When you’re in the middle of a multifamily real estate deal, the stakes are often in the tens to hundreds of millions of dollars—a lot is on the line. And when the pressure is on, that’s when things can be overlooked or unaccounted for. People can easily fail to consider all the smaller details that are not visibly apparent.
Once a multifamily deal is dead in the water, there’s usually no coming back from it. That’s why it’s especially important to make sure you have all of your ducks in a row prior to closing. Here are five common pitfalls that can kill a deal, and how to anticipate and overcome them so your transaction goes smoothly:
Messing up the math—When buying an asset, it’s imperative that you calculate prorations accurately. Otherwise, you may actually lack the funding needed to close.
At closing, you will most likely receive prorated income, prepaids and resident security deposits. Many buyers will take these credits and think that they only need the bottom number, misleadingly labeled “Funds to Close,” to close on their deal. This is a mistake. All three items need to be calculated back in for cash operations and financial liability reconciliation.
Security deposits are a liability to the buyer because when a resident moves out, they may be due a refund for part or all of their security deposit. Prorated income and prepaids also need to be accounted for. Although the funds may have been used at closing, these funds need to be “charged back” to the new buyer. This allows for a healthy beginning cash balance for operations. If these funds are not put back into the cash account by the new owner, they may find themselves in a cash flow issue down the line.
Overlooking escrows—Escrows are a second essential expense to take into account. These costs include insurance, taxes and replacement reserves. Lenders will require these to be set up at closing. You want to make sure that you have estimated the correct amount in your proforma underwriting.
- Insurance escrows: Insurance escrows are the amount that will be owed for property and liability insurance. Lenders will require buyers to pay for a full policy cycle up front at the time of closing, in addition to funding an insurance escrow reserve. To calculate the new policy premium due at closing, divide the new policy’s annual premium up by 12, then multiply it by how many more months are left in the existing portfolio policy. If the new purchase will have a stand-alone policy, then 12 months of premiums will be due at closing. For the insurance escrow, the lender will take your annual insurance premium, gross it up by 5 to 10 percent, divide that by 12 months, and then multiply it by the number of months between the day you closed and the day your policy expires.
- Tax escrows: In addition to paying your pro rata tax proration at the time of closing, the lender will require you pay into a tax escrow fund. There will be a lump sum due at closing, then a monthly amount. Depending on the time of year you close, your tax escrow due at closing may be higher or lower than you calculated. If you close earlier in the fiscal year, you will have more months to pay into your tax escrow account, therefore reducing the number of months your lender will collect up front to pay taxes when they are due.
- Replacement reserve escrows: Replacement reserve escrows are funds set aside for the inevitable periodic replacement of building components. Before closing, it’s important to consider a potential difference in valuation for replacement reserve escrows between the buyer and lender. The lender may ask for a lump sum due at closing based on state of your property. For example, you may have underwritten for $300 per door, but your lender may underwrite at $450 per door. This will affect your total amount due to close the deal.
Not negotiating access to reserves—Talk to your lender about the terms surrounding access to your renovation reserves. If you know that your underwriting will be tight for cash during renovations, negotiate with your lender for two-party checks prior to signing your loan. This will allow the lender to give you access to the repair reserves so that you don’t have to pay for the expense up front. If you negotiate this from the get-go, they can issue a check in the name of your vendor and management company.
Missing key members on your team—Without the right people, any deal is likely to fall apart. Multifamily transactions require a lease auditor to review all leases prior to closing to ensure there are no anomalies, a site walker/bidder to walk the property to identify and bid out repairs, an accountant to set up bank accounts and financial books, vendors in place and ready to roll as soon as you take over the property, and a marketing team to prep the materials you’ll need to get the word out once the ink is dry. Hire the best you can afford, or you’ll pay for it down the road.
Poor document management—In the midst of finalizing a deal, documents are everywhere—or they are if you aren’t well organized. Have a centralized location and a filing system in place that makes it easy to find everything. Also be sure to make a checklist for all stages of the transaction, one that can easily be used to create data documents for handing off to other departments. After all, multiple departments are going to be referencing the same documents.
Everyone should be aware of where the transaction is during the whole process. In addition to that, someone especially detail oriented should be in charge of tracking critical dates: earnest money due, due diligence period, financing contingency, other contingency expirations, and the closing date. Have that person set alerts for these dates and monitor them closely so they don’t catch you buy surprise.
The key to making multifamily real estate transactions happen is to be prepared—to anticipate what might become an impassable mountain, and knock it out while it’s a manageable molehill. These five common roadblocks, as well as any minor inconveniences you encounter on the path to closing, are easily overcome with a little planning. Knock them out, and you’ll be in business.
As The PPA Group CFO, Nalie Lee-Wen heads the corporate finance department. She specializes in developing profitable relationships with capital partners and coordinating seamless transactions during the funding and closing phase of The PPA Group’s acquisitions. Lee-Wen oversees the team of accounting professionals for The PPA Group and its family of companies, including CLEAR Property Management. Prior to joining The PPA Group, Lee-Wen was the chief executive officer of a commercial real estate funding group. Lee-Wen has more than 12 years of experience in real estate financing, asset management and portfolio management.