REIA 53 Rob Beardsley: How to Be a Dealmaker in Multifamily Investing

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Enlightened investors. Today we discover how to be a dealmaker in multifamily investing. Rob Beardsley oversees acquisitions and capital markets for Lone Star Capital and has acquired over $100 million of real estate, and he has evaluated thousands of opportunities using proprietary underwriting models and published the number one book on multifamily underwriting, The Definitive Guide to Underwriting Multifamily Acquisitions. Rob, before we get into underwriting, share with us a memorable experience from your formative years that helped you to be the person you are today.

Well, thank you very much for having me on the show. And what a deep question to begin with. I'm not sure if you want a 2-second perfunctory answer or if you want to really dive into something.

Well, let's dive into it. That's probably more interesting than a 2-second perfunctory answer there.

Sure.

Okay.

So you gave me a second to prepare, but my mind jumped to my senior year of high school where I was my whole life training to become a college athlete. Quarterback in high school. And in my senior year, I transferred to one of the top schools in the state of California where I was living in hopes of having a good season and attracting scouts. And, you know, my dream was to go play football at an Ivy League, you know, get it, have it both ways, get an Ivy League education and play, you know, some good football there. So anyway, so in that senior year, right, everything I'm preparing that summer, the hardest I've ever worked and everything, it's all coming to that point. And just from all that effort, and working out and stress. I don't know, maybe I was, you know, I basically tore a piece of bone off my hip just from kind of running and getting tackled. And, you know, I couldn't move my leg and it was devastating. I just, I laid in bed, I remember, for 3 days straight, kind of like when I just got the J&J vaccine a couple months ago.

No.

But, but I was in bed, uh, not because I was in pain or anything. I was in bed because I was Depressed. And I had never been this depressed before. I was, you know, felt that my whole existence was robbed from me. You know, I wouldn't be able to play the season. And I was so— yeah, I just never had been that helpless and defeated. And it was a really interesting time because I made peace with it at some point eventually, and just kind of made it through the other side. And that was, I don't know, a rebirth where I Let everything go. Let my ego go. Let my identity attachment to who I was, what I was doing. And funny enough, somehow at that point in time, I also had latched onto Eckhart Tolle and started reading some of his books and meditating every day. And so, I really went from as miserable as could be, helpless, hopeless, depressed, to the happiest I had ever been just through acceptance. And funny enough, I guess the fracture, the bone had pulled off just short enough that I didn't need surgery. And then miraculously, I was back on the field game 4 and played the rest of the year, and we won the San Diego championship. So it was a wonderful experience. And thankfully, I was able to carry forward those lessons of presence, acceptance, happiness, meditation moving forward. So I don't have to be depressed to then be happy. I can just be happy.

It's amazing how some of the darkest times in our life can lead to our greatest insights. And you actually were very fortunate to have that experience at such a young age, because I am sure it has made a huge difference in the rest of your life. Well, it's interesting as that is, and I would really enjoy talking with you further about that, but we're not here to do that. So let's talk about real estate and particularly that very critical aspect of multifamily investing, which makes or breaks breaks any deal that one can get into, and that is that aspect of underwriting. So, if you would just take us through the basics, the key metrics, sensitivity analysis, stress tests, comparables, and cap rates, and how does underwriting pertain to all of those very basic aspects of multifamily real estate investing?

