BiggerPockets Real Estate Podcast - 850: Multifamily Experts: Look Out For These 7 “Red Flags” BEFORE You Invest

Episode Date: November 29, 2023

“Want to invest in multifamily real estate, do zero work, and make a million dollars, all in a few months? Well, we have the opportunity for you! We’re about to make you a gazillionaire for the low, low price of your entire life savings. Don’t worry about doing any due diligence; just sign these papers without looking through them. You’re about to strike it rich!” Most people can call out an obvious scam or bad real estate deal, but what about the less-than-obvious signs? Today, we’ve got two multifamily real estate experts, Andrew Cushman and Matt Faircloth, on the show to go through the multifamily and syndication red flags that could cost you EVERYTHING. Andrew even went through the painful process of losing 90% of an investment years ago just to walk through his lessons on the show. Whether you’re partnering on a deal or passively investing in syndications, if any of these red flags show up, you should run—immediately. From vetting a sponsor to investigating track records, which metrics to trust (and which NOT to), and the questions you MUST ask, this episode alone could stop you from losing tens or hundreds of thousands of dollars. In This Episode We Cover: The seven deadly signs that a multifamily syndication deal is a scam (or at least a dud) Vetting a sponsor/syndicator and why you MUST avoid “FOMO investing” Partnerships, inexperienced sponsors, and who you can REALLY trust The new financial “metric” unsophisticated syndicators hope you DON’T look into  The “capital stack” explained, and how to do your due diligence on a syndication’s debt (before you invest) And So Much More! Links from the Show Find an Agent Find a Lender BiggerPockets Youtube Channel BiggerPockets Forums BiggerPockets Pro Membership BiggerPockets Bookstore BiggerPockets Bootcamps BiggerPockets Podcast BiggerPockets Merch Listen to All Your Favorite BiggerPockets Podcasts in One Place Learn About Real Estate, The Housing Market, and Money Management with The BiggerPockets Podcasts Get More Deals Done with The BiggerPockets Investing Tools Find a BiggerPockets Real Estate Meetup in Your Area Be a Guest on the BiggerPockets Podcast David's BiggerPockets Profile David's Instagram Rob's BiggerPockets Profile Rob's Instagram Rob's TikTok Rob's Twitter Rob's YouTube BiggerPockets Podcast 636 with Amy Mahjoory (Part 1) BiggerPockets Podcast 352 with Diego Corzo Join BiggerPockets Pro and Start Investing for Financial Freedom TODAY Ask David Your Question Book Mentioned in this Show Pillars of Wealth by David Greene Raising Private Capital by Matt Faircloth The Richest Man in Babylon by George S. Clason: The Hands-Off Investor by Brian Burke Connect with Andrew: Andrew's BiggerPockets Profile Andrew's LinkedIn Vantage Point Acquisitions Connect with Matt: Matt's BiggerPockets Profile Matt's Instagram DeRosa Group Click here to listen to the full episode: https://www.biggerpockets.com/blog/real-estate-850 Interested in learning more about today’s sponsors or becoming a BiggerPockets partner yourself? Email [e-mail]. Learn more about your ad choices. Visit megaphone.fm/adchoices

This is the Bigger Pockets podcast show 850. What's going on, everyone? This is David Green, your host of the Bigger Pockets Real Estate podcast, the biggest, the best, the baddest real estate podcast on the planet. Today we are joined by two of my friends in the multifamily space, Andrew Cushman and Matt Faircloth. We're going to be talking about red flags that every investor should watch out for. This is particularly important in today's market.

Andrew, Matt, welcome to the show. David, thank you so much for having us today. Yep, good to be here as always. And before we get into today's show, I've got a quick tip for all of you loyal listeners. Sponsors are everywhere and they are looking to get your money. If you're finding a sponsor that's advertising on social media or even dating profiles, that might be a red flag that you want to look out for. Today's show, we're going to go over seven other red flags to be aware of.

Let's get into it. Why are we doing this show right now? Well, we're seeing operators in the news getting arrested on charges of investment fraud. and my gut tells me that as the market gets tougher, it's going to be like the tide going out and you're going to see who's been swimming naked the entire time. Today's show will be about something that has even happened with our previous guests. Now, we've got our guests to the best of our abilities,

but we have had former guests on this podcast that have gotten in the hot water, and that is why this type of show is so important. This whole incident is a reminder that no industry is immune to criminal behavior and bigger pockets will continue to stress to our audience that they do their own due diligence when investing. Now, maybe you're thinking, would never happen to me, but it's more common than you think. And as my co-host, Rob Abasolo has said, though he's not on today's show, an investment fund is structured exactly like a Ponzi scheme,

and it turns into one if it's mismanaged. On that topic, Andrew, I believe you have a story that supports that. Well, so back in 2005, you know, we all like to think we're smart and we can dig into things and we know what we're doing. But the reality is we all make mistakes, right? look at Chernobyl or the Hindenberg or almost any Nicholas Cage movie. Somehow that stuff still happens. So this was essentially a syndication. It was a little bit different spin. It was a group that was, quote, unquote, developing real estate out in North Carolina.

And they did have a couple of assets. But what they were doing is they were coming since, hey, we're selling shares, free IPO. We're going to build all this stuff. And then we're going to go public and you're going to make seven to ten times on your investment. So one mistake I made, I didn't do my own due diligence. My boss at my employer at the time went and did some and I'm like, well, he knows what he's doing, so I'll invest also. I did a shallow look at what the sponsor was doing. So, okay, it seems like they have an asset here.

