I wrapped up an assignment working with a family whose real estate portfolio was in serious trouble. Due to years of poor financial thinking, the portfolio had terrible cash flow, a pile of credit card and other high-interest debt, many major deferred maintenance projects, and was seriously past due on property taxes to the point of almost losing properties to the county and lenders threatening action. And yet, the portfolio had plenty of equity.
Because the portfolio was all residential rental properties, from single-family to a 26-unit apartment, I brought in a colleague, Kevin Grossman, to work with me on this assignment. He has a tremendous amount of multifamily and mixed-use experience, including development, investment, and asset management.
At several times during our investigation, analysis, and drafting of the recapitalization plan, we asked ourselves how the clients got into this situation. Kevin, an operations guy, ultimately felt it was because they did not have the financial understanding themselves or expertise on their team. They needed someone to bring basic financial discipline into the decision process. They could have avoided the obvious problems of having fully paid-off properties while others were over leveraged with terrible interest rates and using the County as a bank despite the very high cost of this approach.
So without the objective, big-picture financial perspective, all of their hard work was precariously at risk. What would a financial expert have brought to the table for them?
- Objective view point. What do the facts say? Does the plan make logical sense? In my client’s case, they were emotionally invested in the properties and unskilled at assessing the financial impacts of the choices they were making (or deferring). Several properties were inherited from a parent, so the emotional connection was high, complicated by the surviving spouse retaining co-ownership and co-control of many parcels. To rationalize the group of assets and liabilities, part of the solution was to sell some properties. That simple idea had not crossed their minds. In their mind you only buy and hold regardless of what the market is doing and actual financial performance.
- Structure and Discipline. This includes the timely preparation of reliable financial statements, confirmation that the firm has all necessary permits and licenses, and proper execution of all documents. After reviewing some basic title information Kevin and I easily obtained from a title insurance company, we discovered that title to one of the properties was not in the name of the client, but the seller. This was news to the client. This lack of attention to basic property ownership documentation put them in a situation of confusion about ownership and control, and therefore clouded the possible paths forward for improving the performance of the portfolio.
- In a family situation, the added problem is that there are people benefiting from or taking on liabilities out of alignment with their actual interests. It doesn’t make for a happy Thanksgiving get-together when things are very out of whack. A financial expert knows the importance of using good information and factual situations to provide a foundation for fairness and equitable management of the assets.
- Risk analysis and mitigation. Beyond insurance, this includes thinking through a plan and looking at alternative (perhaps less positive) outcomes. Have we thought of everything? What if it doesn’t work? What’s our back up plan? What are the governance issues between generations, beneficiaries, and if a controlling person starts exhibiting dementia?
- The numbers. Our client had never prepared a comprehensive analysis of their portfolio’s performance. In all honesty, they didn’t need a spreadsheet to tell them they were losing money. But once we showed them that their portfolio was only producing a return of less than 2%, they were shocked. Yet, the portfolio had a substantial amount of equity – just very poorly allocated.
- Capital market perspective. Almost all real estate investment involves the use of outside money, either equity or debt. A good finance person will know what kinds of capital are available for different situations. In my client’s case, their properties had a combination of high-interest debt, market-rate debt, and no debt. I was able to look at the mix of assets and debt and craft a plan to refinance several, leverage a couple, and sell a few. The end result will be a capital structure better suited to the goals of the portfolio with a substantially increased cash flow.
Our plan was designed so when completed, the portfolio will generate more cash and the couple will be managing fewer units. The annual return will jump from less than 2% to over 5%, with greater stability and sustainability, and there will be lower risk overall from more rational debt on the properties.