Key Things That Passive Investors Need To Know With Dan Handford

 

A lot of people want to be passive investors but lack the knowledge to be one. Dan Handford, a Managing Partner at PassiveInvesting.com shares the story of his journey on becoming a passive investor including the mistakes made and lessons learned along the way. He talks about what he thinks multifamily housing is one of the most resilient asset classes in the market and explains why. Dan also gives away the strategies he learned in order to defer your taxes while growing your portfolio. In this episode, learn the importance of being aligned with the interests of investors in order to grow your wealth and the factors you need to consider when vetting operators.

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Key Things That Passive Investors Need To Know With Dan Handford

I have another amazing guest on the show and his name is Dan Handford. He is one of the Managing Partners with PassiveInvesting.com, which is a national passive apartment investing firm based in the Carolinas. He has led his apartment syndication company to acquire over 2,200 units with a portfolio valued over $274 million. He is also a passive apartment investor himself, and he has invested in over 4,800 units in 21 different syndication investments across the Southeast US and Texas. Thank you, Dan, for coming on the show. I appreciate it.

I appreciate you inviting me on. It’s an honor and I’m looking forward to provide some value to you and your audience.

To get started, I know you have a rich background in business. Can you talk about how you got started investing in real estate?

It goes back to paying money to the government in the form of taxes. As I started to build out my businesses, I started to cashflow them very nicely. I have a group of non-surgical orthopedic medical clinics that are located here in the Carolinas. I have one where I’m located, which is in Columbia, South Carolina. I have one in Greenville, South Carolina, Charleston, and North Augusta. With those clinics, as I built them up, I cashflowing off of them very nicely. Each time we would open up another clinic, we’d have to pay more money in taxes. My wife was the one that said, “Why are we having to pay more money?” I would tell her because I was busy in the growth aspect of the clinics that I would say, “It’s a good thing. It means we’re making more money. The more money you make, the more money you got to pay.”

You started to hear about other people that make even more money than you, but they’re paying zero in taxes and it’s because they are investing the funds that they’re making into real estate type of investments and allows you to be able to have the depreciation, to be able to offset your taxes and offset your other income and things like that. That’s the main reason why I got into where we are and starting the group. It’s been fun and it’s been great to see how we’ve grown from our first acquisition of an $8.9 million property upwards to the deals that are close to about $50 million and over $50 million on the one prior to that.

Before we come off of the business aspect, where you practicing essentially in that space as a doctor and moved into then real estate?

My background is in chiropractic when I first got started. When I got out of chiropractic college, I started my very first chiropractic clinic. About 2 to 3 years into it, I realized that I went to school for a job because I was still trading time for dollars and I wanted to go on vacation for a week. I wasn’t going to make any money because there was nobody in the office to see the patients. I learned that early on and decided to first hire on some associate chiropractors to work for me, to be able to do some of the day-to-day. I started integrating with the medical field. I had some MDs and nurse practitioners that I hired and several years ago, I made the decision to completely cut out the chiropractic and the rehab services that we were doing to focus on all of the medical stuff solely.

Now, it’s full-on medical clinics. We’ve got about 50 employees that work with us. It’s been one of those things where we do non-surgical orthopedics and sports medicine. We also focus on a lot of regenerative medicine like prolotherapy, PRP, and stem cell treatments for orthopedic conditions. Seeing the results from patients is why we decided to take away or take out the chiropractic services. For one, I didn’t have to see the patients, but also for the fact that we were able to leverage our relationships with outside chiropractors now and physical therapists to start to refer to us, to allow us to continue to grow those types of treatments in the community.

To be able to have the hockey stick growth, you needed to surround yourself with solid people and have a solid team that supports you. Click To Tweet

Through that experience, you’ve seen a niche that you liked, maybe the operation or the business aspect of having a business, running a business, and hiring people.

I definitely don’t like the hiring aspect. I know it’s a necessary evil that we need to hire people to know where to expand and grow, but I don’t like to be the person to find the next person. In the beginning, I had to do it all myself. One of the things that I learned in order for me to be able to have the hockey stick growth that I was looking for in the clinics is that I need to surround myself with solid people and have a solid team that supported me because I’m the typical entrepreneur. I am the type of person where I feel like I can do everything better than everybody else.

I know it’s not true, but I still have that mental block. I realized every day it’s a struggle. Every day, I get up and I’m like, “What am I doing right now that I should be hiring a good solid person to do so that I don’t have to do it, and I can focus on the growth and what’s next for the businesses?” Learning that ability to delegate tasks to somebody else and the mental game that I play with myself with that is if I can find somebody that can do at least 80% to 85% as good as I think I can do it, then I can go ahead and hire them and let them do it. Those people surprise me sometimes because they’ll do even better than what I thought I could do.

