How to Properly Vet a Real Estate Syndication Deal with Hans Box – EP 233

Justin Donald: What’s up, Hans? Good to have you back on the show.

Hans Box: Hey, Justin. Great to see you again.

Justin Donald: Well, this is round two. Actually, one of my very first podcasts I ever did was with you. So, early days, you and I got a chance to talk about vetting deals and talk about investing. So, anyone checking this out that wants to learn more, go all the way back to the beginning. I think you’re one of the first five podcasts. You may have even been the third or second podcast. So, obviously, that’s how highly I think of Hans and all the knowledge, the tutelage that you have that you share that I would want you to be literally one of the first people ever on the podcast. So, so glad to have you back.

Hans Box: Honored to be back on, Justin. I know your podcast has done really well, and so, I’m glad to be back.

Justin Donald: Well, our time together is always just so meaningful to me. You’re a dear friend, first and foremost. Secondly, you’re a guy that I’ve done more investments with than just about anyone else. You’ve brought me deals. I’ve brought you deals. We’ve vetted these deals together because we look at them differently. The two of us have made each other better, smarter, more sophisticated investors. And so, I appreciate your friendship and I appreciate just being able to not only do business and investing together, but we get to do life together. And that, to me, is the holy grail.

Hans Box: Well, I 100% agree, Justin. I look back, whenever we met years, years, years ago, it feels like a long time. And being in your sphere, in your realm, you’ve added a ton of value to my life and I’m just thankful we’re great friends and the deals are gravy.

Justin Donald: That’s right, 100%. Well, Hans, for anyone who is unaware, is one of the OGs of the Lifestyle Investor. So, when we kicked this thing off in the very early days, I mean, Hans was literally one of the first five people that we started this whole investment club and vetting deals and trying to put bright minds together and the whole idea of like 1 plus 1 plus 1 equals 10 really did happen with our community, with our OGs. And so, it’s fun now to think about all the stuff that we’ve done.

One of your goals, one of your dreams was to build out a vetting deals course and to teach due diligence. And we were able to do exactly that at one of our live events. I think it was a year ago now, where we literally did a full day on vetting deals live. And one of the women who is in our mastermind, Courtney, who’s just amazing, she actually is one of the highest ranking producers, producing NFL on Fox Sports and Olympics and World Cup. And she does amazing work.

She has produced all of our content now as a giveback, because of what she’s gotten as a Lifestyle Investor Mastermind member. And so, you and I are the beneficiaries of her actually producing this incredible course and turning it into an actual masterclass that people can go purchase on the website. So, that was really fun.

Hans Box: Yeah, that was fun. Being on stage for almost eight hours was a little terrifying to me personally, but it was great to have Courtney and you there to kind of support and provide the technical background that she does. I mean, I could never have done that on my own. So, I know some of the materials, but the rest of it, I have no idea.

Justin Donald: Well, it was great because you were like a deer in headlights, “What? I’m going to be on stage for a whole day. I can’t talk that long.” And I was like, “Oh, you definitely can, as long as I’m asking you the right questions, I know that we can go deep.” And so, that, by the way, of all the courses that I’ve produced, the tech strategy masterclass, the mobile home park investing, the passive income, I mean, this course is my favorite course. I think it’s literally as high value of a product as we’ve ever created. And that’s a testament to you and your knowledge and all the things that you shared. And in fact, Ryan, our COO, Ryan Casey and I just got back from the PAC event in Scottsdale, so the Pro Athlete Community where we hung out with a ton of professional athletes, primarily NFL players, but there were a couple of MLB professionals, and then there were a handful of NBA professionals, but there was primarily NFL players.

And so, one of the things that they wanted most was to learn how to vet deals. And so, this course we have provided to the pro athletes, to the PAC community, free of charge, because we are so excited about the partnership with them and the opportunity to continue to educate the Pro Athlete Community who I know really values having content like this. So, it’s pretty cool to see that, isn’t it?

Hans Box: Oh, yeah, that’s great. And a community like that that gets bombarded with deals all the time, it’s a valuable resource for them to be able to avoid any pitfalls.

Justin Donald: Yeah. It’s awesome to see, I mean, literally, the players were swarming us, asking us questions, diving deep, wanting to get more. I literally just interviewed Devon Kennard (DK) on the podcast and it’ll probably go out before year. So, people maybe have already listened to it at the point that this one comes out. But he said that he went through it and was blown away, just absolutely blown away. And he’s done very well for himself in real estate, which is cool.

Hans Box: Yeah, that’s neat. I’m glad we can provide value to them.

Justin Donald: Well, let’s dive in because what I would like to do is give people an overview of the most important concepts. So, for people that want to take a deep dive, go check out the course. But for those that kind of want the cliff notes, I would like to offer that here today. And probably, the best place to start and the most important place to start, I think you would agree with me is in vetting the sponsor. I think everything starts and ends with the sponsor. There’s a saying that it’s all about the jockey. The jockey is more important than the deal. Obviously, you want a good deal, but a really good jockey can take a bad deal and make it okay, maybe even good. But really, like, a bad jockey can really screw up an amazing deal, right?

Hans Box: Oh, that’s right. That’s right. I mean, it’s where I learned my lesson in my first two deals that I ever did years and years ago. It’s really about picking that sponsor, first and foremost. A bad sponsor can take a home run deal and run it into the ground and vice versa with a really good sponsor. So, that’s the first thing I always want to look at, generally, in a deal, if I don’t already know the sponsor is, is what’s their strength. And there’s a million ways to look at it. And that’s what we’re going to cover a little bit here today.

