REIA 424 Julian Vogel: How to financially structure your multifamily deal!

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.

Welcome back to Real Estate Investing Abundance.

I'm your host, Dr. Allen, and I am so delighted that you have decided to join us once again today. And we We are going to take a look at how it is that we can financially structure our multifamily opportunities. And with us to talk about this today is Julian Vogel. Julian has worked in over $11 million in real estate transactions, and he has originated debt and equity for almost every commercial asset type and scenario. So he has a lot of experience in structuring deals. And so I'm anxious to talk with him about how we can improve on structuring our own deals. So Julian, take us into the show and share a memorable experience that was beneficial in helping you to be who you are today.

Sure.

Yeah, I'll just make one correction, Alan. You mentioned $11 million. It's actually been, uh, $2 billion.

Wonderful.

Uh, just a little bit of a difference. That's the only reason why I made the comment. I would say the realization that launched me or helped launch me into where I am now is finding strength within myself as opposed to looking for it from others. Uh, being my own source of strength and power, knowing, taking control over the monologue inside of my brain. And speaking to myself internally, as I would ask a best friend or a spouse or someone who loves me to speak to me, right? So I had that realization probably in my mid-twenties, and when I had that realization, it sort of cracked the code for me, and it led to confidence, self-esteem, love, good ideas, humility, etc. Not to say that I'm extremely humble, but it was— I realized that it was a door to a lot of good things. So, and that struck me like a lightning bolt, that realization.

Can you share that experience in terms of how that lightning bolt came about?

Yeah, I used to suffer from a lot of anxiety. And self-doubt and negative thoughts. And I'd see other people being very comfortable in their own skins and confident and saying to myself, why can't I? I want to access that. What are they doing that I'm not doing? And with a tremendous amount of introspection, journaling, thought, prayer, Et cetera. It sort of, you know, hit me that, oh, I can't and I shouldn't be looking for strength from other people. I have to, I have to generate it from within.

Well, that's a good lesson to learn at, uh, at a young age, uh, and, uh, I wish more people did, um, because certainly we have to go within to find our own strength and our own abilities. Well, when you talk about real estate, what is it that you're talking about when you are talking about neutral versus positive leverage?

So when I talk about real estate, Colony Hills Capital, I'm the fund manager for Colony Hills. We focus solely on garden-style multifamily real estate. So that's 2 to 3 story sprawling communities that are 150 to 500 units most of the time in, in hopefully in growth markets, markets where there's people are moving, where there's strong industry, there's strong demand, a dearth of supply, etc. And so when we're offering on a deal, right, we're judging that offer based off of many different variables. But one of the prime variables that people talk about and know about is the cap rate. And for those of you who don't know what a cap rate is, it's just the net operating income divided by the purchase price. And that gives you a good sense of what the yield is for that deal. What's the going-in cash flow for that purchase? So a good cap rate for a multifamily deal would be typically somewhere between 5 to 7%. And you see those sorts of cap rates in secondary markets or tertiary markets. And then in more primary markets or for newer assets, you'll see lower cap rates because you're buying more quality. And so the yield is a little bit lighter. So it's more like 2%, 3%, 4%. So that's a prerequisite. You need to know that before you can understand what neutral to positive leverage is, right? So neutral to positive leverage means that you're buying a cap rate that matches or is higher than the interest rate that you can borrow for. So if you can borrow at 5.5% fixed or 6% fixed, you want to make sure that your cap rate is at 5.5% or 6% or ideally higher than that, 6.5%, 7%. So then you have positive leverage. And what that means is, is that you're making more money off of the deal than what you're paying in debt service and interest to the bank. It's a good barometer of the health of the asset versus your cost of capital. And then to boot, if you're buying a deal where there's dormant value that you can extract, maybe the rents are below market and you can capture what's called loss to lease, meaning the properties next door are charging $1,800 for a 2-bedroom and the property you're about to buy is only charging $1,500, that's $300 of loss to lease you can capture. So not only are you getting good going-in yield, but further, there's future yield you can extract. And then when you sell, make even more, you know, profit on the, on the exit. So that's neutral to positive leverage.

How can a passive investor who is fairly inexperienced, how can they quickly figure out if a deal is conservatively underwritten or whether they are actually essentially overpaying for the property?