It didn't really dig into, well, where's the money going? How's it being used? And then, you know, just there were some red flags or things that didn't quite seem right that I overlooked because, of FOMO, right, fear of missing out, and essentially greed, right? Like, dude, I can 10x my money by just, you know, invest in it with these guys. And so, like, for example, one of those things that, you know, I found and I should have just said, nope, I'm out, is a little bit of research. I found that they already had shares trading on the pink sheets. And I asked him, I was like, wait a second, how are you going public if you already have shares out? And they gave me

some bogus information. I should have said at that point, I'm out. But I said, well, you know what, Actually, this just sounds good. It's too much of a great opportunity. And so I invested. Ended up losing 90% of our investment. I invested and then they were paying dividends and there were some more red flags. And the day before I was going to call and request my money back, the SEC swooped in, froze everything.

Three years of special servicer later, we ended up, like I said, I think we got like 10% back or something like that. So it can happen to anybody. There are pretty sophisticated guys. out there who can pull the wool over almost anybody's eyes. Look at Bernie Madoff. He did it for how many decades? So don't feel bad if it happened to you. It's, you know, either has happened to all of us or probably will. But we're going to talk about a number of things that we can do to try to prevent or minimize that. Thank you, Andrew. Today we are going to cover the biggest red flags to look out for to keep you and your investments safe after this quick break. We all joke that rentals are passive,

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charges, and expenses of the Fundrise Flagship Fund before investing. This and other information can be found in the fund's prospectus at fundrise.com slash flagship. This is a paid advertisement. All right, welcome back. We're here with Andrew Cushman and Matt Faircloth. Andrew is my partner in multifamily investing. And Matt is the author of Raising Private Capital,

a book with Bigger Pockets. Let's give a quick shout out there. Matt, where do they go to get that book? on the Bigger Pockets platform? What's up, brother? Good to be here. They can go to BiggerPockets.com forward slash RPC to get a copy of that book. And if they buy it from Bigger Pockets, they get a bunch of bolt-on bonuses, including another small e-book that I wrote on buying apartment buildings and a 90-minute interview with my SEC

attorney. So people should watch that just to get the book just for that interview because that interview would help people avoid a lot of the mistakes we're going to talk about today. All right. Speaking of those mistakes, let's get right into it here. All right, when they're vetting a sponsor on a deal, Matt, briefly describe what a sponsor is, and then let's talk about what they should do when it comes to looking internally. The sponsor is the syndicator and raising private capital.

I talk about the deal provider. That's the person bringing the opportunity. They're likely putting in plenty of sweat, contacts, resources, their market knowledge, all the doingness and a lot of time. as well, all that stuff put together into a big package. They're bringing the deal, the opportunity, and the intuition, the know-how, the drive, all of that. So that's the deal provider. That is the sponsor, the syndicate.

They have all kinds of different names, general partner, sponsor, syndicator, opportunity provider. All these things all kind of fall into the same guys. And they're providing the opportunity to the people that are going to invest in the deal as limited partners or cash providers. And, you know, going back to some of the things that I mentioned in my story, about when I lost money. Keep in mind, it's not just the sponsor. The first thing to do is to look at yourself internally because whether it's a prince from Nigeria or a sponsor with ill intent, they're preying off human emotions. So what are some of the things I mentioned? Fear of missing out. A bad sponsor is looking for somebody who has a fear of missing out, not getting

the great returns. Everyone else is doing this. Number two, are you investing because you're following a celebrity? You don't really know who they are. You haven't met them. You don't know anyone else who's worked with them, but hey, they got a TV show or whatever, or a really flashy social media. Are you investing solely because of that? It's not automatic red flag that they have those things, but it's internally that's not good if that is the sole reason that you were investing. Another one, too, is just, are you being greedy? You know, a lot of times we'll talk to investors and they're looking at four different investments. And like, well, this one says it returns 8% and this one says 12, so I'm automatically just going to invest with a guy who's promising 12.

that's greed. Just because an investment says 12% doesn't mean you're actually going to get it. So take the time to dive in and make sure that you aren't just being attracted essentially what is greed. And we are all subject to this to whatever is promising the highest return. Because generally the highest it is, there are more risk that might be buried in there. And you need to take time to dive into that. Matt, do you have something you want to add? What I want to say is the way that a sponsor plays into all those things all together, is they're going to provide you with an opportunity, just as Andrew talked about earlier, that is really, really high above the norm rates of return, 7x in Andrew's case, right?

But you got to get in right now because we're almost sold out, right? So it's going to be really, really high rates of return to create the FOMO, really high rates return to create that greed. And also, it's got to be, you got to wire the money right now. And I've been subjected to these kind of things myself. And it's always been above the norm rates of return and I need the money immediately. So you don't have really have time to vet it, think about it. think about it, any of those things. So that's, when you see those things, investors, listeners,

just put the brakes on and run the other way. Time will start to allow these things to unfold. And if it's too good to be true, probably is. And another thing that I would add before we dive into some of the actual red flags is keep in mind there's multiple ways a sponsor can fail. It's not all fraud. Unfortunately, there are some fraudulent actors out there and we're going to try to help, you know, everyone listening in ourselves to avoid those. But there's fraud. Also, there's incompetence. Whether that's lack of experience, lack of knowledge, the wrong partners, there is incompetence. And then, unfortunately, there is also just bad luck.