Justin Donald: Yeah. So, what are the things that you want to look into? I mean, overview, as I think about it, it’s like track record matters, transparency, basically, that you know what they’re up to and that they’re open and honest with what they’re doing, and in the vetting portion that they actually will share stuff. Their motivation really needs to be aligned with our outcome as investors. And then we got to be really careful with people who are really salesy and put pressure. And it’s like you have to invest by this point in time, like I used to allow the FOMO to force me or encourage me to make decisions without finishing my due diligence, because it’s such a good deal and there’s a deadline and I want to get it. And all these great people that I know, smart people, successful people are in it. And those are horrible reasons to get into a deal. So, please, dive into some of this, would you?

Hans Box: Yeah. You mentioned kind of the high points there and I’ll kind of add some detail here. So, to start out with the track record, I mean everyone knows what track record means. It’s how well they’ve done in other deals. But you have to do more than just look at their spreadsheet that they might provide you in the business plan and see their IRRs and equity multiples. And actually, to start out with, everyone, we don’t have time on this call, but there are a bunch of terms that we may be throwing out on this call that you need to know the definitions of like IRRs, equity multiples, pro forma, etc., and that’s all part of our course.

But on the track record, number one, I want to know that they’ve done this in the past and in the same asset class, preferably in the same market. It doesn’t have to be, but at least in the same asset class, meaning multifamily or mobile home parks, and in the same size. If somebody has done a bunch of good deals with 10-unit apartment complexes, that’s great. But if they’re now buying a 200-unit property, that’s a completely different type of deal. So, to me, that’s not similar, right? Even though it’s the same asset class, it’s a different type of deal.

One thing you have to be careful of nowadays that I’ve noticed, and this is more of a recent update is, as many of you know that multifamily went to a very frothy time over the last few years and now is having a downturn, unfortunately, because of interest rates and expenses, etc. And so, many times I saw, two or three years ago that people had these IRRs that were crazy, 50%, 60%. And that’s great because they were buying a deal, say, in 2019 and sold it in 2021. So, they held it for two years. And the shorter you hold the deal, the higher the IRR is if you make a decent return.

And so, many times, people were able to buy these multifamily properties and literally flipped the deal to somebody else two or three years later. And the IRR was great. And even, equity multiple may have been great. But did they actually execute on the business plan? And so, many times, you would look at these track records and go, “Okay, they did well, but they only owned it for three years. Did they actually implement the business plan that they said they were going to?” In that case, you have to ask for more information. You have to ask for what was their original projected NOI and what was your NOI at sale. That tells me whether or not they made their gain on sale through the cap rate compression, meaning prices just went to the sky because everyone was chasing the deals. Or did they actually execute and kind of have a higher income, which is how commercial properties are valued? So, little things like that.

You also want to look at experience and make sure that they have direct experience, that they’re not a money raiser only. It’s okay to raise money for other deals, but they need to have direct experience in the same asset class and have done it themselves hands on where they work full responsibility.

Justin Donald: Totally. And a lot of these pro athletes that we were just hanging out with, they were getting pitched by people that this was the first deal they have ever done, the first real estate deal. And we’re like, hold on, pump the brakes here. There is no track record. This may not be where you want to invest. I mean, having a track record to me is imperative. And having something go full cycle, meaning you provided a pro forma, you raised money, you then were able to fulfill at the level or better than what you projected.

And then how many times have you done that where it’s gone full cycle, you’ve gotten your investors the return that you said you would get them. And again, not because of inflation, not because asset values appreciate, but because they actually produced the business plan they set out to produce. They increased occupancy, they increased revenue, they decreased expenses. If it’s a value-add type of play that they actually added value, they didn’t just come in and raise rents.

Hans Box: That’s right. And adding value, of course, is something we’ll touch on here later, but it is the most important part of any deal. You shouldn’t buy a deal unless there’s a value-add component to it. And all I want to do is I want to see that they had that value and didn’t just rely on market appreciation as you spoke about. And then I will sometimes compare their deals if they haven’t sold ones that they own right now and ask them, okay, what is your NOI now? And what was your projected NOI for the same time to see if their current deals are kind of tracking? I mean, it’s never going to be perfect. They’re going to be ups and downs, but I want to see that they’re adding value throughout And a big question you might want to always ask is have you ever lost investor capital?

Justin Donald: Yes.

Hans Box: And I want to start with, it is okay if they have and if they admit it, and then they can tell you the story behind it. And it has happened a rare number of times, obviously. And they have a story behind it. They have a good reason that it happened, whether it’s a combination of their fall to the market and then what they learn from it, because sometimes sponsors that have been through a little bit of a rough spot will be more careful of your capital than people that have been in the business two or three years and flipped a bunch of deals and made a ton of money. They tend to get too aggressive. And that’s what we saw in multifamily recently.

Justin Donald: And we’ve invested with a sponsor that lost everything in 2008 to 2012. And literally, like, I mean, it cleared him out. But because of that experience, he is so good today. He’s not making those same mistakes. He goes about his plan differently. He’s much more conservative, his leverage is more conservative, his financing is more conservative. Like everything that happened to him, he has turned that into a good and he’s done very well for us. So, that’s a great example of someone that did lose money and really figured out why and it’s not making those same mistakes.

Hans Box: Yep. It shapes investment philosophy sometimes. And sometimes you have to go through a rough spot to understand it clearly.

Justin Donald: That’s right.

Hans Box: Transparency, motivation, alignment, all the sponsors must have all those. And when I say transparency, will they consistently answer any and all questions you may have as an investor? It doesn’t matter whether you’re an investor that’s investing $25,000 or $25 million, to be honest. You should get your questions answered because that’s your hard-earned money that you’re entrusting a sponsor with.

I’ve invested in funds that are $500 million plus, and I’m only putting in, say, 100 grand in the deal. I’ve still had that sponsor spend an hour on the phone with me explaining their investment philosophy, their thesis, and why they like their fund. And so, to me, that showed alignment, that showed transparency, and they weren’t just talking to me because I had a big check, because to them, it wasn’t a big check.