Yeah, perfect. That's a perfect segue question to what we just talked about. They can ask 3 questions, really. What's the going-in cap rate? And what's the going-in cap rate on the total capitalization of the deal, meaning not just the purchase price? The purchase price, the closing costs, the renovation budget. What's the cap rate? How much are you borrowing for? Right. What's your interest rate and is it fixed? Okay. Now I know if it's neutral or positive leverage. If it's negative leverage, that's not necessarily terrible, but there has to be some sort of upside or dormant value that this operator is going to be unearthing like we just talked about. So then you can ask, okay, what's the future cap rate? What's the cap rate in year 3 based on applied? What's the future? If you take the cash flow, the future cash flow in year 3 and you apply it to the total basis going into the deal, is that positive leverage when you compare it to your interest rate? Okay, that's another question you can ask. And then the third question is, what's your exit cap rate? Meaning when you're forecasting this deal and you're projecting what you're going to be able to sell it for in the future. What cap rate are you using? Is it a 4 cap, a 4.5 cap? Is it majorly compressed, meaning much lower than what you bought it for from a cap rate perspective? That's a red flag.

Why?

Because the seller, the operator is assuming that there's going to be tremendous market appreciation, that the market's going to turn around in a matter of years. It could happen. It's happened Many times in real estate, but to bank on that and to invest on that is risky, right? So then the exit cap rate really should be the same as the cap rate as you're buying, or maybe even higher. If it's higher, even better, right? So those are some really quick three variables that an inexperienced investor can ask the operator and very quickly determine. whether or not the underwriting is conservative. And then the— I'll add one more as a bonus. An investor can also ask the operator, are you— like we talked about before, are you— is your model based on capturing loss to lease? Meaning, are you buying a deal that's being mismanaged, or is your model based off of growth, rental growth? Meaning in your model, are you assuming that your rents are just going to grow 5%, 10% per year and you're banking on tremendous appreciation in the market that you're buying in? That's also risky. But if the answer that the operator gives is no, you know, the rental growth we're underwriting is 2%, 3%, which is pretty standard, and we're really underwriting based off of capturing that loss to lease, meaning capturing that $300 premium that's being left on the table that we talked about before, that's a great model. That's a good conservative model, and you should consider investing.

Those are definitely good tips and good things to think about. So how does your team decide what deals or markets to invest in?

So we're based in Western Massachusetts, And Colony has done a little over $1.2 billion of total capitalization since 2011, a little over 12,000 units, 36 transactions. And most of those deals have been in the Southeast, have been in Texas, Florida, Alabama, Georgia. We're starting to creep into the Northeast as well. And we're— what determines whether or not we want to be in a market for a deal, first we're looking at a top-down. So first we're looking at the market before we even get to the real estate. So we want to see average median incomes in a 1 to 5 mile radius around the property that we're looking at. We want to see that it's north of $90,000, let's say, or $100,000, strong incomes. We also want to see that the housing prices in that market are half a million or higher on average. We want to see that it's— there's demand there, right? There's certain variables you can look at in the market and see there's demand, there's wealth. And then what are the major job suppliers? What sort of industries are they? Medical, education, tech, distribution. Those are things that are resilient and people need those industries whether or not the market is strong or weak. Okay, so now we've checked the box in the market. Are people moving there? Right? If people are moving there, that's creating that demand, and that's driving up the housing prices. Once all those boxes are checked, then we're actually looking at the real estate and taking into consideration the history of the asset. How much money has been spent historically on renovations at the property? What are they currently charging for rents? What can they be charging versus, you know, we do a survey of all the The comparative properties in the market. What are the expenses? Where are they possibly mismanaging the deal from an operations standpoint? Is the property overstaffed? Are there utility tricks that we can put into place to reduce utilities? Is there other income that they're not tapping into that the market's offering, right, that other properties in the market are offering, like concierge trash, for example, just to name one. And then what does the property need for us to actualize all of that? Does it need— do we need to renovate 50, 80, 100% of the units? Is there deferred maintenance? Do we need to offer amenities that the property is not offering right now that the property down the street is, to then justify the increases in those rents? Once we've taken all that into consideration, then we're making an offer on the deal. If everything checks out, if all those boxes are checked, And we're usually looking for property-level IRR of 18% to 20% and an average yield of 6% to 8% on a 5-year hold. For investors who don't know what an IRR is, that's just your— when the property sells, if you look back, that's your average return on a per annum basis. Or you could think of it as a multiple. You know, if someone invests $100K, um, usually a 20% IRR, if they're holding it for 5 years, will yield a 2 multiple, right? A 2x, uh, because, right, they've gotten 20% per year over 5 years, it's 100%, right, when you add it up. So, so that's, um, that's a long-winded answer to your question.

Enlightened investors, if you haven't done so already, be sure and click that Like button and also click that share so others can take advantage of the content.

And finally, be sure to subscribe so you don't miss a single one of our upcoming episodes. Well, it is, it's a good answer and a reasonable answer. So you primarily invest in garden-style apartments, and you mentioned in Texas, Florida, Alabama, Georgia, and you are moving into some areas in the Northeast. So these, these particular areas have been performing really quite well over the last decade for sure, and projected to continue to grow, although there's, you know, there's variations from year to year in terms of what are the hottest markets in the country. But you say you're moving into the Northeast. What is it about the Northeast, and where exactly in the Northeast are you considering?

