5 Multifamily Mistakes to Avoid

Discover the top 5 multifamily investing mistakes and how to avoid them, so you don’t waste valuable time and money learning these lessons the hard way. If you want to be successful investing in multifamily deals, you must avoid these 5 multifamily mistakes, and this video will show you how.

Mistake #1: Over-Confident Proforma

The first mistake to avoid is being overly confident confidence in the Proforma. A Proforma outlines the expected income and expenses for a multifamily property, including the Net Operating Income (NOI). Warren Buffett‘s experience with the Dexter Shoe Company serves as a prime example. In 1993, he acquired it, anticipating high income and value. Unfortunately, the company’s performance fell short, leading to a decrease in value. Buffett’s overestimation of the company’s projected income and value resulted in a loss of billions! Thus, a critical mistake in multifamily investing is overconfidence in the property’s projected income and valuation. To understand why it’s important to avoid this, consider the following simple example. You receive a deal from a broker, and the information provided with the listing is as follows:

Broker Proforma

Income: $80,000
Expenses: $40,000.
Net Operating Income: $40,000
Mortgage: $15,000
Cash Flow: $ 25,000

The broker assures you that with proper management, the property will perform as expected. Feeling optimistic, you secure the property under contract. However, during the due diligence phase, you review the seller’s actual financials.

Actual Financials

Income: $75,000
Expenses: $42,000.
Net Operating Income: $33,000
Mortgage: $15,000
Cash Flow: $ 18000

The income is about $5,000 lower and the expenses are a little higher. So you have lower income and higher expenses, which is common when you’re dealing with a listed deal. However, as a result, your NOI is going to be lower too, by $7,000. You have the same mortgage and the cashflow ends up being $18,000 not the $25,000 that you thought it would be.

The income is $5,000 lower, and the expenses are slightly higher. As a result, you’re dealing with decreased income and elevated expenses, which is typically with a listed deal. This leads to a reduced Net Operating Income (NOI) by $7,000. Given that the mortgage stays the same, the cash flow is actually $18,000, not the $25,000 you anticipated. So, what if the Proforma is overly optimistic? Here’s the outcome:

• Cash flow lower than expected.
• Paying the broker’s price means you’ve overpaid for the property by $100,000 (the valuation based on NOI: a $7,000 difference divided by 6% amounts to just over $100,000).

Conduct Thorough Due Diligence

Over-confidence in your Proforma can lead to miscalculations and financial setbacks. Essentially, you’re paying the property’s future value today, which is not a wealth-building strategy in multifamily real estate. Our approach focuses on creating profitable value-add deals now, striving to boost rents and income, and increasing the property’s value.  Overpaying today based on these projections means that even after all the work, the property’s worth will remain unchanged in the future. The key is to avoiding this mistake is to perform thorough due diligence and rely on accurate financial data instead of inflated projections from brokers. My video, 6 Tips on Due Diligence for Commercial Real Estate, provides training in financial due diligence. It will educate you further, ensuring you understand the risks involved when you purchase a multifamily property.

Mistake #2: Taking on Extremely Distressed Multifamily Projects

The second mistake is diving into highly distressed multifamily projects without adequate experience. For novices, pouring resources into such properties, plagued by either physical decay or financial distress, can be risky. However, it’s important to distinguish between simply distressed properties and those that are extremely distressed. A distressed property might suffer from 30% vacancy or rental delinquency, require some overdue maintenance like a new roof or plumbing fixes, or need a few units refurbished. These issues are generally manageable, and with proper guidance, a novice investor could handle them. The real error occurs when beginners pursue extremely distressed properties. Despite the allure of high returns, the substantial risks involved outweigh the returns and make this a huge mistake. So what qualifies for an extremely distressed property?

Extremely Distressed Multifamily: 3 Common Scenarios

High Vacancy: Imagine discovering a property that’s completely unoccupied but it has great potential. The units have been empty for five to six years, but with the right renovations, it could be worth millions! For a novice, this is a mistake and not worth the potential risks.

Half the Property Destroyed by Fire: Perhaps you find a property where half of a 10-unit property is destroyed by fire. The remaining five units have significant potential. If you could get the insurance payout from the seller and and renovate those units, the property value could skyrocket. That’s the allure—the promise of what the property could become. However, the risks are substantial: protracted negotiations with the city, obtaining permits, holding costs, and managing contractors can be a recipe for disaster. It’s a gamble that might not be worth taking if you’re just starting out.

Severe Financial Distress: A third scenario is when 50% of tenants stop paying due to property management issues. This occurs when a poor property manager has bad relationships with tenants by neglecting repairs, leading to tenants withholding rent. These properties are in extreme distress, both financially and physically, due to not only the strained relations between management and tenants but also the unresolved issues at the roots of the conflicts. And because tenants talk to each other, a situation where half refuse to pay can quickly escalate to all tenants. This level of distress requires skill to handle, and for a beginner, taking on a project like this would be a big mistake.

Start with Less Distressed Properties

It is risky for the novices to jump into projects with high levels of vacancy, severe property damage or significant financial stress because these properties require expertise and capital to turn around effectively. In fact, the number one cause of failure for extremely distressed multifamily projects is a lack of money and the lack of experience. As an experienced investor, I can handle these projects, but as a beginner, you need to start with less distressed properties.