I have followed and seen you out there in the multifamily space providing value and helping investors. Given the environment of COVID, I’d like to take some time to explore some of the key things that passive investors need to think about as they navigate investing as the market starts to change?

There are a couple of different things that we should be looking out for. We should be looking at the underwriting of these projects a little bit closer than what maybe we would have looked at before because I’ve seen some projects that have been released even in the middle of COVID-19 that I don’t feel like they’re going to work because there are lots of assumptions that you have to make an underwriting. Those assumptions are very hard to make and it’s going to be very challenging to hone in and have an understanding of the full impact that COVID-19 has had not just in multifamily but in real estate in general. There are definitely asset classes that are going to get hit a lot worse than what we’re seeing in multifamily.

Multifamily has been spared very well during the whole COVID-19. When I look at various operators, I want to make sure that I’m investing in markets that are going to be solid blue-chip stabilized markets or blue-chip corporations in that market. I also want to make sure that the asset class that I’m investing in is going to be a solid one as well. The asset class within multifamily that has been hit the worst is the lower end assets. Those C class and lower and B products that are having a hard time meeting some of their underwriting guidelines that they had set before because of rent growth assumptions and renovation timelines, all of those are out the window.

Those are the ones that are going to be having more challenging time. I’m in a few of those projects myself as a passive investor, and there have been deals where I’m not getting to distributions because of it. Thankfully, with all of our projects, the cashflows have been coming great. We haven’t had to withhold distributions from many of our investments so far from our projects, not to say that we might not have to do it in the future, but so far, we haven’t.

One of the things that you have to look at is when you’re looking at asset classes as a passive investor, when you look at any investment, the lower the return, the lower the risk, the higher the return, the higher the risk. It’s the same thing within multifamily, you have these nice assets or these class A assets, usually safer secure investments, they’re lower return. You have these middle of the roads, which are your B class assets, which have moderate returns, they have moderate risk and then you have the C Class assets, which have the highest risk, but they also have the highest reward. You’re balancing that high reward with that high risk. As a passive investor, the first thing I would say is, is making sure that you’re diversified. I’m personally only invested in B plus assets and A class assets.

 

I’m staying away from lower-end B’s or the C class assets because of the way the market is and how the lower end asset are also the residents that are living paycheck to paycheck. When you have some disruption like this is going to cause them to have a harder time being able to make those obligations that they set out in the lease agreements. When you’re buying assets that have people who are renting by choice, not by necessity, then they usually have some excess funds to be able to put up if they need to. They’re also usually in a better paying position where they’re not necessarily being threatened by COVID-19. The people that are losing their jobs the most or the lower-paying jobs, which are in those lower end assets.

Those are a couple of talking points that I always try to bring up with investors to look at when they’re looking at investing in other projects and even in our own projects. When we find projects, we’re going to fit the criteria that I want to have in the projects and our other two partners, but we want to make sure that we’re not the only group that people are investing in and are vetting. I even wrote an article which is the Five Red Flags for Passive Investors. If any of your readers want that, they can certainly go to our website, PassiveInvesting.com. Sign up for our investor club and we’ll send that over to you. Those are the high-level things that are the big things that I would watch out for.

When it comes to vetting operators, you even mentioned people do have a choice in who they choose to invest with. Outside of the different asset classes, are there certain things that you would advise or recommend for passive investors as they’re thinking about vetting operators?

I’m a big believer in investing with somebody who is full-time in the business. They need to be treating this syndication business and taking investor funds as a true business. Even before COVID-19, I won’t personally invest with somebody unless they are full-time. If they’re working a corporate job or something like that and they partnered with somebody else, that’s totally different. The main operator needs to be full-time because number one, we’re in it ourselves as a full-time operator and we know it’s a full-time gig, and it’s not one of those things that I’m willing to put my own hard-earned money into somebody else’s properties that they’re basically running those properties as a nights and weekends job.

I want them to make sure that they’re taking it seriously. One of the other key things when you’re vetting an operator is making sure that that operator has some form of background in business and being able to manage people, systems, processes, put in certain key performance indicators to make sure that they can pivot when they need to pivot and make changes. It’s a black swan event that you need to have somebody at the helm that can make some of those hard decisions.

One of the areas that comes up for a lot of people is returns. As the market changes, people get concerned about what the returns are going to look like and how that’s going to impact things. Where I’d like to start and you can pivot accordingly is the preferred return versus no preferred return structure. Your thoughts on that and what investors need to look out for when they’re looking at deals with those kinds of structures.