Justin Donald: Right.

Hans Box: And how they treat you when you’re giving them money shows you a little bit how they might treat you if stuff goes bad, right?

Justin Donald: That’s right.

Hans Box: And so, if somebody ignores your questions in the up front when they’re asking you for your hard-earned money, then what do you think’s going to happen if stuff goes a little rough or will they be transparent? Will they communicate then? Most likely not. So, it’s a really good way to test sponsors is how they answer your questions and if they’re happy to answer your questions. And I’m a sponsor myself. I’m happy to answer questions. There’s no dumb question. We have new investors who come in our deals every time, and it’s usually the same questions because they’ve never invested. So, it’s your job as a GP to educate that investor.

Justin Donald: Now, you and I have walked from a ton of deals because either (a) they refused to ask questions, (b) they got tired of how many questions we asked, or (c) they couldn’t adequately answer the questions that we’re asking. And they’re trying to like, smokescreen us either because they didn’t fully understand what we were asking, which is a problem, or because they were trying to divert us away from what the real answer was.

Hans Box: Yeah. When money’s easy to raise, they don’t like LPs like Justin and myself who are asking. And to be clear to everyone, we’re not asking these questions to be bugs and just to annoy them and see if they’ll answer. These are actually legitimate questions where after I read the business plan, the deck, or the PPM, I either wasn’t clear on some of the terms or I wanted to dig deeper and understand more. And so, it is a– Justin is right, we walk on many deals where they just– I think they become just interested because they know that we’re a little bit more sophisticated and we’re going to ask them legitimately good questions, and they’d rather deal with easy equity.

Justin Donald: Yeah. A retail investor, someone that doesn’t know the questions to ask. They are quick to wire money. I mean that to a lot of these sponsors want to work with because it’s not hard work. And in many cases, the retail investor, the unsophisticated, uneducated investor doesn’t even recognize that the splits are totally out of line, that the fees are way above market fees. And we’ll get into some of these specifics, but I think it’s important that they answer any question that you have.

Hans Box: Yeah. That’s right. I mean, again, this goes back to transparency. And I will sometimes ask them for, say, their performance spreadsheet in Excel so I can understand how their returns work. And honestly, any sponsor should be able to share their performance spreadsheet because it’s not proprietary info. You will get told it’s proprietary by some sponsors. If you’re told that, pretty much, yeah, it’s baloney and it’s a red flag and you probably should just don’t waste your time anymore with that particular sponsor, or I’ll ask them for reporting from their current deals. How do they report to their investors? So, that’s again a transparency thing. What are they sharing with their investors on a monthly or quarterly basis?

And basically, are they willing to share their P&Ls from their current deal? There’s a deal that I was looking at, Justin, that we looked at for our mastermind, where I asked for the P&Ls of their deals that they currently owned, so we could get a sense of, like I mentioned earlier, are they on pro forma? Are they pro forma? And they wouldn’t share those P&Ls with us, because they said those P&Ls are private and only for the LPs in those deals. And I’m like, you can sanitize and it’s just a bunch of numbers. I just want to see if your numbers match what you projected. And so, little things like that can tell you a lot of info.

Justin Donald: Well, and it’s great because you’re world class at finding these discrepancies. Sometimes they’re yellow flags, sometimes they’re red flags. Sometimes it’s enough yellow flags kind of equal a red flag. And this is probably a good time to segue into evaluating the pro forma, which is probably the next most important thing. So, we want to evaluate the sponsor, then we want to drill down and evaluate the pro forma. So, talk a little bit about what is the pro forma. And then what are we looking for on this? Because this is where we’re going to learn a little bit about financing. This is where we’re going to learn a little bit on their sensitivity analysis and how conservative or how aggressive are they? We’re going to find out, do they have a bear case, a base case, a best case and how do those numbers actually line up? Like, are these reasonable or are these unreasonable?

Hans Box: Yeah. And one more point I’d like to mention on the sponsors before we move is they should always have skin in the game. Always ask how much they’re personally investing. That is like the number one question to ask them. And that’s a given on any sophisticated sponsor, but it should be asked.

Justin Donald: Yes. 100%.

Hans Box: Yeah. So, the pro forma, you might see the name projections or pro forma. And usually, what this means is the P&L, the profit and loss statement, they’re taking a deal that has X P&L and trying to move it to Y P&L. In other words, you’re trying to add value. So, really, the first thing that I really look for when I look at our pro forma, is there a value-add component to the deal? So, whether you’re investing in multifamily, mobile home park, self-storage, industrial, whatever, is there a way– in the business plan, is it clearly articulated that you’re buying a deal with X income, can you get it to Y income?

And in most times, it’s done by raising rents in some form or fashion, right? Because everybody runs a deal typically on the same expense level. Obviously, there are improvements. You can make an expense through scale and everything else, but where you really can add value is on the income side. And so, as you increase in a Y net operating income in a deal, that increases the value of the deal itself. So, if there’s not a clear value-add component, i.e., where the sponsor can add to the income, meaning raising rents because they did upgrades to the units, increase the curb appeal, whether they’re buying a property that is just flat-out below market rents because the current owner is lazy and is happy to have it fully occupied and doesn’t– they’ve owned it for 30 years and they just don’t care. They don’t want to rock the boat, right?

But you come in, you’re like, “Well, no, they’re 20% below market. We can raise these rents and add value,” right? And the idea of adding value is again, kind of goes into Justin and I’s philosophy here is mitigating risks, don’t lose money. So, if you buy a deal at retail here and there’s no value add, if there’s any kind of drop in the deal value because of market, a recession or things like that, then suddenly, you’re equity is the first thing that gets lost. But if you add value and create this margin of safety, then you have a margin of safety. And if the market then, after you’ve added the value, drops because, I don’t know, we have a black swan event or we just have a recession, then you’ve got a margin of safety to protect your own equity. And that’s why value add is incredibly important. You will see value add everywhere. It will be in every deal you ever look at.