And, you know, I know some operators who have decades in the business truly put their investors' interests before anybody else's. And they've had a situation where a fire destroyed half the property, their insurance tripled, there was a shooting and all of a sudden the property is in trouble. So be careful not to broad brush everybody with the same color. Just keep in mind there's multiple ways to fail. And part of the red flat, part of what you're trying to do with these red flags is to hopefully root out all of these and give yourself the best chance of successfully investing as an LP. All right. So we had five red flags we were going to cover in today's show. But in just the last few days, events have unfurled

that have led to two more being included. So we're going to be going over seven red flags in today's show. We're going to get through these as quick as we can with as much values we can possibly bring. All right. So number one, the first red flag. The sponsor has a different partner for every deal. Yeah. So you notice this is really popular the last few years, is you would see these sponsors and it would be like, I mean, they'd be like the O for Winfrey of syndication. It's like, you get to be a GP and then you get to be a GP and you're a GP. Everyone look under your seats. there's equity. And the reason that this is and can be a problem is a lot of times what that represented was just someone grabbing any partner they could to get a deal done. And as all of you

know, partnerships have a high risk of blowing up and not working. So then the question becomes when it hits the fan and we get into the market environment that we're in now where the Fed is raised rates over 500 basis points, insurance is doubling or tripling, vacancy is going up a little bit, etc. When things get difficult, who's in charge? Which partner is it? If a sponsor has six different partners for six different deals, who's going to contribute the half a million to save this deal? Who's going to step in and in place of the property management company that's maybe not doing so well? If one partner declares bankruptcy and is just like, that's it, we're out, and I've actually seen this happen in the last six months, then what, right? Because now you've got half of a

partnership. So that is definitely a red flag. Now, again, it's not something where you're automatically out because, you know, on the flip side of this, there's what you call fund of fund investors where it's very experienced professionals who will raise money and then from maybe, let's say, 50 LPs and then go invest with another sponsor. In that situation, if you're, you know, someone who's raising that kind of fund, what you're doing is you are relying on their expertise that they have done all this due diligence and that they have picked the right sponsor and that they've done all of this vetting. So don't confuse the two. It's okay to invest with, you know, someone who's raising for another sponsor, but you just realize that you are relying on their

due diligence. And in fact that, you know, if you're a busy doctor, you don't have time to do all this, you're going to invest with that fund, then you know, you're relying on them to do that. And picking the right fund, you know, fund to fund capital raiser can be a great and safe way to invest. Just make sure you dive into it. Matt, anything you want to add? Well, it's when things are going well, uh, these folks look brilliant. We see people that met at a conference one week and the next week they're doing deals together. Right. So, um, and, and that's okay sometimes, but also I, I believe even building businesses together. So maybe it's okay for people that just met to do a deal, but you should see a plan beyond that. If you're going to consider investing in something

where it's a couple of operators first time doing business together, if flags, if they've all got different email address domains, right, you know, or if they all have different websites and everything like that, or if you see them on, I've seen sponsors promoting multiple deals at once with different teams and things like that. So that's really, To Andrew's point, all well and good, if things are going well, when things start to not go so well, that's when you're really going to see the tide go out and see who's naked, right? I think that you want to see companies that are building brands, building businesses, building something that's going to be doing deals over and over again.

That should make you comfortable. It's okay for people to pop around a little bit first, and then they should really kind of drop anchor and find a home. Yeah, and the logo on this red flag to highlight here is that most people, get into trouble when they're picking a Spartan because they are trying to delegate the due diligence. Oh, you did a deal with him? Oh, I know this person. Oh, Logan Paul is selling that NFT.

Okay, I'm going to buy that one because I know Logan Paul. No, you don't. In fact, the reason Logan Paul makes the podcast is probably just because people like you will buy stuff without due diligence and he can convert. The Kardashians have made an empire doing this. Is Kylie Jenner's makeup better than anyone else's makeup? No, but Kylie Jenner's makeup is well known because it's her name on it. I like it.

that's good so remember that due diligence is not an area that you want to delegate or give up on it it is sometimes laziness i myself have had deals where i tried it out with somebody didn't go well that's not a person i want to partner with anymore but guess what that person went out there and did a bunch of deals with other people saying he was my partner and unfortunately other people got into bad deals because he said i did a deal with david green that was a consequence i was not expecting when i did that first deal with him and now i have to be super careful maybe i just don't partner with anyone anymore because I don't want my audience to get exposed to, oh, you did a deal with David? Well, then I can trust you and it actually wasn't the case. I was just trying

it out to see if they were a good operator. All right. David, one more thing to throw in the back of it is a thing that a lot of the cool kids were doing in an up economy was raising capital for lots of opportunities. And since I'm the author of Raising Private Capital, I should comment on that briefly, right? That was something that happens a lot of people just all raise half a million for this person's deal and then I'll raise a million for that person's deal over there. That's all fine in an up economy. But what the problem with that is, as we've said before, that if the deal starts going south, the capital raiser that you liked and trusted has no control over the real