I will not invest with a deal as a passive investor unless it has preferred returns because those preferred returns are what align the interest very closely with the operator or the sponsor and you as the investor. To find a deal that has no preferred returns, to me, it’s not even considered and look at. That’s something that I recommend to our investors to make sure that there’s always a preferred return there because there’s a couple of reasons for that. An operator that needs to have the share of the cashflows on that first fruits. Let’s say, it’s a 7% preferred return. If they need to share in that instead of giving the preferred return, they’re probably not a group that’s well-capitalized enough for me to want to invest with them. They have to have that to be able to survive.

When you look at any investment, the lower the return, the lower the risk, the higher the return, the higher the risk. Click To Tweet

For me, I want to make sure I’m investing with people who are well-capitalized, and they have the ability to jump in if they need to. I also want to make sure that my investors and our projects are getting those first fruits because, from a standpoint of the syndicator, we couldn’t put together these projects and do them without our investors. Our group is not the type of group that’s wanted to put one project together or one deal. We want to be able to put on these projects for decades and decades, grow our wealth as well as our investors’ wealth together. The only way we’re going to do that is align our interests with the investors and making sure we take care of their interests more than ours.

I know that there are lots of dual-class structures where you’ll have a preferred equity and return, can you dive into the pros and cons for that kind of structure?

What you referring to there’s usually class A, or class B and not asset. We’re talking about within the deal itself. There’s a class A and class B investor and there’s class C, which will be the operator, but the class A investor would be in a preferred equity position. For you to fully understand this is you have to understand what a capital stack is. The way it works is it’s built from the bottom up. The priority level of the investor starts from the bottom and goes up. Meaning that the bottom of the capital stack is the debt. The senior note or the senior lender, and right after that is going to be this class A investor, which is that preferred equity piece that you mentioned. That particular capital stack, you have to be careful too, because it can be enticing to want to invest in a class A because of the types of returns that can be inside of that class A.

If it gets to be too much of the capital stack then the risks don’t outweigh the benefits in the lower amount in the capital stack that you have. For example, if the common equity is $10 million and you’re raising it for the property, it’s best to have anywhere between about 22% to 40%, capital stack reserved for that preferred equity piece. The lower that percentage of that capital stack, the better it is, and the lower the risk it is for that class A investor. The class A investor is going to be the one that gets paid first before anybody else gets paid. Once the lender is paid, the class they investor gets paid, then the class B investor gets paid.

It’s as close to a guarantee as you can get being in that class A position. You can see that if I have to pay out more in class A, it’s going to take more money to be able to fill that bucket up versus if it’s going to be the lower amount of that equity stack. That preferred equity position is going to have no participation in the upside, or when we have a capital event or when we sell, they’re going to be maxed at a percentage of return. I’m seeing those between about 9% to 10% returns. You’ll see those class As. You’ll get that, usually paid out on a monthly or quarterly basis. I prefer monthly. That’s what our group does as monthly income returns, but the class B investor going to have a preferred return still. It’s going to be lower.

It’ll be a 7% preferred return and 9% or 10%, but then they’ll also have that opportunity to participate in the upside when you sell the asset or some form of a capital event. As a passive investor, you have to ask yourself which one do you want to be in? Do you want to have more of that preferred equity position? Where you’re going to have a lot lower risk, a lot more surety of getting your preferred return of that 9%or 10% and being able to make the decisions like, do want more cashflows and you want those now, but no participation side? Are you the type of person that doesn’t need a lot of cashflows right now, even though there’s still some nice 7% or 8% cashflows on there, but you still have that participation in the upside?

Those are the kinds of questions that you have to ask. You can also look at doing a blended option, or instead of doing A or B, you can say, “Let me take a $100,000, but $50,000 in A and $50,000 in B.” You diversify those risks within the same investment vehicle. There’s a lot of different considerations to take into account when it comes to which one of those class A or class B do you want to be into, but I will tell you that the more sophisticated investor that you have, they will probably prefer to be in that preferred equity piece because you pretty much are eliminating the majority of any of the risk of that investment at all by getting that surety of that 9%. When it’s being paid out monthly, they’ll take that monthly payout and reinvested in a different vehicle instead of compounding that for that return are reinvesting those higher cashflows.

 

From a syndicators’ point of view, when you guys choose to make this offering, is it to attract different types of investors with different needs essentially or different wants?