Justin Donald: It’s a catch phrase. People say value add because everyone, all the professionals do this. So, now, everyone’s like, “Oh, yeah, this is a value-add deal.” And over half the deals out there aren’t even value adds.

Hans Box: That’s right.

Justin Donald: They demonstrate no added value, yet they call it a value add. So, what you’re calling out here is so, so important.

Hans Box: Yes. And so, your job as the LP is to figure out whether this is truly a value add. And you do that by looking at their pro forma and you’re looking at their business plan. Number one, the sponsor should clearly articulate that to you in the business plan. If it’s not front and center and very clear to you as an LP, what the value add is, that’s already a red flag. It needs to be very clear. If they kind of beat around the bush and you see what the value add, maybe their income increases but you’re not understanding why, are there comps that support their rent increases? Are there comps that support their purchase price, etc., etc.? How are they adding value? It should be very clear.

And that’s where, it just takes practice as an LP. There’s no easy way around it. You have to be able to read a P&L. You have to understand how they’re increasing their income. And if you ask intelligent questions around the value-add component to the sponsor, you’re usually going to know pretty quick whether they feel strongly about their value add and whether they’ve done the proper research to get there.

Justin Donald: Yeah, 100%. And we could talk about this later, but I feel like I want to bring it up now because something that I think bothers me is when new investors see a pro forma, they just think that that’s what’s going to happen. If you’re uneducated, you’re like, “Oh, this deal has a 20% IRR, internal rate of return. This is great. I’m going to invest in this deal.” But the reality is the pro forma could say anything, like I don’t actually believe what’s in the pro forma. I hope that they can operate at what they have laid out, but just because it’s there doesn’t mean they’re going to do it. And if you actually want a better– most people make their decision on that current pro forma. We talked about this earlier where we love to make decisions based on past pro formas, give us the deals that have gone full cycle, show us the pro forma, the original pro forma, not your modified updated pro forma, the original pro forma and how did it perform, because that, to me, is a better indicator of whether this new pro forma is achievable or likely than anything that the current pro forma says.

Hans Box: Yeah, that’s right. I want to see conservatism built in throughout these, right? And you’re right that pro formas are just that, they’re guesses. They are wags. And I’m a GP2. And when I tell you that this deal is going to have X and Y and this cap rates sell in 10 years, yeah, I’m making educated guess at it. But what’s key is, is what are the assumptions I made along the way. Am I being conservative? Am I only increasing rents at market, what they’ve done over the last 20, 30 years in the particular market that I’m in? Or is it a growing market and I have a right to actually increase rents? Am I being conservative on my expenses? If I’m in Texas, am I assuming 100% property tax valuation, things like that. And again, there’s so much detail behind this.

This is obviously in the course, but you have to look at each component and see, you can’t dive into their entire underwriting. But what you can do is give it a good 30-minute overview and get a very good idea of whether or not they’re being conservative. And that’s in, like Justin said, if their prior pro formas are being met by their current deals, then you probably know they’re pretty accurate and they were conservative and that they were able to beat their own projections.

Justin Donald: Yeah, 100%. I want to dive into financing. But before we do that, is there anything else you want to mention about, like the sensitivity analysis or anything else with evaluating a pro forma?

Hans Box: Yeah, that was one thing I did want to mention before we jump into the financing. So, in all our deals, we perform a sensitivity analysis. So, I would say there’s a downside, a target, and an upside. Target is what we’re actually targeting. It’s what we reasonably think that we can do on this particular deal. And I like to see that in every deal that I get into, every real estate syndication I invest in, I want to see some sort of scenario analysis. And most importantly, the upside is great. Maybe that’s, if things go really well, here’s what we’ll do. But really, the reason I asked to see is because I want to see the downside.

Justin Donald: That’s right.

Hans Box: Yeah, I want to see what these sponsors assume that could happen reasonable. Now, we’re not talking zombie apocalypse kind of situation. We’re talking a downside scenario where certain knobs that affect the performance of the deal are dialed back, basically. And so, in other words, instead of using, say, organic rate growth of 3% and stabilized occupancy of 95%, maybe we say maybe it’s going to not grow at all the first two or three years and then only grow 2% after. And maybe it’s only going to achieve 90% or 91% occupancy, right? Or maybe I can’t do all the upgrades.

So, typically, we’ll have anywhere from like three to five knobs that we use in our deals to dial back the returns. And you look at enough of these, you’ll be able to tell the difference between the target and the downside. And if I’m still getting to single digit IRRs, mid to high, meaning 5% to 9% IRRs on the downside scenario, that tells me the deal probably has a lot of padding, right? It has a margin of safety built in. So, you always, always, always want to ask for sensitivity analysis. And one of those should be cap rate, by the way. Cap rate should be one of the first things you see adjusted in the sensitivity analysis.

Justin Donald: And I think for those of you that are learning to invest or wanting to get better at investing, you have to invest, or maybe I shouldn’t say you have to. What I do, what I know Hans does is I invest knowing that the worst case can happen, and I need to be comfortable with it. I recognize that the best case is unlikely. I can’t go into it thinking that’s what’s going to happen. Obviously, I’d love that to happen. That’d be great. I have had some deals that that has happened with and by the way, almost all the time, those deals are because of a frothy economy in an environment, not because it just went so well. It’s because they performed on the value add. And it was a frothy environment and the economy was pumping and likely, M2 money coming in, right? Some sort of stimulus. But what’s likely to happen is that, base case, that target case that you referred to. But I don’t invest based on the target case. I invest based on can I live with the worst case, because if I can, then I’ll do it. And if I can’t, I won’t do it.