ongoings in the deal. And so when you're getting in with the fund of funds that maybe is putting a lot more juice, a lot more opportunities into operators, maybe that's okay. but if you're investing with a capital raiser that's contributing a small portion to the capital stack for a real estate deal, I would be wary because the capital raiser you're working with, your relationship as the investor really doesn't have any sway. And I'm already starting to see deals like this fall apart, Andrew. I've had capital raisers call me up to say, hey, I raised a million for this deal where there was a $15 million equity piece. And they're

now talking about giving back the keys to the bank. And this capital razor doesn't really have any control for these people that put millions of dollars of their hard on money into the deal. There's really nothing they can do because they're in minority control of the opportunity. So I would be very leery of subcapital raisers in this changing market. Yeah, and that's a question that should be asked. Is this your deal or are you raising money for somebody else's deal? Because if you think about the fact that money can change hands three or four different degrees here, I raise money to give it to this person who then gives it to this person, who then gives it to

this person and then puts it in the deal, you've got a lot of distance from personal responsibility and nobody is getting to be vetting it exactly it's like a copy of a copy of a copy can easily come out really really fuzzy all right red flag number two the sponsor or the seller suggests anything suspicious like inflating the proof of funds not disclosing material facts etc andrew oh this one i mean this one really is kind of a gut intuition thing right if somebody is telling you to do something or that they're doing something that seems unethical or suspicious or maybe like something you wouldn't do, like don't tell the bank, don't tell the other investors. You know, we're going to swap these signature pages at the last second.

You know, those are some things that, you know, you want to look out for. And, you know, this one, it's, you know, it's hard to give a list of the 27 tips to avoid this. This is really kind of boils down to using your gut, right? You hear that a lot, trust your gut, trust your instinct. If it's something you wouldn't do or you wouldn't, want your mom to know you were doing, that might be your good litmus test right there. Great point there. I mean, the problem is that an LP might not see a lot of the things that are happening behind the scenes. But you got to go with your gut. And sometimes the things

look a little bit suspicious, then they could very well be, right? I would say that if you're looking to be an LP in someone's deal, you can always, you have the right to ask for things like the contract of sale on the property. You have the right to ask for a lot of the documents that went back and forth between the buyer and the seller on the deal. And if the sponsor is not willing to give you full transparency and give you copies of the agreement of sale, the appraisal, the this or that, they should have actually those documents very easily. And if they won't, if it won't give you those things, then maybe there's a little bit of smoke and you should look for the fire. All right. Red flag number three, no successful track record in the business. This one has been

extra common the last couple years with the market being incredibly easy to succeed in. Andrew, what do people need to look out for here? Yeah, think of it this way. Like, if you, you're on a flight, right? It's like, this is your captain speaking. Thank you for flying syndication airlines. It's been noted there's some turbulence between here and our destination today. But the good news is your captain and co-pilot covered this in flight school.

And speaking of flight school, we just graduated yesterday. So we really appreciate you joining us on our first flight. Trade tables and seatbacks up. Let's get rolling. You hear that. You're going to want to get off that flight. And it's kind of a similar thing if you're investing in any kind of syndication or sponsorship. If there is no track record whatsoever, it doesn't, again, it doesn't mean they're fraudulent, doesn't mean they're incompetent.

It just they don't have the experience, right? So, and then with that said, none of us would get started if people didn't trust the inexperienced. I mean, there's a point where every single investor out there did their first deal. However, how that can be mitigated and what you want to look for is, is that inexperienced, person partnering with somebody who is experienced. And it could be a literal partnership. It could be a mentorship. It could be maybe someone who's really experienced is putting money into the deal. Is the new person putting money into the deal? And then also, track record and experience does not always have to be direct. It's kind of a catch-2020, catch-22, right? It's like, well,

you know, people who are applying for a job, it's like, well, you have to have experience to get this job, but you can't get experience because you don't get the job. So, you know, track record can be somebody who maybe excelled in another, you know, occupation for 10 years and has just a stellar reputation for being honest and hardworking. Or maybe they ran an incredible flipping business for 10 years and made it into a seven-figure business and now they're going to start going into self-storage, right? So again, if I was investing with that person, I would be like, okay, I like this person's work ethic and their business skills. If it's their first deal in another asset class, I might want to see a mentor or some kind of more experienced partner. But I would still consider investing with them even though they're technically not experienced.

So what you're looking for is either the direct experience or making sure that the person is partnering with somebody who truly has experience. A lot of the deals that are going bad right now are the ones where somebody went to a boot camp and in the last couple of years ran out, just went straight into buying 200 units, had no experience managing it, operating it, or anything like that, and doesn't have anybody to fall back on now that things are getting difficult and then those deals are having trouble. So that is why you're looking for experience. Just do on top of that, Andrew, I agree. The only thing I would say in addition is that it's one thing to,

site that I've got this mentor or a site that I've got this, you know, experienced person sitting over top of me. But I've, um, we, we were actually a brief story. We were selling an apartment building a couple of years ago in North Carolina. And we had a bitter that pointed to a mentor that said, well, I'm working with this person as my mentor. And it gave me a lot of comfort. But then I realized after a little bit further investigation, that mentor wasn't at risk on the deal. All they were, we're just kind of like sitting over top of this student. The student really just took the mentor's class and was allowed to point to the mentor as their advisor. But the mentor wasn't the going on the debt as a sponsor. The mentor really wasn't engaged and a at-risk sponsor, meaning the reputation