It’s for a couple of reasons. It doesn’t make it any better for the syndicator. It lowers the return for the syndicator themselves because when you’re giving up more of the cashflows for the class A then you’re having a 9% profit. Now, you have the 7% profit, you’re getting less. It doesn’t help you. You get to make more money doing it that way from syndicators perspective. When you first underwrite a deal, if a deal has high cashflows, but the overall return on that investment is lower. We underwrote a deal and it was around 9.5% to 10%, IRR on a seven-year hold. When we first underwrote it with no dual-class, it was a single class structure.

Trying to present that to an investor and it’s not as palatable. They want to seal a bit higher on that internal rate of return in order to come off their wallet and invest with you. For us, being able to have those higher cashflows allows us to give up some of those cashflows to that class A investor and because they’re not sharing in the upside, all the upside gets shifted over to class B and it makes for a higher return for those class B investors. It also helps us to attract investors that want to have that. It does also give options for investors. They can either choose the cashflow route or more of the growth model route or diversify.

One other thing that is key for me is reserves. Still talking on the topic of passive investors looking to invest in real estate deals in this marketplace, having sufficient reserves and what does sufficient reserves mean in a market condition such as this one? I want to know your thoughts on that.

I’m a big believer in making sure you have more and not having enough. More is better. Some syndicators would say that they would prefer not to have as much because it lowers returns for the investors when you have a high amount of operating reserves because that money, you have to raise upfront when you first acquire the deal and it sits in the bank account. You might put it in a small money market account where you’re earning 1% or something like that, but it’s costing you money to sit there. When you look at the risks versus the benefits, you are lowering the risk for the investment because investors are always fearful of the capital call. The deals are starting to go south. They read the operator reaching out to you saying, “We need everybody to infuse another $5,000 apiece to be able to allow the property to afloat,” or whatever the capital call structure would be like, it’s always dependent upon the equity amount that you own.

I would rather have over raised and have a high capital reserve account and not having to go to those capital calls. It makes it less risky for those investors and they don’t have to worry about in the future capital calls because you have those operating reserves. We like to see at least 4 to 6 months of operating reserves. Meaning if the property goes all the way down to 0% occupancy, then we can continue to float that property for 4 to 6 months. We never want to dip into that operating reserve, but it’s there as a just in case. We’ve run the scenarios of doing it versus not doing it. It only changes the returns by about 1% point or 100 basis points.

To us, it’s worth that extra level of comfort and security to have that there in case we need it versus having all the investors get an extra 1%. All the investors we’ve talked to were like, “I’d rather have that extra fund reserve there as a just in case emergency fund if we need it versus having to have the worry of losing the property because we didn’t have enough operating reserves and we couldn’t raise money from the capital call or bringing out other investors.” It makes things a lot more complicated when you try to do that.

Align your interests with the investors and make sure you take care of their interests more than yours. Click To Tweet

You mentioned this earlier about being an asset that has performed fairly despite the current conditions. What are your thoughts long-term on multifamily being a resilient asset and perhaps, if you do think it is a resilient asset, what are some of the reasons why you think so?

Multifamily historically has done even in downturns, recessions, corrections, and pandemics. One of the things that we’re seeing is the demand for multifamily is going up. There are two reasons for that. One of the major reasons in the middle of COVID-19 is that people are being forced to stay where they’re at. They can’t find a house. They can’t leave and go buy a house. The lenders have tightened up the restrictions for their lending. People who might’ve qualified before aren’t going to qualify now, and those people also are having to dip into some of their savings. They might not have a high enough of a down payment.

What that all does is it forces people to stay in the rental market longer, or if they were planning to go buy a house or whenever they left for college, it forces them to enter the multifamily market. On the other side of it, if you look at pandemics over the last 100 years, it’s done three things from multifamily. It’s created marriages, divorces, and babies because we’re staying at home. In January and February 2021, there going to be a lot of Corona babies out there and all that does is increase the demand for multifamily.

One of the last questions I have is the key performance indicators. In the environment, asset management becomes the primary focus to move through the storm. I’m curious about the key performance indicators that are imperative that good asset managers are putting in place to ensure that the properties do survive the storm.

There are not just a few of them. We have probably close to about 60 to 70 KPIs that we keep track of on a weekly basis. We have our property management companies submit those to us that we’re keeping track of those on a very close basis. One of the biggest KPIs we’ve got to watch is collections. We got to make sure that the collections are staying high and staying stable. We get a daily report from our property management companies to let us know what the status of the overall collections for that property for that month is. We’re comparing that to the prior months so we can see what was it like before COVID-19 and how does it fairing? Are we getting better? Are we getting worse? Are we staying stable?