Hans Box: Exactly. Goal number one and two is not lose money as Warren Buffett said.

Justin Donald: That’s right.

Hans Box: Just don’t lose money. You’re going to, you invest enough, you will. But the idea is that you try to mitigate that risk. You can’t be perfect, but just try to mitigate the risk. And that’s what we’re trying to do when we look at a scenario analysis.

Justin Donald: Yeah. And I want to dive into financing because this is a really important component of evaluating a pro forma, evaluating a deal that most people overlook, most people don’t know what to look for. And so, let’s dive into this a little, Hans.

Hans Box: Sure. So, financing, meaning debt leverage, right? And so, typically, in almost any real estate deal, unless you’re pension fund paying cash, your biggest partner as a general partner, as a sponsor, and as equity, your biggest partner is the debt provider, the lender.

Justin Donald: That’s right.

Hans Box: Because usually, it’s 50% plus of the money in the deal, right? So, that is extremely important because the more debt, the more sensitive the deal will be to debt terms.

Justin Donald: Because they sit in front of you in the capital stack, which will lay out more a little bit later, but it means they’re sitting in priority. They’re going to get paid before you as an equity investor get paid. So, it’s really important to understand the debt structure.

Hans Box: Oh, yeah. I mean, the higher the debt typically on the loan to value or the loan to the cost the deal, the higher the risk, the deal is for you as the common equity because you sit below that tranche of debt.

Justin Donald: That’s right.

Hans Box: So, to kind of make a point of how important debt is, and I’m going to take this back to where we are in multifamily right now. Back in 2019 and more like 2020, 2021, and 2022, we saw a lot of multifamily deals across the South, more the South than anywhere else. This is happening in Texas, in the Sun Belt, in Arizona, and etc., where people were buying these class B and C apartment complexes using bridge debt, bridge lending.

And bridge debt is what it is for, what it sounds like it’s for. It’s to bridge a deal. To take it from today when I buy it because it’s distressed, to then I stabilize and then I put permanent debt on it, right? So, it’s bridging that gap because most permanent lenders like banks and Fannie Mae and Freddie Mac won’t lend on a deal that has a lot of distress. They only want to lend on deals that are fully occupied and stable and producing cash flow.

So, what was happening is, though people were using these bridge lenders and bridge debt on stabilized deals that really had not a lot of upside, and the reason they were doing it is because the permanent lenders were looking at these deals, and because these deals got so frothy and expensive over those three years, Fannie Mae and Freddie Mac, because of the way they lend, they have limits on debt service coverage ratios. And again, it’s too much for today. But basically, they would only lend up to, say, 55% on a deal because they’re like, “Well, the deal’s too expensive. We’re not going to give you 75% because we don’t think it’s worth that. So, we’re going to give you 55% of what you’re buying it for.”

Well, when you have to raise 45% of equity, the deal suddenly didn’t make sense. They couldn’t make the deal pencil and produce a high enough “cash on cash” return to their investors. But if you get an 80% loan on floating rate debt at a 2.75% interest rate, suddenly the deal works, right? It’s just math.

Justin Donald: Sometimes interest only, right?

Hans Box: Yeah. Almost always interest only on these floating rate loans.

So, it makes it really easy to cash flow it for that term, but that term is short term. I mean, that is short term.

Hans Box: That’s the whole point, right? It’s a two or three-year debt with maybe you can add a year at the end by paying a fee. But the bigger issue is that people were putting, it was floating rate interest only. Well, floating rate, as soon as the– everyone knows our interest rates went up like 500 bps, almost 4% or 5%, right, in some cases. Somebody that was at a 2.75% suddenly paying an 8% or 9%. In some cases, even worse than that on this floating rate debt. And they didn’t reserve. Everyone assumed debt was just going to stay cheap, right?

So, what happened is all the money that they had reserved up front to do all these rehabs and add value, they had to use that money just to pay interest on the debt because their debt went from doubled or more than doubled, almost overnight to them. And so, now, they don’t have the money to do the upgrade. Now, they can’t do the value adds. Oh, and guess what, insurance rates spiked also over the last two or three years. Property taxes always seemed to keep going up, at least in Texas, and they really did everywhere else.

Oh, by the way, we also had inflation. So, your other expenses also went up. Oh, and by the way, we also had a bit of a slowdown, too much supply being built across the multifamily space. So, guess what that means? Lower occupancies, lower rents. All these things hit these GPs at the same time. And because they chose risky upfront debt. Many of these deals, I mean I’ve been on multiple calls, in fact, this past two weeks, trying to figure out rescue capital for some of these deals where they basically are over their skis. They paid way too much for the deals, and now, they’re in big trouble.

All going back to, if they would have gotten fixed rate debt and bought it conservatively, they can ride out, yeah, maybe your cash flow is not great right now, but you’re in fixed rate debt and you’re able to ride out the rough times. And we’re now approaching multifamily getting good again in the next two to three years because supplies dropping off a cliff. So, if they would have used fixed rate debt and just held on and made lower returns, eventually, you can come out of that when you plan properly. But when you use bridge debt, you’re playing a fire.

Justin Donald: Yeah. And really, this is the catalyst to the majority of issues that we are experiencing right now is floating rates, not buying rate caps, anticipating, having their worst-case scenario, not really a worst-case scenario in the pro forma, right? Their worst case scenario wasn’t realistic. It didn’t have anything about interest rates going up. And so, now, all the equity is about to die. If you’re an equity investor in these deals, you could lose all your money. And a lot of people have. We are in like the frothiest multifamily environment, the past, a handful of years ago now at this point. But we’re still seeing the fallout today and we’re going to continue to see it for a couple more years, maybe a few more than that.

