Right-Sizing your First Deal
“She lay down in the first bed, but it was too hard. Then she lay in the second bed, but it was too soft. Then she lay down in the third bed and it was just right.” Goldilocks and the Three Bears
What is the “right size” first deal for you?
That’s a really good question and one that is worthy of a significant amount of your time and attention.
If you try to go too big, you run the risk of spinning your wheels without gaining any traction. Brokers make a living from knowing what it takes to close on a big deal, and if they think you don’t have what it takes, they will simply ignore your emails and voicemails - that’s something that most proponents of going big will typically fail to mention.
If you set your sights too small, you’ll probably find something that works and close on it, no problem there. But there’s also the opportunity cost associated - meaning you will spend your valuable time on that small deal and make less money than you could have made.
Of course, of the two situations, I’d prefer going too small on your first deal because it gets you in the game. I’ve seen way too many people chase the monster properties and get frustrated, whereas the people and groups that right-size their deals from the beginning have a much higher success rate. What’s more, once you have your first property under management, it is much easier to purchase more and larger properties.
Bottom line, by right-sizing your first deal, you will have a much higher probability of success and will likely get into the larger properties much FASTER from the momentum you gain.
Factors to Consider in Right-Sizing
Here are several factors you should consider when determining the right size for your first deal.
Money - Raising Capital
I put this first for a reason. If you boil it down to the single most important thing in buying apartments, it’s the money. You need to be able to bring the full purchase price (plus closing costs) to the table before the contract expires. Period.
When you look at the money sources, there’s usually a bank involved that provides a loan for up to 75% of the purchase price and you are responsible for the rest. When you factor in closing costs, operating reserves, and planned capital expenses, you typically need 30-40% of the purchase price to be fully funded.
One quick way to determine what is right-sized is by looking at how much capital you can bring to the table within 2-3 months (the typical contract period). Multiply that number by 3 and you have your approximate purchase price. If, for example, you’re able to raise $1 million from your network, you would be able to close on roughly a $3 million property.
Many people overestimate how much money they can raise on their first deal. They sometimes count on a wealthy relative or family friend to fund a disproportionate amount of a deal, or they just plain guess because they’ve never really thought about it. If you do overestimate your capability, you’ll find that closing on the property will be an extremely stressful ordeal.
Money - Securing Debt
Back in the mid-90s, my college roommate and I went to Best Buy for a TV/VCR combo for our apartment (yes, a VCR) and applied for in-store credit to take it home that same day. Turns out that even Best Buy has minimum criteria for lending money because they denied my credit application.
Lenders all have minimum standards for whom they’ll call credit-worthy, and if you are pursuing a multi-million dollar loan to purchase a multi-million dollar property, you can bet that the lender will have relatively high standards - even more so than Best Buy. Though each lender may have slightly different criteria, most follow these standard guidelines:
Partners collectively need to have net worth greater than the loan amount
Partners need to have roughly 10% of the loan amount liquid (in cash or a brokerage account)
Partners need to have experience managing a similar property
Partners need to have money invested, or skin in the game
So, when right-sizing your first deal, be sure to look at your own financial situation because the brokers and lenders certainly will. Your team’s net worth and liquidity will determine the maximum loan size.
There are many other areas in which your work and life experience should inform your decision on what size asset your team can handle. You can leverage related experience in another business or your employment in the apartment investing arena.
For example, asset management involves managing people and resources. If you have no experience as a manager and the largest project you’ve managed is a single family rental, you may want to start with smaller properties with a relatively simple business plan. On the other hand, if you and your partners have managed several complex, multi-million dollar projects, you may feel comfortable with larger, value-add properties.
When assessing your relative experience, you’ll need people who are detail oriented and can manage projects, people that are good with numbers and can analyze properties, and you’ll need people that are good at building relationships. Teams with less experience should be a bit more conservative in determining their deal size.
Many people liken partnerships to marriage. If you purchase a property with someone, you will have to work with them for several years. If we use marriage as the analogy, let me point out that over 50% of the marriages in the U.S. end up in divorce. If you just met your business partner at the last multifamily conference you both attended, you should probably be more conservative when it comes to deal size. On the other hand, if you’ve been in business together for several years and already have a strong partnership, you can be a little more aggressive in determining your deal size.
How to Stretch and Go Bigger
Ultimately, there are many ways to get into bigger deals. There are creative solutions that bypass the so-called gatekeepers to this industry (aka the brokers and lenders) and allow you to really stretch your limits. For example, you could do a direct-to-seller campaign, negotiate a fair purchase price and obtain owner financing.
In my opinion, the most reliable way of increasing your buying power is to find partners that can fill in where you’re weak. If you're lacking net worth or experience, you can find a deal sponsor into the deal and combine your balance sheet and experience with theirs to increase the size of properties you can tackle. If your ability to raise capital is limited, you can find a partner that can bring more money to the closing table.
Of course, the best way to find a good partner in any business is to BE a good partner. You will need to provide similar value to your partner as they will be providing to you. And that’s going to be the subject of the next article: how to attract partners that can help you go bigger.