Excellent. So, and I want to be courteous to your audience and speak to them as what's relevant to them. We don't need to go into full details like how you mentioned, but I want to definitely stick to what's relevant to even just the passive investor, the casual investor, because I think there's a— one of the issues that I see in the market is investors often look at underwriting, which is the financial analysis of an investment as a black box, and they wall themselves off from it and just say, well, that's the professional stuff I can't begin to decipher, so I won't do anything. Rather than maybe doing a little bit, they just don't do anything at all. I think that's certainly doing themselves a disservice. We'll talk about maybe my book a little bit later, but when I wrote that book, it wasn't just for investors looking to be active and do deals on their own, it was also for passive investors to become equipped with that skill so that they can actually go out and take a look at a deal and summarize it themselves depending on how deeply they want to get into. So approaching it from that angle, just to run through the basics of underwriting, the components are, of course, to model the operational projections for the property. And that begins with understanding the in-place performance. We have to have a starting point. And what's wonderful about buying existing multifamily assets is you often have a very sturdy, robust base that you're working from, right? You have historical financials that can go back many years. Typically, when you're underwriting, you only get the previous 12 months, but that's, as a starting point, that's plenty. So starting with the 12 months of previous financials, you can obviously get a good sense of the in-place revenue and expenses. So when we underwrite, obviously, we are— the revenue is the revenue, but on the expense side, there's variation between the way that we would integrate the property into our portfolio versus the way that the owner is currently running it. And that's where things start diverging and that's where there's some finesse, right? It's not just copy and pasting numbers and then, you know, in and out. It's understanding, okay, well, their property taxes are X, you know, ours are going to be Y, what is Y? And payroll, maybe they have a bloated staff and maybe we can integrate and have a smaller staff because we have property nearby or something like that. So it's just, you know, thinking about keeping in mind all those different things, because if you just underwrite plainly, you know, you're often going to miss out on insights or opportunities to really maximize value. And in today's market, as you know, you have to find ways to be creative and maximize value. Otherwise, it is very difficult to make sense of a deal. So after the revenue and expenses, we have to layer in the kind of the debt and the growth aspects which lead to the exit. So debt is obviously a hugely important aspect of multifamily investing and all real estate. And so making sure that the debt is appropriate for the business plan, right? If you have a short-term plan, make sure you have short-term flexible debt. If you have a long-term plan, it's all common sense, but we often ignore it or just look past it. And I think, yeah, I mean, that can lead to undue risk. So we look at— we could talk about debt more if that's where we want to go, but Certainly, that is something that we heavily focus on. And, and it's a, it's also a risk factor for us. And talking about underwriting, at the end of the day, the point about it is we need to price the asset, right? It's not just throwing revenue and expenses together, it's to come up to a conclusion of, okay, what, what do we pay for this? And a big factor of that is not just, okay, well, here's the NOI. So this is the price, it's the risk, because obviously, for something that's riskier, we need a return premium. And so we have to price the property lower. So for us, you know, the major determinants of risk are the debt, the business plan, right? If we're trying to retenant the property, renovate, and, you know, raise rents substantially, that's a lot riskier than just buying an in-place asset. So we gauge that on the risk as well. And then, of course, the quality of the asset and the quality of location. So those are our major risk factors that lead towards us saying, you know what, this deal should project for us a 13% return, or this deal should project a 20%. Because we want to be paid for our risk. So that's kind of the quick and dirty components of underwriting there for us.

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Well, I like how you point out the fact that it's more than just numbers because you can have a beautiful financial statement and yet the owner— there's a lot of things that sellers can actually do to manipulate those numbers and still be very legal and give a very, very different picture than what is actually there, which goes back to that aspect of risk and the aspect of debt. And of course leverage is Extraordinarily important to real estate and to the growth of portfolios, but it is kind of a razor's edge. It can either benefit you or it can work substantially against you. And we'll go into debt here a little bit later, but before we go into the aspects of debt, let's go into partnership structures and how it is that it is best to structure these deals with investors and what are things that investors, particularly passive investors should be looking out for in terms of the partnership structures?