Hans Box: Yeah. Now, I want to give a personal example to kind of like, we started a self-storage conversion on a deal south of Atlanta back in this same time period, right? And now, because we were doing a conversion which is essentially almost like a massive rehab, we paid $2.5 million for the property, but we’re putting $8 million into it, you have to get floating rate debt. We are actually using bridge debt, floating rate debt in the right way.

But when we did that, we knew floating rate. We didn’t trust rates. We just were conservative and we wanted some way to fix it, so we negotiated with that bank before we ever closed that loan. And we didn’t have to buy this. We just negotiated up front with a lender. Our rate will never go above 7%. And then we took that 7% and we plug that into our numbers to see whether our deal would still work if rates went to 7% for that loan. Guess what? It did. Rates did go to 7% for that loan.

And thank God we asked for that cap. And thank God that we underwrote the deal assuming, as a downside, that it would hit 7%. So, we essentially have fixed rate debt on that deal and we’re going to be fine. But if we hadn’t done that, we could have been in the same boat as some of these other people because of the floating rate jumps.

Justin Donald: Yeah. And I’d like to just– I’ll paint an example. I had tons of friends during this frothy, basically it was a decade of like frothy, frothy multifamily, other assets too, other real estate asset classes, but let’s just talk multifamily for the time being, where people are like, “Justin, you’re crazy for not getting in these deals. Look how much we’re making. We’re turning these. We’re flipping these in two or three years and making all these great returns.” And I wouldn’t do it because they were using bridge debt in a way that I didn’t think that it should be used. And so, my friends, many of these people are kind of laughing like, “Oh, Justin, you’re missing out.”

But then interest rates went up and I was in no deals that had these floating rates. And so, I didn’t lose money. So, the same people that made a bunch of money that we’re kind of joking and making light of the fact that I’m not getting the returns that they’re getting, they’re losing a lot of money right now. And they have been for the past few years. But I maybe didn’t get the upside that they got during the frothy market because my investment criteria is very strict on the type of debt. I want long-term debt. I want low-interest rate, long-term debt. Not variable, right? And not short-term debt.

And if that’s the case, it needs to be used the right way. It really has to be a value add. And it really has, and likely, like a distressed deal. And then there needs to be a rate cap. And so, to me, that story is like the exact thing of what everyone does. They rush into these deals. They want to get these great returns. Everyone’s touting it, all these brand-new sponsors who don’t really know what they’re doing, but things have worked because the economy has been strong. They’re getting good returns. But that doesn’t actually mean that they’re good at what they do. And so, my investment criteria saved me by not going into these deals and having no losers because of the rates jumping.

Hans Box: Yeah. And I like what you just said there at the end, Justin. They may have made great returns, but they’re not necessarily good at what they do. And that did happen unfortunately a lot, where it led on these investors, where they did get good returns because of the deal flipping and because of cap rate compression and using cheap but risky debt. It worked out. I mean, it’s like musical chairs, right? And the music stopped and people got caught.

And so, the idea behind what we’re trying to teach here is how do we figure out if these sponsors know what they’re doing? That’s really what we’re trying to figure out. All these questions, all these things we’re covering, in the end, are they good at what they do? And are they being conservative?

Justin Donald: Yeah. And Hans, something that I think is important to point out, when you’re using debt, and whether it be bank lending, whether it be CMBS, whether it be agency, Fannie, Freddie, there are loan covenants that you really have to abide by. And I’d love for you to just talk about that a little bit, because it’s basically criteria the bank has for your loan to stay in good standing if you’re not performing well.

Hans Box: Yeah, that’s right. I mean, most banks will ask for financials on an either annual or quarterly basis, typically. And what they’re looking for is they look at your debt payments that you have based on your interest rate and your amortization. So, like Fannie and Freddie are typically, they have an interest rate in their amortizing over 30 years. That’s typically what Fannie and Freddie are.

And Fannie and Freddie are the biggest lenders for multifamily in the United States. They’re pseudo government-backed loans. They may go private, blah, blah, blah. But long story short, it’s around 5. Right now, it’s in the 5s, low 6s, interest rates on multifamily deals, and amortize over 30 years. So, you have an X amount of payments per year, right? They want to look at your income, your net operating income, and see that your income covers your total debt payments interest plus principal by about 25% or more. So when you hear the number 1.25 debt service coverage, that’s what that means. They want your NOI to be 25% or more than your annual debt payments.

And so, those kind of covenants on top of everything else, being transparent, not, in other words, like if they have issues, if one of the guarantors, the loan goes bankrupt, you have to disclose any changes in the structure of the deal, in the org structure of the deal or ownership changes to the lender, things like that. There are many different loan covenants, and you’ve got to make sure as a GP that you are meeting all of those or you can get on a kind of a red flag list or whatever they would call it with these lenders. And so, that’s why it’s important that you, as an LP in the deal, pay attention to the ongoing financials. If they’re meeting pro forma, I guarantee they’re meeting loan covenants. But in general, you just want to see a good track record and make sure that the sponsors themselves are abiding by the loan and haven’t gotten trouble in the past. Trouble in the past is usually the best indicator.

Justin Donald: Yeah, well said. Let’s talk about returns. Let’s talk about the difference between ROI, return on investment; IRR, internal rate of return; and equity multiple, which sometimes you might hear as MOIC or multiple on invested capital. Because I think if you don’t know what you’re doing, there are definitely deceptive practices around sharing the return, the pro forma of what they’re projecting the return to be. And well, I’ll wait on a couple of things because we could go a couple layers deeper here in a moment.

Hans Box: Yeah. So, in general, on most of these commercial real estate syndications that you might be looking to invest in, the two important measurements of return to me personally are internal rate of return, which you hear is IRR, and then what Justin mentioned, equity multiple or MOIC. And those are two completely different measurements. They’re complementary. You need them both. And you always want to see them both.