wasn't there to lose if the deal fell apart. So if you're going to be investing with someone that points to someone above them that taught them everything they know and is going to be bringing a lot of their expertise to the deal, just make sure that that person with the experience is also at risk, so to speak, in the deal. I should stop and clarify that we're not. throwing all boot camps under the bus. So the education that Bigger Pockets does and that Matt's involved in is the right kind of good education. What we're talking about is some of the big flashy ones that you'll see all over social media on billboards where it's more about the excitement of just getting out and doing a deal and not necessarily, well, what, you know,

it's kind of like the dog who finally catches the car and then doesn't know what to do with it. That's what's happened with a lot of these multifamily deals in the last few years is you have somebody that is doing their, I mean, their heart is in the right place, right? They tried to get the education. They took action. They raised money, but they don't have the expertise or the partners to fall back on now that things are getting difficult. So to clarify, Andrew, when you take the bigger pockets multifamily boot camp, you're not allowed

to say that Matt Farragloff and the DeRosu Group are your business partners for every deal that you do. But we do teach quite a bit, but we're not everybody's business partner for the Bigger Pockets Boot Camp. We have to draw the line somewhere. Yeah, exactly. And candidly, it's not on the boot camp. The responsibility for this is on the individual, right? Again, it's like, you know, you can't sue Harvard if you get out and you can't get a job, right?

That's on you. It's not necessarily the boot camp. Again, it's just the person who just like got an education and ran out and just bought 200 units without building the team and the resources in the bench that's required to do this successfully. I agree. Yeah, and that's a good point there. And there's analogy here where maybe you look at partnering with someone is like betting on a fighter. Well, you can lose your money if the fighter throws the fight. That's someone operating outside of integrity, doing something illegal. But that's not the only way you lose. You might just bet on a terrible fighter and they just go out there and get beat. Either way, you lose your money. So don't assume it's

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Stop letting outdated lending practices hold you back. That's hostfinancial.com where your property's potential meets unlimited. financing. Now, on the topic of bad operating, that leads us to our next red flag, which is lack of focus. Is this investment their core area of expertise or just one of 27 different things they do? And they're a part-time operator, not a smooth operator. Andrew, what do people need to look out for here? Again, this is another one where it's not an automatic no. It's just something to dig into. There are a lot of sponsors and syndicators out there that, for example, have done 10,000 units of storage or 10,000 mobile home communities. And, you know, they've gone in,

you know, an inch wide and a mile deep on that asset class. And odds are when things get tough, they're going to know how to handle it. They're going to know how to steer the asset through tough times. What seemed to get prolific in the last few years is we had a lot of groups that their thing they were best at was raising money. And then the problem became, man, I got a all this money raised, what do I do with it? Okay, well, I'm going to go over here and I'm going to invest in this and over, I'm going to put this in here. And you know what? There's, I got this stuff in Venezuela that I heard has just great returns. And so just, you know, all of a sudden you got a sponsor who has got, like you said, 27 different asset classes. And you know, so again,

the reason that's a red flag is because you need to ask yourself, well, are they an expert in any one of them. Now, there is the situation where they have partnered with an expert in one of those. And then what you need to do is you need to find out who that partner is and then go do due diligence and vet that partner. And if that partner is an expert in that asset class, then you might want to go for it. That might be fine. But what you want to be careful of is, you know, like if it was just, just Andrew, and, you know, I'm in self-storage and I'm in mobile homes, I'm in apartments, I'm in a crypto farm, all this different stuff. I'm probably not really good at any of those.

So that's what you're looking for. To add on to the, Andrew, is that if I'm involved in a lot of different things, I don't have the time availability that I might need to turn the asset around. There are times. And you and I have both been here in our careers that we need to go and put ourselves on an airplane and go get boots on the ground at the asset to go and address a specific issue, whatever that may be. If you're working with an operator that everybody in the operations team has a day job.

Or there's just, as you said, they're involved in a crypto farm and a self-storage facility and a resort. And they're too busy with those other things that they can't put the time into the multifamily asset. The multifamily assets could just languish a bit from the attention. We looked at buying a multifamily asset in the southeast recently that was owned by a consortium of doctors. None of them were full-time active. They all were trying to own this thing passively thinking they could just buy the apartment building and wish the property manager the best and tell the property manager where to send the checks when they're ready, right? So that all, well and good, but sometimes there is the need for daytime availability. And if the operator

your part you're working with doesn't have that, that they can't just go parachute them into the property and get in the face of a contractor or go and look at the property, look at the property manager did in the eye and find out what's going on, you might not be in the best boat. You know, in Pillars of Wealth, I talk about one of the mindsets to avoid if you want to become wealthy, which is what is the easiest, shortest, fastest way to make a bunch of money? It's people looking for the downhill road. And in this space, when they hear about Matt, Andrew, some other multifamily operator, raising money and making a bunch of money with it, there's a lot of people that go,

ooh, that looks easy. I want to do that. So they start saying, how can I raise money and then give it to someone else to go invest? or how can I raise money and throw it in a deal? How hard can it be? And to the person investing, they don't know the difference between a person who's done this for 10 years, 15 years, really the captain that's seen the stormy sees, or the person that's only sailed in the harbor, which would be like the last eight to 10 years of rents increasing and cap rates decreasing. And almost every single thing that could go right in multifamily has gone right. And everyone's