Mistake #3: Building New Multifamily Properties

The third mistake is building new multifamily. What’s the problem as a new investor wanting build something new? Well, there are 3 common risk factors to consider when building new that make it a mistake for most multifamily investors.

Length of Time Start to Finish: One of the reasons why new builds are a mistake is because the length of time it takes and potential market changes during that time make it risky for beginners. For instance, there’s a new build near one of my properties that took almost four years to complete. Here’s what happened with that project: The developer hired a civil engineer, and architect and submitted the plans to the city. It took two years of going back and forth between the city, the commissioner, the architect, and the civil engineer for the plan to get approved. Then, after two years waiting for approval, it took 18 months to build. That’s risky for a new investor because as you wait through this lengthy process, market demand can change and it no longer meets your expectations.

Construction Delays: Once you get over the protracted approval process, you have yet another risk factor to overcome; construction delays caused by bad weather, labor shortage and supply chain issues. The problem here is that construction delays cost money and you need the holding power or financial reserves to complete the project.

Construction Loans: And that leads us to the third reason new builds are a mistake: construction loans mature within a given period. The bank will finance the construction, but that loan will come due and transition into more permanent financing. And because building new is a lengthy process, changing market conditions can derail a project. In the past few years, high interest rates have caused projects to be abandoned because when they started, their loan rates were more affordable. Since then, rates have doubled, even tripled and now the project no longer makes sense. It is no longer penciling out because it took four years to finish, and that’s a risk that beginner investors can not afford to take.

Focus on Existing Properties

As a new investor, getting involved in ground-up developments is time-consuming and financially draining, especially without prior experience or a seasoned team to guide you through the process. For novice investors, it’s better to focus on existing properties rather than new builds.

Mistake #4: Chasing High Cap Rate Deals

While high cap rate deals may seem enticing with promises of high cash flow and low prices, focusing solely on the numbers without considering other factors is a big mistake. High cap rate deals in less desirable neighborhoods often come with higher risks, including lower rent collections, increased vacancies, and increased expenses. Beware of low-priced multifamily deals, in 10 cap area with promises of $4,000/month in cash flow and 20% cash on cash return! Here’s why: location, location, location.

• High cap rate deals promise high cash flow, but because they aren’t in the best neighborhoods, the tenants can’t be relied on to consistently pay rent. Lower rent collection means the promise of high cash flow is not a reality and you will struggle.
• And low price that you were so excited about? Well, the lower the price, the worse the neighborhood.
• The deal promises high cash on cash return, but again, this is a promise, not a reality because of the location. When your property is in a bad area, you will have high vacancy and a continual turnover of tenants because you’re renting to people who don’t pay on time. In turn, this unreliable tenant base increases your expenses with eviction costs, turnover costs, marketing expenses, and no rental income while you are filling those vacancies. So, you’re generating a lower income and at the same time have higher expenses. All this starts to add up and the promises of high cash flow and cash on cash return fade away.

Mistake #5: Going it Alone

Lastly, the final multifamily mistake to avoid is going at it alone in real estate investing. One of my mentor’s best advice was to create a strong support team, other people with expertise that can make you better. Why is this great advice? Because surrounding yourself with experienced professionals can provide the guidance and expertise you need to avoid costly mistakes. Michael Jordan, one of my favorite basketball players, said,

“Talent can only win you games, but to win a championship, you need intelligence and a team.”

And that is true for multifamily investing too. I would not be where I am today if I didn’t have an exceptional team and the same applies to you. If you are a beginner investor, you need experienced people on your team to help you do things the right way so you can avoid making costly mistakes.

Building a Championship Team

Experienced Property Manager: To have a championship team you need a property manager with at least ten years of experience.

Experienced Advisor: Learning from mistakes is valuable, but avoiding them altogether can save you time and money. A multifamily advisor or mentor with a 20-year track record of success can help you avoid these pitfalls and save you from making costly mistakes.

A Lender Who is Entrepreneurial: Many lenders are by the book, and if your deal does not fit in their box, they want nothing to do with it. The lender you want on your team is the one who is willing to think outside the box. At Commercial Property Advisors, we have lenders we work with that are entrepreneurial, who find less conventional solutions to make financing work. You need that lender on your team.

Real Estate Attorney: Attorneys will tell you what you can’t do, but rarely do they tell you what you can do! You need an attorney on your team that’s not a deal killer. The type of attorney that will tell you how you can structure your deal and still protect yourself so you can make a lot of money while avoiding mistakes.

Accountant: Properly accounting for all income and expenses is key to optimizing the performance of any multifamily property. It also allows you to monitor the Four Ms: management, money, marketing, and maintenance. And with proper bookkeeping you can take full advantage of all the incredible tax benefits of commercial real estate investment. Which is why having a CPA (Certified Public Accountant) who thoroughly understands multifamily investing on your team is critical. And if they are an investor themselves, that it a bonus because then they know just how important this component truly is. Do not use a franchise tax advisor for your tax prep if you want to a championship team.

Every Successful Multifamily Real Estate Investor Has a Mentor

If you have any comments or questions, text PETER to 833-942-4516.

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