So, long story short, IRR is basically– a good way to describe IRR is the percent return, annual return you’re making on every dollar of invested capital for the amount of time that dollar was invested in the deal. That sounds a little confusing. I get it. So, high level, basically, an IRR typically will be higher, the sooner you get your money back, because it’s about the velocity of money. Velocity of money is very important. It’s something you teach, Justin, in your book and you teach in the mastermind is that you want to churn your money. If you’re trying to grow your network, you want to churn your money. So, if I invest in a multifamily deal that refinances in year 3 and can return half my invested capital and then continues to throw off cash, that’s going to typically have a higher IRR than the identical deal, it’s the same overall return, but returns might cash later in the deal.

So, typically, you would want to invest in a deal in that case that has the higher IRR because you’re getting your money back quicker. You can go reinvest that money. But it’s key that, and this goes back to our examples and keep going to the deals that happened over the last few years where people were flipping deals in two or three years, that means your IRRs are very high because you’re getting back your money quickly, but their equity multiple may not have been necessarily that high.

The equity multiple means the absolute return on the deal. If you invest $100,000 and you get back $200,000 at the end of the deal, meaning you got back your original 100 plus 100 in profit, you made it 2x multiple. So, I want to see the absolute return, 2x, 1.5x, 1.75 x. And I want to see the IRR. Those two are very complementary.

Justin Donald: Yeah. And I think you also need to be really careful that a lot of sponsors are going to represent gross returns as opposed to net returns. So, gross returns are not actually what the investor is going to end up with, right? Because there are fees and things that come out which we’re going to talk about here in just a moment. But it always bothers me when sponsors represent a higher IRR or a higher MOIC than what it actually is, that they’re representing the gross, not the net.

Hans Box: Yeah. You got to always pay attention to that. If it’s not evident, if it doesn’t say explicitly in the business plan and the PPM, we are estimating 15% net IRR to investors. And it just says, 20% IRR, you have to know to ask that question. I see that more often than I’d like. And I see it in very experienced, very good sponsors that still do that. I don’t understand the purpose, but as an LP, you have to pay attention to, whether it’s gross or net IRR. In other words, net of their fees and their carry. Sponsor should get paid. Don’t get me wrong, but you need to know what your actual number will be, not what the deal is making.

Justin Donald: Yep. All right, Hans, let’s talk about fees and compensation. We don’t have a ton of time, but I think it’s important that we get into just some of the basics, like the preferred return, the hurdle rate, waterfall splits. I think that all of that is, this is fundamental information that still, a lot of people don’t know. And we need to make sure that they do so that expectations meet reality.

Hans Box: Sure. And so, we’ll start with fees briefly. Sponsors do receive fees and they’re justified. And because of the work, it takes to find a deal, negotiate a deal, sign on the loan, do things like that. So, there’ll be an acquisition fee. Anywhere between 1% and 3% is typically what you see. The lower the better, of course. Loan signing fee, if they’re signing for recourse, that’s usually a given that they get a fee for that.

And then you always will typically see, at least see an asset management fee of 1% to 2% based on monthly or quarterly receipts, in some cases and funds, if the asset management fee is based on total equity invested, it depends on the type of deal. But again, we can get into super big details on fees. I think, more importantly, like you said, it’s kind of a compensation or waterfall.

So, when you hear compensation models or you hear waterfall structures or you hear hurdles, these are all describing how the sponsor gets the main part of their payment. In other words, they’re getting part of the profit of the deal. And the general overarching idea of any of these, when you look at these as an LP is, are your interest as an LP aligned with the sponsor’s interest in terms of making money? In other words, as you as an LP make more money? Do they make more money? Are they making a bunch of money and you’re not? In the end, that’s what you want to look at, right?

And there are countless, and I mean countless compensation models or waterfall structures. There can be a million different ways. But generally, and this is my preference, and I believe this is Justin’s preference as well, is that the first thing I always want to see is I want to see that there’s a preferred return.

Justin Donald: Yes.

Hans Box: Okay, meaning that every dollar of profit up to certain percentages goes to the LPs 100%. And so, when you hear an 8% pref, that means if I invested $100,000, that I will get $8,000 of profit in that particular year before the sponsor could start sharing in the profits of that particular deal. And different levels of pref exist. I’ve seen them as low as 4 or 5. I’ve seen them up to over 10, right? It really depends on the deal.

But usually, you’ll see them in the high single digit or so, and then there’ll be a split. So, say, they pay me 8%, but the deal made 10% in that particular year. Well, then there may be a split of say, I don’t know, 70/30 above an 8% pref. Well, that means that the sponsor then gets 30% of every dollar above the 8. It means the LP gets 70% of every dollar. And so, that’s what that means by hurdle. The 8% is a hurdle. And then the 70/30 up to say a certain IRR could be another hurdle. And the idea being is that the splits typically get more in favor of the sponsor as the deal returns go higher in general. Again, you want to see an alignment between you as the LP and the GP, and they make money when you make money.

Justin Donald: That’s right. And you actually want them to be incentivized to take the deal full cycle. So, I’ve seen a lot of deals where the fees are really heavy in the beginning, meaning the sponsor is making a lot of money before they do anything, which to me is a huge red flag. And then you see some deals that are straight split deals, meaning there is no preferred return, meaning the investors, the LPs are not being paid back first.

So, this means that the sponsor is making money all the way through. They’re making money before they’ve done anything with the deal. They’re making splits all the way along the way, with or even before investors make money. And now, they may have made so much money, it doesn’t matter what the end result of the deal is. And so, that is a true misalignment that we look to avoid.