doing well, you start to hear this confirmation bias of, well, they're doing it and they're doing it. And everyone's doing well. So what's the risk? And maybe, you even put some money into a deal and it goes well so you're like well i'll put more money in the next one i'll put more money in the next one not knowing why it's working out so just those are elements of human nature you want to be aware of so that maybe you sniff out if something doesn't seem right versus like what you're saying here Andrew is you're looking for the operator that has done this for a period of time and they're doing this full time they have seen the things that go wrong and they know when a happens we have to do b they've got some clever solutions in mind versus someone who

doesn't have the experience that won't all right the next red flag is a sponsor that is new to that market or MSA. Why is this something that people should look out for? So, David, in the multifamily boot camp, one of the main core strengths that we talk about you need to have on your team is market knowledge. We call it the market hunter. And the reason for that is that there's such unfair advantage you can create for yourself as an operator if you get to know a market like no one else. You get to know the brokers, the good property managers, the bad property managers, you know, the property managers that everybody knows. If you're not, if you're from out of town, that's the property manager you use.

But if you really know the market, you use the other property management company. You get to know who the acceptable vendors are in the market, who the good roofer is, who the not so great roofer is, all those things. Those happen through market infiltration. If you are new to a market, you're not going to have all those great contacts. And so it's okay to invest with an operator if it's their first time in the market. But you do want a little bit more due diligence and ask them, who did you select as your property management company and why?

What else do they manage in the market? market because they're the PM company when we did our first deal in Winston-Salem, for example, Winston-Salem, North Carolina, that PM company was the one that introduced us to the roofer that we ought to talk to and the roofer and said, no, no, don't call that other roofer because they've really messed up a few of other properties, right? So you want to know who they're relying on to help them infiltrate the market. And a lot of times it's the PM company or maybe a fellow other real estate investor that's on the operations team on the company. But whatever it is, make sure that they've got some good boots on the ground that's helping them infiltrate very quickly.

I love that. And here's why in my own experience, when I'm new to a market, I don't know it that well or new to an asset class or new to anything, I don't like rushing into it. I have this analogy that when I was in the police academy that we were learning how to drive the cars on a course. And basically, they set up all these cones and you have to drive it under a certain period of time. And it was very difficult. They don't give you that much time. And if you hit even one, cone, they say that's hitting a pedestrian. So you fail immediately if you just touch a cone at all. So people made two different mistakes. They would either drive it too fast and run over the cones or they would drive it too slow and not make the time. And I think at the first run, like 70% of our class failed. It was really hard. The only way you could do this was you had to study the course and anticipate when I'm in turn A, I know what turn B is going to be. So you're actually thinking at least one step ahead. Ideally, you want to think two or three steps ahead. So when you're in a sharp turn, you're not just staring at what you're doing. You're like, all right, I'm about to come out of this.

I need to get on the accelerator for half a second, build up some speed because I'm not going to break for a minute. And there's a straightaway coming. And I need to be bringing speed into the straightaway, right? So what I would do is drive very slow until I learned what to expect. And then when I was anticipating the next step, I would go a little bit faster. And I would just sort of run that back and forth until I could do the whole thing quickly. Moral of the story here is when you're new to a market or new to a strategy or new to anything,

you don't want to smash on the accelerator. that is that is what raising money is it's hitting noss you go way faster when you raise other people's money than yourself so when you're putting together a team or an area when you get a great contractor a great property manager and i know it's the same for you guys you start thinking oh boy i could do more with now that i finally have this person i could scale i could have two projects at one time i could take down a deal i normally wouldn't have been able to before because there's some more margin here that only happens when you find the property manager that you trust the contractor that you trust, a marketing system.

All of these pieces give you the confidence to go quicker. So I think that's great advice. If you're talking to the sponsor, you want to ask, yeah, what do you think about turn three? And if they're like, I don't know, I just wait until I get to turn three before I do turn three. That's a red flag. You definitely don't want to go down that path. What do you guys think about that analogy? I love your analogies.

That's what I do. I love that. Yeah, I don't think I can top that. You know, the only thing I would add is, yeah, just be careful of the sponsor who is picking markets like they're swiping on 10. and just stopping on, oh, this one looks good on the surface, right? Because, you know, odds are they don't have the depth and the resources. The two most successful, you know, types of sponsors that I've come across over the years and when it comes to market selection are either the huge national guys who've got maybe

10, 20, 30,000 units and they have the resources to go into a new market with power and understand it and bring in their own management and just really take it on big time all at once. Or, and these are the guys that most of us and the listeners are going to know, is the sponsors that live in and invest in one market and have been doing it for a long time. I know sponsors like in San Antonio and Atlanta and Houston, they literally know every block in street in which one you should invest in and which one you shouldn't. And if I'm giving out money, I'm going to go with someone like that. The only comment I have here is I love David and Andrews analogies.