Yeah, partnerships are definitely a fascinating thing, something that gets my juices flowing. I love talking about deals, making deals and partnerships. And what's interesting is if you are an individual investor investing $100,000, right, you're most likely going to be coming into a deal which with a pre-prepared structure, and, you know, the deal's already baked, and you don't really have the opportunity to come in and say, okay, well, I would like this structured this way and this all that good stuff. Whereas if you come in, these more institutional or larger partners that are coming in, let's say, for $5 or $10 million, the investor at that point is the one typically who's dictating the terms. So it flip-flops, right? Sponsor dictates terms in more of a syndication format, because obviously, it would be madness if they had to go and build a structure and cater to every single individual, right? But then the investor really steers that ship on the larger side. So as a passive investor, where the structure is already pre-baked, it kind of makes your life easy because you have the luxury of getting to know various sponsors, interviewing them, understanding what their structures are, and then aligning yourself with a partner and a structure that makes sense to you. And so that may be different for different people. For example, I think— and I'll also just lay the basics just for those that are less familiar. Some of the key components of a partnership structure that, in my opinion, should exist in the deal are a preferred return, That would probably be one of the more important aspects where a preferred return is a mechanism where the investors are paid first prior to any performance compensation being paid out to the manager. This does a few things. Obviously, depending on how it's structured, it can be more economically advantageous for the investor than other structures, but where preferred return really shines is in a downside scenario. If you just look at 2 deal structures and projections side by side, they'll often look fairly similar, but if you stress them and show a downside scenario, that's where the preferred return is going to perform better because, again, that's the minimum return to the investor before anything is split. So I feel strongly about the preferred return, and the only real nuance that I wanted to share about that is not all preferred returns are created equal. And that is something that investors definitely need to understand and not just looking, oh, well, this is an 8% preferred return, or this is a 6% preferred return, and that's that. Well, no, there's different ones. Some are compounding, some are not compounding. And as an investor, obviously, compounding is better, but can you live with a simple— sure, you have to look at it holistically. The other piece is return of capital subordinate to the performance compensation or the promote split. And this is something that's industry standard in more larger institutional deals, where the investor first gets their minimum preferred return, secondarily, they get all their money back, and then the profits are split at, let's say, 70% to the investor, 30% to the manager. So this further helps the investor protect themselves in a downside scenario. And it's a great alignment of interest. And we could talk about alignment of interest as well, because it gets more complicated, but basically, the investors can understand, I am going to get all my money back, I'm going to get a cumulative and compounded minimum return of, let's say, 8%, and only then is the manager going to get performance compensation. So that's compelling, and I think that's very reasonable and straightforward. While it's industry standard for the institutional realm, it is less so in general syndications. And not to say that syndications that don't do that are bad, it just— and I'll actually go into why it could be not bad, but it's something that we really like. And we've done some deals with more institutional partners and kind of, it was surprising to us at first. We thought, oh, wow, this is unfamiliar. But once we got accustomed to it, we really like it. And we like, you know, being able to tell that and give that to our investors. So sorry for continuing so long, but the nuances that I had brought up there were First, alignment of interest, and that may sound great to one investor, but that could lead to potentially disalignment in other scenarios. For example, if you're a long-term hold investor, you probably actually don't want to be in a deal with a partnership structure like the one I just laid out. And that is because thinking about it logically from the sponsor's perspective, you don't make money until you sell because how else are you going to get a minimum return to your investors and all their capital back. You'd have to perform an extraordinary refi in order to do that, or obviously a sale. So that pushes the sponsor to sell rather than hold. So if you're a long-term investor and sale is not what you want, then this actually actively works against you, the partnership structure that is. So you would actually want a partnership structure that has a cash flow promote, which would be meaning that your return of capital is not subordinate to the performance compensation, meaning after a certain threshold, now the cash flows are being split at a certain rate, and the manager is getting something, and that can incentivize the manager to stay in the deal because they're, they're making money. So yeah, definitely need to align the partnership structure to what you're looking to get out of the deal and make sure that it's in alignment.

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And there are a lot of nuances in that, but thank you for that brief explanation there. Let's go into this aspect of actually raising capital. And how to partner with institutional investors and how to form not only deals with institutional investors, but joint ventures and co-general partners as well.