Hans Box: Exactly. And it’s really a math equation on these things. I do know some sponsor to do straight splits that are really good sponsors. And I actually invested with them. Only one, actually, that I will invest with that has a straight split. But he has a great track record and I know that he’s honest and I know him personally, right? So, it’s a little bit different than when you’re investing with a sponsor that you don’t know.

And Justin’s right, a straight split means every dollar profit is split directly with the sponsor and with you. And so, typically, straight splits can– if the deal does really well, that means the LPs do really well. But if the deal doesn’t do very well, the LPs can really get hurt on a straight split because they’re not even making a minimum return.

And even the deal only makes 6%, they’re still having a split, that 6%, 80/20, or even 70/30. And that’s where they can get really hurt on a straight split deal, and then on the fees, like you said, you don’t want an acquisition fee of 3% on a $100 million deal. That’s crazy. It needs to be capped, right? They shouldn’t be making millions of dollars on fees day 1, no matter how big the deal is.

Justin Donald: That’s right. And I’ve just seen so many deals with above-market fees, with so many fees, with fees for things that I’ve never heard of before, but then, even with the standard fees that are marked up 100% or 50% over what market is, and it really drives me crazy. I want that alignment. So, the thing that I just despise about financial services, the whole industry, is that it is predicated on the ability for the person managing your money to make money, even if you lose money.

So, I really hate the design of assets under management because you could lose money and they make a lot of money. I don’t like the design of a split where the sponsor can make a lot of money. And there’s one specifically that we know that right out of the gates made like $40 million of first money out of a deal. So, now, whether the deal performs or not, they made a ton of money like they’re whole. And the LPs aren’t. And I don’t like the deals where the LPs lose, but the sponsors can win even if the deal goes bad. So, we just try to avoid those type of deals.

Hans Box: Yep, and that deal you mentioned goes back to our earlier conversation about transparency. If I recall correctly, it took a ton of digging for you and I to figure out actually how they were making their money.

Justin Donald: That’s right.

Hans Box: And they didn’t want to tell us. And we kept digging and digging. And once we figure it out, we were like, “No, we’re not going to sign up for that.” But they literally tried to hide it.

Justin Donald: Yep, without a doubt, every way they could. They tried to divert that question, all the questions regarding splits and fees. And by the way, that $40 million out of the gate, that was an egregious fee. Like, they are so far, like it is the most egregious thing I’ve ever seen and they are so far in the profit, no matter what happens with this deal on day one.

Hans Box: Yep.

Justin Donald: Tthat is a huge issue, a huge concern for investors. Last but not least, we should probably just fly through this. I do think it’s important to talk a little bit about company agreement. I mean, we’ve talked a bit about the PPM, but the operating agreement. We’ve talked a bit about the business plan often referred to as an offering memorandum or an OM. We’ve talked a bit about cap rate. We’ve talked about the pro forma. We’ve talked a little bit about the capital stack.

But I do think we should probably mention replacement of managers. So, anything in there on the company agreements? Let’s just touch base on it real quick and then wrap things up.

Hans Box: Yeah. So, I mean, a company agreement is basically the document that governs that limited liability company you’re investing in. And so, much of it is boilerplate. But one thing I do always like to look for is if they’re kind of the managers, the sponsors be removed from management of the company if they are negligent or they commit a crime or they commit fraud or things like that. You want to at least see the ability, to remove them by their LPs if they commit something very egregious like that.

Now, typically, there are some smaller deals that will even let you remove them if they’re just not performing. But in general, that doesn’t exist, but you should be able to remove them if they commit fraud or negligence or break a law or things like that. And the other thing I think you have to pay attention to in the PPM and company agreement when you review it, is that’s where you’re going to understand the different classes of equity and you want to understand where you are in this equity stack, because like Justin mentioned earlier, you have the debt and then you have the equity here, right? The debt becomes before you as the equity. Well, there may be different classes of equity that are also before you as the common equity.

Justin Donald: That’s right. Preferred equity.

Hans Box: Exactly. Preferred equity or just another class...

Justin Donald: Class A, class B, class C.

Hans Box: That’s right, yes. And it can get very convoluted. But in the PPM and the company agreements where it should be, should be explained and that’s where you will find the details about where you lend. The higher you are in the stack, the actually higher risk it is for you, and you should be compensated for that risk. So, that is really where you find the nuts and bolts of any deals in the PPM and the company agreement. Business plan is great. It kind of makes it all pretty and puts it together the plan for you. But when I really want to get into the details of the deal itself and want to find out certain terms, that’s where I dive into the PPM and the company agreement.

Justin Donald: Hans, this has been awesome. For anyone that wants to learn more, go to LifestyleInvestor.com, check out the vetting deals course. We go into much more detail. I mean we’re given a cursory overview. So, if this sounds really detailed, imagine what the actual master class. I’m vetting deals is like, but Hans, you’re brilliant. You’re great at what you do. I appreciate you as a friend. And I appreciate your partnership, your insight. Where can people find out more about you and Box Wilson?

Hans Box: Sure, sure. I will mention that in a second. One thing I do want to say is everyone, when you invest in these deals, don’t have FOMO, never be rushed and just try to hit singles and doubles. You’ll be surprised how that will add up. Don’t try to go for home runs. Don’t go for the high return deals necessarily. Just go for singles and doubles and don’t lose money. And you can reach me at BoxWilson.com. And then my actual email is hbox@boxwilson.com. So, you can probably find us there on the internet. And feel free to reach out. Happy to chat.

Justin Donald: Love it. Well, I like to end every episode with a question for our audience. So, if you’re watching or listening, what is one step that you can take today to move towards financial freedom and move towards the life you truly desire that’s on your terms, so not by default, but by design? And hopefully, there’s more than one thing you can take away from Hans. Thanks so much, and we’ll catch you next week.