing a value add, it's very difficult to find them cash flowing in its current condition with the market. So if they're going to market, there's high competition. We have found that under 150 units and built in the '60s and '70s is typically going to have less competition and more likely to slip through the cracks because they're older buildings and they're smaller. A lot of it, there's so much big money out there, they're not going to make an offer on a $7 or $8 million property. Or $10 million. They're paying 20 plus. And then as far as the vintage, most of the investors that we see, they're pursuing '80s and newer, even '90s and newer. And '60s and '70s need a little more research, a little more due diligence to make sure that what you're buying doesn't have problems. But we're willing to do that and we're capable. So we like the '60s and '70s product just because there's less competition in that. And we also know when we sell 'em in the future, we're gonna have the same challenges. It's gonna be less desirable to some of these major institutions unless we can put together a portfolio sale if we were to Bundle them with multiples. And then you could do something like that potentially. But that's why the 10-year hold feels good. The other thing is when we go to sell those properties, we can sell them when we're ready, as opposed to trying to time the market. We can say, hey, we'd like to sell this property. We know we can get for it. We have another asset we want to buy, free up the capital, do an exchange. Things like that are less pressure than trying to time it. Okay, we got to get this out because we said it's a 3-year model. So buying a 60s and 70s product is going to be a little slower sale cycle typically as well. When you go to sell it.

Yeah, I would expect so. And you had mentioned the due diligence has to be increased because I would expect with '60s, '70s, you're going to typically, you're going to encounter sewage problems, plumbing problems, out-of-date electrical applications. And that's probably just the beginning, but all of that is going to be, all of that's kind of hidden. It isn't things that are going to be apparent, right, to anyone who's just going in to look at those properties. And with that, of course, is going to come increased expenses in turning all of that around. So what all are you going through to ensure that you can actually turn those around, have cash flow and value add?

Yeah, so during our inspection, we'll invite the plumber. They'll test the water lines. They'll check to see that it's copper plumbing. They'll check to see if the underground, if it's steel where it's starting to be some issues, they can check that. Now, they're not going to dig it up, but there's certain tests that they can do on the supply lines. And then we also have the sewage lines all camera'd. So they camera all the lines and make sure that there's no issues. We've had them find tree roots and other collapsed pipes where there's just a slight trickle going through. We know it'll be addressed. And then as far as the electrical, you want to make sure that it's copper and not old aluminum. There's some issues with some of that. Make sure that— we have purchased properties that have had the twist-in round fuses as opposed to breakers. So you got to make sure that you're comfortable with that. 'Cause a service panel can be expensive to replace and upgrade the panel with the utilities. And then the roof is gonna be looked at by a roofer, and then the HVAC will all be inspected by people from the HVAC, you know, heating and air conditioning. So having those people there at the inspection or during the inspection period is very, very important to hire capable people to come alongside. We know what to look for generally, and they come in specifically. And by doing that, sometimes we've had 13 different people show up. I think that's the record is 13 people show up for an inspection and just take 3, 4 hours that we've completely looked over the whole property. So it's pretty impressive to see. And it does cost, but it's better to spend $2,000, $3,000, $4,000 upfront than to come up with a $100,000 surprise later. You know what I mean? Put that in your budget, put that in your CapEx, make sure that you have the funds set aside to take care of those problems that are now foreseen, foreseeable. Now, do we get them all? No, you can't possibly get them all. But by doing that, we're more likely to catch them and to be very judicious in tackling those problems when they are, when they do arise.

Yeah, there's always going to be a surprise no matter what you do, it seems like. Well, Bruce, you've got a tremendous amount of experience and knowledge and a lot to share with our viewers and listeners. So tell us how we can get in touch with you and what do you have to offer?

Well, the best way to get in touch is to go to bakerson.com. And if you go to our bios, About Us page, you can click on my picture and get right on my calendar. And I'm willing to share Any information people would like to know about us, or if you have any questions about how to navigate any real estate challenges you're facing, I'm very willing to be a resource and to help others get through some of the challenges that they might face in real estate investing.

Well, wonderful. And we'll have all of that information in the show notes as well. So Bruce, unfortunately we're out of time, but it's been a delight having you with us today and good to hear things are going so well for you. Take care and thanks for being with us today.

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