I mean, this is obviously a big topic, but in terms of kind of more institutional investors, in many ways not different from raising capital from individual investors, because both start with relationships. And people often have a misconception, or maybe Maybe they do, maybe they don't, that institutions are just all about the numbers and they don't really care about, you know, relationships or the person behind the deal. But that's, you know, couldn't be further from the truth because in reality, as an institutional investor, you have access to so many sponsors, so many people vying for your capital, and a lot of deals look very similar. So the differentiating factor becomes the people. And that's, you know, these are— they say you date your lender, but you marry your equity partner. So it has to be the right fit, because it's a long-term relationship, and it often is a scenario where you might not really get a chance to date much, and boom, you're off to the races, and you've just signed up for a long-term relationship. And so that is all about the people at that point. So I definitely— if someone's listening, and they're looking to go out there and raise some capital, definitely start with the relationship. And don't think about it just from the perspective of, well, I need to make sure that I'm a good partner, because obviously, You should, but also, are they a good partner? You know, starting out, you might think, oh, well, I want, I want to partner with this person, I want to partner with anyone that will have me. But then as you get further down the line, you start to realize, well, actually, you know, those things you were looking past before, you start to realize that's probably not a good fit for me. So I think that's a great way and an honest way to, you know, to come across as a legitimate partner if you're doing some due diligence on them, not just trying to sell yourself.

Absolutely good advice, not just with institutional, but just with anybody that you are going partner with. And I like the analogy that your equity partners you actually marry and we date our lenders. Good analogy there. Well, let's go back to this aspect of debt. And it is definitely a critical part of any deal. And it is an important part because leverage is how we make money in real estate. But too much leverage is going to be very, very devastating. So just give us an overview of debt structures and the various different kinds of debt debt financing that are available and some of the pros and cons of each there.

Yeah.

And I like what you said earlier about kind of the razor's edge. And obviously, everybody knows that leverage cuts both ways. And it's kind of a cliché, but it is obviously very true. And the thing about that is it never— not never, but it doesn't show itself in the numbers, right? You put debt on the property, and then you just add more leverage and the returns go up. in the spreadsheet. Like you said, in a certain scenario, debt could be catastrophic. I think you used the word, but never in your model, in your projections, are you going to put a certain debt piece together, and then the model is going to say, this is catastrophic. It just won't do that. You have to look under the hood and do some sensitivity analyses to really get a picture of, okay, well, in a downside scenario, what does this look like? So in terms of the actual risks associated with debt, you really have 2. And you have the 2 risks are payment risk, which is obviously, your mortgage is due every month. Can you pay it or can you not? Right? And then secondly, you have maturity risk, meaning the loan is due, and you have to pay it off. Can you do that? Can you either refinance it, meaning arrange a new loan to pay off the old loan, or sell the property? So out of those 2 risks, maturity risk is by far The bigger risk. Because when the loan matures, if it matures at an adverse time, or let's say you're in the middle of your business plan and it's maturing, that's not an ideal time to have to deal with something like that. If you don't have enough value, or the capital markets are not in a good place at that time, let's say right at the beginning of COVID that would not be an ideal time to be seeking financing because at that time, It was a little rough out there. So basically, you want to avoid having a situation where, you know, your $10 million loan comes due and you look out in the market and all a lender is willing to lend you is $8 million because now you've got a situation where you've got to make a capital call or you're forced to sell. That likely would be the worst time to possibly sell. And so, you know, you never want to take a permanent loss or, you know, impair the deal permanently by selling at the wrong time. Because your loan was maturing, right? You want to keep the deal afloat and moving in the right direction. So that's why we stress maturity risk a lot. And if we're looking at a deal that isn't a longer-term debt term, meaning 7 to 10 years, if it's shorter than that, then maturity risk becomes really relevant. At 10 years, maturity risk is very low because it's highly unlikely that 10 years from now, your property won't appreciate, rents won't be higher. And you won't, you know, you also likely have amortized the loan at that point as well, meaning you're paying down the principal as you go. So the loan at that point, 10 years down the road, should be very low loan-to-value. But if you have a 2-year loan, 12-month loan, you know, even, even 3-year loan, that is where we stress maturity risk a lot. So I would say that is, that's a key component.