So we've invested in— 2 summers ago, we bought a deal in Trumbull, Connecticut, which is a submarket of— you could call it a submarket of the city of New York. It's a sister market of Stamford. We also invested in a deal in Princeton, New Jersey. We have a deal under contract right now in Mount Laurel, New Jersey. And the reason why we started shifting our focus to the Northeast is because honestly, the Southeast is discovered. Everyone is looking at the Southeast and the cap rates have compressed drastically there. And a lot of times deals for sale in the Southeastern markets— when I say Southeast, I'm really thinking Florida, Texas markets, Carolinas, Atlanta, you know, the deals aren't as favorable. The other bit that we're a little skittish on right now, the Southeast, is insurance. Insurance nationally has skyrocketed, and obviously the Southeast, in particular Florida and Texas, are suffering from that drastic increase in insurance. Texas also suffers from an unpredictable tax program. It's the tax reassessments are are not very predictable, to be honest with you. So what we're finding in the Northeast in particular, we like Jersey, we like New Jersey right now. We also like the Midwest. We're looking at deals in Ohio and Michigan. We like the fact that the uncontrollable expenses, meaning the insurance and tax, are more predictable. And we also like the fact that it's more difficult to build. So there's a dearth of supply. And the incomes in the industry is very strong. So those are some of the reasons. There's certainly pitfalls in those markets as well, just as there is in any market, but we're finding it's easier to maneuver in those markets.

That, that is interesting because, well, over the last 10 years, they certainly have not been favored markets, although the Midwest has been showing a lot of promise from Kansas City to other places as well. But you mentioned Michigan, which is a a little surprising to me because the economic outlook for Michigan has not been very favorable. So what is it about Michigan that has changed in the last few years here?

COVID— there's a lot of silver linings for COVID. One of those silver linings is a lot of the coastal MSAs emptying out, people moving from the coastal MSAs into Secondary markets and tertiary markets and sleepy markets. And so parts of Michigan, first of all, there's, there's strong industry in Michigan, and there's also in certain, certain markets very good wealth. And so there's just, there's growth, there's growth in certain markets in Michigan that we're, we're focused on, and it's overlooked. That's the other thing. It's overlooked. The other one market I mentioned is Ohio. Same story. I'd say the growth in Ohio is much stronger and much less contrarian of a perspective than Michigan. Just logistically, I saw a map recently of how Ohio is perfectly placed with perfect access to basically the entire East Coast and also the Midwest as well. And just growth there is, is, is not going unnoticed by us, that's for sure. The hurdle in Ohio is tax reassessments and the need to do what's called the drop and swap when you buy a new deal, meaning you have to inherit— you have to inherit the seller's LLC in order to figure out how to avoid egregious reassessments. So every market comes with its own hair, if you will. But just some superficial thoughts as to why we're looking at those markets.

Yeah, that's interesting. Well, tell us a little bit more about, uh, your company, um, and how investors can, can get in touch with you to take advantage of the things you offer.

Sure. So I'll start with the last question. Our website's www.colonyhillscapital.com. We have a lot of information on our website, video collateral, And very easy to get in touch and register and put in contact with one of my counterparts, Melissa Barber, who's a director of investor relations. She's extremely responsive. Colony, I already mentioned our track record. We're 23 people at this point. We use third-party property management in the markets where we, where we buy. I mentioned that because if we were vertically integrated, we Likely have a much larger staff than what I just mentioned. We have a fund. We're on our third fund. These are what's called co-GP funds. So it allows investors to invest passively into what's called the GP stance or the general partner stance alongside Colony Hill's principals and employees. And that allows investors to gain access to the carried interest or the promote. the gravy, if you will. And then investors also have the option to invest on a deal-by-deal basis into the GP stance, because typically our LP equity is coming from an institutional source. We have a pretty vast network of institutional LP funds and private equity firms that invest with us and provide 60 to 90% of the required equity. And we're usually holding deals for 2 to 3 years. So once we've extracted the value out of a deal, we've renovated the property, we've increased rents to or marked to market the rents, brought them to what they should be, then we're looking to sell. And historically on deals we've taken full cycle, which have been 10, we've had an average levered IRR of 36%. So our investors are very pleased with our track record. And their participation with us. And it's a simple equation that we rinse and repeat.

That's interesting. So if you could tell me a little bit more about how the passive investors are investing on the GP side.