And I listen to this show so that I can laugh at the phenomenal analogies they come up with and making real estate relate everything to driving courses, to Tinder, to basketball, to everything else that I hear about. So that's my thoughts on the matter. Keep an eye out for Bigger Pockets episode 851, which is how to improve your Tinder game while making money through real estate. All right. The next red flag, other than trying to,

to use Tinder to find love. That's a red flag in and of itself. But the next red flag for real estate is going to be the sponsor only pushes one return metric. I love this one because this is a clear sign of deception when people are trying to pull your attention away from areas and into others. And before I turn it over to you, Andrew, I have another example for this. My mom told me when she was a kid, she was in this group called 4H where they raise animals and she had like a pig. And she would take the pig to a competition where it would be gauged on how good of a pig was. I have no idea how this works. It's a weird thing. But my mom said her pig had like a lazy eye and a droopy face on one side of its face. And she knew the minute that they see this like

really jacked up pig, I'm out. So what she did was every time the judge was starting to walk to that side of the pig, she would just point something else out or she would say, oh, I forgot to tell you about this. Or she would start talking about herself. And actually she used up the entire timer and the judge never made it to that side of the pig. And she ended up winning with a like less than ideal. animal. And that is something people do to deceive. So can you explain how this would look within a multifamily deal? That's a trend that we've seen in the last few years is if anyone who's been getting solicitations from sponsors, you know, the last five years you've typically seen equity multiple, and I'll explain what all these are, or internal rate of return IRA. And then all of a sudden,

the last couple, like the last six to 12 months, all everyone's talking about is AAR. And, oh, okay, sure. All right, sounds good. AAR. I don't. like that, says I'm going to make an average annual return of 18%. So I'm going to define these each really quickly and then and kind of run through what you need to look for. And then why, the key thing to take away here, if you miss all the details, but the key thing to take away is when evaluating a sponsor and their investment, do not rely on any one of these metrics. You need to know all four to determine if that investment is number one good for you. And two, knowing all four will help you ferret out the different risks and levers that are being pulled to generate the

returns because any one of these four is easily manipulated on a spreadsheet. And if all you look at is the one that's being projected to look good, you might miss what's showing up on the other factors that will reveal what's going on. So internal rate of return IRA. That is basically a way of looking at kind of your compounded return over time. And basically it says, hey, money today is worth more than money tomorrow. The second one, AAR, that is average annual return. And that's exactly what it sounds like. Just take your return, divide it by the time, and that's your average. So here's the difference. Let's say you have two investments. They're both five years. You put $100,000 in, and it's a great investment. Five years later, you get $200,000 out. For one of them, you get $10,000 in cash flow every

year, and at the end, you get $50,000 back. The second one, you get zero for five years, and then you get 100,000 back. Which one's the better investment? It's the one that gave you $10,000 a year up front and then 50 at the end. Well, and if you look at, if you evaluate, you know, those two investments with these two metrics, the IRL, Internal Rate Return is going to be higher for the one that gave you $10,000 a year because you got your money back sooner. And if the IRA on the second one, where you had to wait five years to get anything, it's going to be much lower. So what's happened recently is that as cash flow has gotten more and more difficult to generate with new assets, everyone has switched to AAR to, I wouldn't say hide the fact, but maybe not to fully disclose the fact

that almost the entire return is on the back end and that until you get there, there's not, not much is going to be happening. So that is why you want to look at both IAR and AAR. The other two are cash on cash. I think most listeners are probably pretty familiar with that. It's just, does the investment generate 4% a year, 5%, 6%, 7%, the key thing here is to make sure that the cash on cash is actually being generated by the asset and is not just extra money that was raised up front to give it back to you and call it a distribution. That's kind of a whole other topic, but that's something to look out for.

And then the fourth one is equity multiple. This is really just exactly what it sounds like. you put in your equity or your investment, how many times over is it going to be multiplied at the end of this thing? If you put in 100,000 and five years later, you get a total of 200,000 back. Your five-year equity multiple is a 2.0. And so by looking at all four of these together, you can, again, determine if it fits your investment goals, but also figure out if and where the sponsor may be hiding something. And then again, it may not be intentional.

They may be using, for example, really high leverage, like 80% or something in mezzanine debt or preferred equity to get a high RR. If all you look at is the IRA, this is going to look exciting because it's a 20%, but then you go look at these other three that I talked about, and they're not going to look so good because of that. So those are, you know, bottom line is look at all four of those together. Matt or David, anything you want to add or that I missed. I should say that first of all, thank you, Andrew, for summarizing those. things because they get thrown around a lot. And it's assumed or maybe hoped that people don't understand what those things are or maybe assume that people do. So I'm glad that you went through then define them. The only thing I would say on top of that is as an investor, what's your duty

to do is to look at how they calculate the IRA, the cash, the cash, those kinds of things. Because there's levers that the syndicator, the operator, the sponsor can pull to make the IRO look really, really good. We're going to sell it five years from now at today's cap rate, or we're going to sell it and double our money, whatever it is a year or two, a year or two from now, or five years from now, whatever it is. There are factors that they can use to not so much manipulate the numbers, but to make the numbers shine in the best light on the deal. And you want to look at what the assumptions that they made, because every syndicator is being asked to look into the future. And so if they look into the future with super rosy-colored glasses, well, we're probably going to

sell into a booming economy. We're probably going to sell initial rates are going to be back down to 3%. We're probably going to refinance and get a 4% loan. Well, given today's standards, you might not. And so it's important to make sure the operator made conservative, made conservative assumptions when they present those metrics to to investors. Yeah, you can see why AAR is going to be a more popular metric because it doesn't account for the inflation. If inflation is 5% a year and it's a five-year deal. That's actually a 25% pad that they've been able to work into what their numbers would look like versus the IRR. You're getting your money right now and it can't be inflated literally by inflation.