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I totally agree. Maturity risk is probably the greatest risk of the two. And I mean, you pointed out why that is, but even with a 10-year maturity risk, which is pretty typical in multifamily real estate investing, there is still a risk there because perhaps your value-add didn't go as planned, or it may have gone just exactly as planned and everything looks great and wonderful. And then a pandemic hits and the lending markets shut down. So even if everything goes correctly, that maturity date could just happen to come up at just the wrong time in the market. So it's always a risk, but as far as multifamily real estate investing goes, unless you have gazillions of dollars, that's a risk you're going to have to deal with. And to But for passive investors, that is something to look out for. I mean, you point out that preferred is the best structure for passive investors, and to some degree, I totally agree with that. But as you said, most all deals look similar, and one could have a preferred return and the other not a preferred return, and you could go, well, I'm going to take the preferred return. But in actuality, the deal that you took maybe hasn't been stress-tested. To the degree that the non-preferred has. And in that case, and in that scenario, you might've been better off to go with the non-preferred. So there's a lot of things to consider from a passive investor perspective. And the better that passive investors are informed, the more they can decrease their risks in conjunction with their investments there. Never go blindly into any particular thing. Well, our viewers and listeners would really like to connect with you. So tell us what's going on in your life and tell us a little bit more about your book and what it is that you have to offer them when going to search you out and find you.

Yeah, absolutely. Yeah, like we touched on here and there, I published The Definitive Guide to Underwriting Multifamily Acquisitions. It's a mouthful, but it's not, like I mentioned, just for people who are looking to do this professionally. Really does go A to Z, but it's, in my opinion, accessible to someone who's just starting out. So I highly recommend if someone's interested in kind of peeking back, you know, behind the curtain, you know, check the book out. And also to accompany the book, you can head over to our website, which is lscre.com. And you can download our underwriting model for free, check that out. And, you know, learn to use a spreadsheet. Mine isn't the best, no one's is the best, just the one you use becomes the best to you. So my recommendation, if someone is going to dive in and start using a spreadsheet to actually analyze investments is to pick one, learn it, and really understand it, and then consistently use it because at the end of the day, we are comparing deals on a relative basis, right? My numbers might spit out a 15% return, but in the same model or in a different model, same deal, your model could be a little more conservative and spit out a 13%. You know, neither is right or wrong. It's just maybe if all the deals you underwrite spit out at 10%, then that 13% is a great deal. And so similarly for us, you know, we underwrite hundreds of deals. So when we see one that kind of sticks out, that's the one we chase. So it's more about the relative than the absolute. But yeah, so I recommend, you know, listeners head over to our website to learn more about us, get the free download to the model. And, you know, they can reach out to me from there as well.

Well, I'm gonna have to head over there and get your free underwriting model and check that out. For our last question, imagine that you have come to the end of your life, And as you lay on your deathbed, what will you look back on with your greatest sense of joy and fulfillment?

I will certainly look back on 2-ish things. I've got business and then personal. So at that point in time, I'm like Warren Buffett. I plan to retire 5 years after I die, subject to extensions. So for me, I hope to continue my professional life forever. and look back on a wonderful ride with colleagues who are friends and building a big family experience. That is extremely fulfilling. That's something that is what I will look back on. Then of course, family, friends. As we mentioned before we started recording, I'm currently in London doing some traveling. I've been traveling to some locations where I'm just completely alone, And just doing some exploring on my own, or in others, I'm with friends and whatnot. But largely, being away from the people that I typically see every day, and it's made me realize just life is all about people. And to try to think differently or to try to build yourself a life that doesn't have people in the forefront of it is a mistake. So I hope to look back on all the people and relationships in my professional and personal life.

Well, Rob, it has been good having you today. Enlightening and enjoyable getting to know you. Thanks for being on the show.

Yeah, thank you so much.

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