So we have a fund that's an LP, it's a limited partnership. And the mandate of that fund, we're the manager of that fund. And the, but the mandate of that fund is to place the liquidity in that fund into the GP member on a deal-by-deal basis that Colony Hills owns and operates and acquires. And we invest— our alignment of interest with the fund is we invest alongside the fund into the GP. The fund is passive. It doesn't sign on any carve-out guarantees. It's basically— they're basically LP. It's basically an LP dressed in a GP coat, so to speak.

Okay.

And so it allows for the fund to achieve, you know, more outsized returns than what they would see elsewhere.

As a—

Yeah, right, exactly. So the fund targets a 20 to 25 net IRR for fund investors.

Interesting concept there. We've got just a few minutes here, but if you could explain to us how Waterfall works. And because this is— it throws a lot of investors off because it can get quite complicated. So if you can simplify that for us.

Yeah, I'll do my best. Yeah, sure. So let's say a deal requires $10 million of equity, right? We're putting the debt to the side, right? $10 million of equity. And there's 2 partners. There's a GP and the LP. LP is the limited partner and GP is the general partner. The LP is remaining passive throughout the ownership period. The GP is doing all the work. And the GP, let's say, brings 20% of the equity and the LP brings 80%. Right. So going back to the $10 million, the 80% would be $8 million and the 20% would be $2 million. Okay. Pre-acquisition, before the deal is actually purchased, the GP and the LP forge an agreement that this is how the cash flow during the ownership period and on sale is going to be split. So assuming there's no preferred return for the LP, Let's just assume in this example that it's what's called a pro rata split. Pro rata means that I get 20% of the cash flow and you get 80% because I put in 20 and you put in 80, right? I being the GP, you being the LP. Okay. Deal sells. It's been 3 years. We as the GP have executed on the, on the business plan. We've, we've spent all the CapEx dollars, the renovation dollars. We've raised the rents. We've sold it for a success. And now there's a bunch of money sitting on the table, on the table from this sale. How is it split up? This is where the waterfall comes in. So first, the money is split pro rata between the GP and LP until each member receives back their original contribution. So I get my $2 million, you get your $8 million back. There's still a bunch of money left on the table, right? Because this was a 2x multiple, right? So there's another $10 million sitting on the table. How is that split up? All right, well, it's split pro rata until you as the LP achieve a certain return. So once you hit, let's say, an 8% IRR, then I get my promote as the GP. Just like in a job, you get a promotion for doing a good job, right? Your salary goes up. It's the same thing for the GP. I did a good job. I yielded you an 8% from all my hard work. Okay, so now my 20% share of the upside goes up to 30%, and your 80% gets demoted to 70%. So now the cash— remaining cash is split 30/70, right? Until you hit an additional return hurdle. Let's say that additional return hurdle is 12%. You hit a 12% IRR. Okay, wow. I deserve another promote because I did such a good job that you got a 12% IRR. So now my share goes from a 30% to a 40%, and your 70% goes down to 60%, right? So that jump in my share of the upside is called promote. And LPs were fine with that. Why? Because they didn't have to do anything throughout the ownership period. They brought the lion's share of the equity. But they didn't do any of the work. So they're happy for the GP to get promoted because the GP needs to be incentivized. So that's what a waterfall structure is. There's many shades of gray of a waterfall structure, but that's a simple explanation.

Okay.

Yeah, good explanation there. I just want to add one thing, that waterfalls are explained in the private placement agreements going into them. It's not something that a GP surprises the LP investor with. Oh, We've done well here, so we are gonna imply a waterfall.

Right.

Apply a waterfall. It's agreed to at the beginning of the agreement there. Well, it's been wonderful having you, Julian. Thank you for sharing with us today. And Enlightened Investors, thank you for being with us. Always a pleasure having you. Be sure to like, share, and subscribe, and I look forward to seeing you in the next episode.

Enlightened Investors, wait, wait, don't go just yet. I just want to remind you about our recently launched webinar. That you will not want to miss. If you're at all curious and would like to learn more about how real estate investing can diversify your investment portfolio, alleviate the anxiety associated with Wall Street swings, leverage your 401s and IRAs to substantially increase the return on your investment, and do all of this with turnkey, hands-off, passive real estate investments, then you'll want to immediately go to— stevetalker.com/webinar. In the webinar, we'll also address the common dubious investment schemes that you want to avoid. To access the webinar, go to stevetalker.com/webinar. I look forward to seeing you in the webinar.

Thank you for tuning in to Real Estate Investing Abundance, brought to you by Steve Capital, a company working for passionate professionals like you to develop financial independence built on solid passive real estate investments. As part of our efforts to make the world a better place, Steed Talker Capital contributes to activities and organizations committed to better understand the equine. These endeavors attempt to enhance the human treatment of horses worldwide. Steed Talker Capital, working for a world where all creatures great and small flourish abundantly. For resources to develop your financial independence, connect with us. At stevetucker.com.