So you can see like this is the tricky way that people can adjust what they're saying to make it look better than it is. All right. Last red flag. The sponsor is not transparent about where the money is coming from and where it is going or if there are strings attached. This is another one where we could really, we could almost do an entire podcast. on it, but essentially, you know, what you're looking for as an LP here is, there's a couple of different things. Number one, sources and uses, right? So if they're raising $8 million, how much of that is for down payment, how much of that is for fees, how much is for renovation, how much is for

reserves, how much is for maybe a rate cap or all of those things. And that kind of gets into how you vet a deal. I actually just talked to somebody, unfortunately, today, who had a situation where, whether it was there, you know, they didn't understand or it seems like this maybe not have been disclosed, but an additional capital partner was brought into the deal. And they were a large capital partner. And that large capital partner came in with a clause that said, if certain targets aren't met, we have the right to arbitrarily buy out the entire LP position at a value we determine. Basically, let's just say that investor is getting zero. Because, you know, you ever seen those contracts where it's like for a consideration of one dollar, seller does the blah, blah, blah, blah, this, that's essentially what happened where this large capital partner said, because of this, this, this and this, we have the unilateral right to buy out the limited partners for an amount we determine.

And the amount they determined was effectively zero. And unfortunately, this is really common. These kinds of clauses and strings are common with mezzanine debt, with rescue capital, with institutional capital. So it's not that this situation was completely out of the norm or even fraudulent. It's just that it doesn't seem like it was fully disclosed to the investor and or the investor didn't fully understand the ramifications of it. So make sure that any investment you're doing that you fully understand the capital stack.

And when I say capital stack, think of literally a stack of pancakes, right? The debt, maybe a big juicy layer of preferred equity, maybe some, and then the LP equity on top of that, and, you know, however you want to stack that up, make sure you fully understand not the structure of it and then the rights that come with each piece of that structure. Lenders are not the only ones who can come and take over a deal. All right. Thank you for that, Andrew. Matt, to close us out, can you give us some common sense principles for people to keep in mind when choosing a sponsor?

Thank you, David. So, guys, here's some common sense principles for you guys to take home and take the heart when you're looking at deals as either a investor or even as an operator. A great sponsor can turn a bad deal into a good one. Just like a bad sponsor can turn a great deal into a terrible one. Good sponsors can have deals not work out and they are willing to tell you about them. So good sponsors guys are transparent. Good times and bad. Look for asymmetric risk, meaning the amount of money you could make on the upside of the deal is much, much more than you could potentially lose on the downside of the deal. Use your gut, guys. Listen, a lot of times your gut's right. There's some spidey senses. If I may use a superhero analogy, there are some good things in your intuition. So use those when considering a deal. And if your gut says slow down a little bit, maybe a little bit more diligence, do that. If you don't understand, don't invest in it. That's a great analogy for anything, don't invest in anything that you can't comprehend or explain to somebody else very easily.

And if you guys want a lot more thoughts, as in from an LPs perspective on how to select the right operator, consider all of our good friend Brian Burke wrote a book called The Hands Off Investor. And it is a great book about selecting operators. And at the very end of that book, there is, I believe, 72 questions that I've had investors ask me to answer all 72 of them. So maybe don't do that to a poor out to an operator. But pick the maybe the top five you like. and send them over to an operator you're considering investing in because Brian put a lot of hard work into that book about, and it's intended to help you guys select operators

that are really going to be there for your best interest. All right, so several good book recommendations on today's show. We mentioned my book, Pillars of Wealth, How to Make, Save and Investor Money to Achieve Financial Freedom. Brian Brooks book, The Hands Off Investor, Matt Fair, Classbook, Raising Private Capital, and I'll throw a bonus one in there for you. You can also get this at the biggerpockets.com slash store website. the richest man in Babylon, which covers investing principles, and one of them is don't invest in

anything that you don't understand. A quick recap of our seven red flags. The sponsor has a different partner for every deal. The sponsors suggest anything suspicious like implating proof of funds or not disclosing material facts. The sponsor does not have a successful track record in the business. They lack focus, meaning that this is not their core expertise. It's just one thing that they're doing. The sponsor is new to that market. The sponsor only pushes one return metric. the old smoke and mirrors. And the sponsor isn't transparent about where the money is coming from and where it is going to. Matt, Andrew, thank you so much for joining me on this show.

This is very valuable to our audience, which hopefully we can help people save some money. I've said it before. The old flex was bragging about how many doors you got. The new flex is holding onto what you have accumulated during the good years. All right, guys, thank you very much for today's show. This has been fantastic. Appreciate you all being here. I'm going to let you guys get out of here.

if you're listening to this and you enjoyed our show and helping save you some money, please consider giving us a five-star review wherever you listen to podcasts. Those are incredibly helpful for us and share this show with anyone you know of that is considering investing in someone else's deal before they send their money. And if you'd like to get in touch with any of us, you can find out more in the show notes. Do I look like a sharp, eh, when I do this? A little bit. Actually, you kind of look like one of those Sega characters that had the line.

The bad guy and Sonic the Hedgehog. Dr. Robotnik. Yeah, that's right. You know what, quick side note. I think pigs should be man's best friend instead of dogs because three quick, number one, highly intelligent and trainable, two, easy to care for, and three someday when they pass away, bacon, right? So. Do you ever notice how every passive investment somehow turns into a very active lifestyle,

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