When we see that data in those trends, it allows us to be able to make decisions and pivot whenever we need to pivot. If for some reason, we see one property lagging or the other, we can jump in and see, “Why is it lagging? What are some of the issues? What are the problems?” Then, jump in and create some solutions to those problems to be able to make sure we can maintain those high level of collections on the property.

The collection percentages are crucial. Just like any multifamily asset COVID-19 or not, you got to be monitoring the traffic on the property and monitoring the property manager to see if they’re getting traffic to the property, are they signing leases? If they’re not, why are they not signing leases? Is there a problem with the property? Is there a problem with the property manager? We have to keep track of those on a weekly basis. Some people look at them on a quarterly basis, but you can’t, you got to look at those things on a very close basis like that. We have a full-time director of asset management who manages that for us and is watching those things on a weekly basis to make sure that if we need to pivot, we can pivot.

Any further recommendations or things that I didn’t touch on that you think would be beneficial for passive investors to think about or know?

 

One of the biggest things we touched on it is a lot of times when we’re thinking about passive investing in multifamily, there’s the whole philosophy in a downturn or recession that A go to B and B don’t want to go down to C. B is the best place to be in. We’ve all heard that in this space, but we’ve done some research ourselves inside of the software called CoStar, which is a data analytics software that dates properties all the way back to 2000 and has occupancy levels. We’ve done some analysis to determine is that actually true? It is true that it happens on a small level that there are people that do shift from A’s to B’s and you even see B going on to C.

Even people who say, “No B’s go to C’s.” It does happen. It’s part of the process. It only takes a drop in all the asset classes of about 30 to 50 basis points across each asset class. It’s not like it’s a major run. What you’re going to see with COVID is that there’s going to be a big push from urban living to suburban living. You’re going to see a lot of people migrating from some of these tight close cities and you are going to start seeing people migrating out of those cities, but you’re also going to see MSA. For example, Charlotte. You’re going to see a lot of those Charlotte urban lifestyles starting to migrate out and filling up. The class A’s are going to get hit the worst are those urban class A’s that are number one, higher rent. Usually, $3,000, $4,000, $5,000, $6,000 a month in rent, but they’re also in a downtown urban living. You’re going to start seeing people starting to push out. It’s going to be called the great migration over the next years, you’re going to start to see that.

Investors will have to get creative about how they then pivot the use of those multifamilies or the way in which they’re built or what they’re used for going forward as well.

They’ll definitely have to be making some pivots and some changes with that. When people start to migrate away, they will try to attract people back in. They will still see them come back in because in the next years, we’re going to see that migration out. Those class A’s when they lose, they’ll start to lower their prices to a point where it attracts people to come back in. You’re going to see this migration out. I don’t think you’re going to see as many migrating back in, but you’re going to definitely see people migrating back in as it makes it more appealing for those people to come in. They’re going to have to make some pivots and changes to some of the structures of how they’re set up.

What are you grateful for in your life?

I’m very grateful for my beautiful family. I’m married and have four beautiful children. It’s been a pleasure watching them grow up and looking forward to seeing them grow as well. It’s nice to be in a position where I have the freedom to go and spend more time with them, especially during the formative years.

What has attributed to your continuous growth and success?

The delegation is one of the biggest keys that I’ve had from my success and then going all along the same lines with watching the KPIs. I’m a big believer in that if you can’t measure it, then you can’t manage it. One of the biggest things that has been a big contributor to my success is making sure that I measured everything that I can measure even to the point of being like nauseous, looking at all these different numbers. You never know when there’s going to be a certain number that is a crucial statistic that you have that will allow you to make some changes that will save something, save an investment, save a business, save a division, whatever it might be.

What do you know now that you wish you knew at the beginning of your journey?

I wish I would’ve started investing in multifamily sooner rather than later. I started late in my business career investing in it because I was so focused on growing the business and we would only take out of the business when we felt like we needed, and then we would pour all the money back into the business. It’s served us well, but I wish I would have known about this earlier on so I could have started the investing side of things, at least probably years ago.

If my readers would love to learn more about you and your offerings, what are some of the best places that they can go to find out more information?

You can simply go to PassiveInvesting.com. On the top right-hand corner of the website, you will see a little blue button that says, “Join the Passive Investor Club.” My assistant will reach out to you and schedule a one-on-one phone call, we’ll discuss your investment goals and see if you’re right fit for us. When we have our next offer, we look forward to having some people partner with us. Thank you for having me on, Lisa. I appreciate it.

Thank you for coming on. I appreciate it.

Important Links:

• PassiveInvesting.com
• CoStar
• www.MFINPodcast.com

About Dan Handford