204. REAL DEAL: Converting Hotels to Multifamily with Mitchell Rice

Summary

Podcast Summary: Real Estate Investing School Podcast – Episode 204. REAL DEAL: Converting Hotels to Multifamily with Mitchell Rice

Introduction

In Episode 204 of the Real Estate Investing School Podcast, host Brody Fawcett welcomes guest Mitchell Rice to discuss an innovative real estate strategy: converting hotels into multifamily apartment buildings. This episode delves deep into the intricacies of identifying, financing, and executing such conversions, providing listeners with actionable insights and valuable lessons from Mitchell's real-world experience.

Finding the Deal

Mitchell Rice and his team targeted Houston for its unique advantage of having no zoning laws, described by Rice as "a little bit Wild west" [00:00]. They identified an extended stay hotel in the Channel View area, a region with high demand for workforce housing. The property, known as RelaxInn, was being operated as a no-brand hotel by an owner who planned to franchise it under Red Roofs. However, financial strains during the renovation process made the seller motivated to sell [00:17].

Quote:

"The first hurdle with converting a hotel to an apartment is zoning. You've got to get the city on board, and a lot of them shut it down immediately because cities get more taxes from a hotel than from an apartment." – Mitchell Rice [00:00]

Financing the Deal

The deal was secured off-market through networking with a local hotel broker who recognized Rice's sophisticated investment approach [07:46]. Mitchell negotiated a seller financing arrangement where the seller agreed to finance half of the purchase price, becoming "the bank" with a $2.5 million note at a 2.5% interest-only rate over 24 months [09:12].

Quote:

"He became the bank, which is awesome. To do that with a big commercial deal like this is a little more rare than with single family." – Mitchell Rice [09:17]

Appraisal and Valuation

Rice explained the significance of the income approach in commercial real estate appraisals, particularly using cap rates. The property was initially purchased at a 12.8% cap rate based on an in-place NOI of $611,000, leading to a purchase price of $4.75 million [24:44]. Upon converting the hotel to multifamily, the property's valuation increased significantly as multifamily properties typically enjoy lower cap rates (e.g., 7%), resulting in a potential new value of approximately $9 million [30:08].

Quote:

"Commercial is figure out how to increase the income and you just create value just like that." – Mitchell Rice [28:34]

Renovation Process

The renovation focused on essential upgrades to meet residential codes and enhance the property's appeal:

• Installation of fire sprinklers across the building: $200,000
• Conversion of the lobby into a leasing office and adding storage and laundry facilities
• Expanding the unit count from 100 to 108
• Enhancing security with cameras and gated parking
• Addressing balcony railings to comply with safety standards

Overall, the capital expenditures (CapEx) totaled approximately $500,000, which was considered relatively low for hotel conversions, thanks to the property's pre-renovated state by the seller [31:42].

Capital Raising

The total capital raise amounted to $3.1 million, covering the purchase price, CapEx, acquisition fees, and reserves. Rice detailed a tiered share class structure to attract larger investors, offering preferred returns and profit splits based on investment size:

• $100,000 Share Class: 8% preferred return, 70/30 split after a 20% IRR hurdle
• $250,000 Share Class: 9% preferred return, 80/20 split after a 20% IRR hurdle

This structure ensured that all investors received their capital back with preferred returns before any profit sharing [39:15].

Quote:

"Everybody knows somebody with money. Everybody. And if you have a good deal, money will find you." – Brody Fawcett [41:44]

Refinancing Strategy

Post-renovation and leasing-up, Rice plans to refinance the property through government loans (Hud or Fannie Mae), leveraging the increased appraisal value. For instance, with a new valuation of $9.5 million and a 70% loan-to-value (LTV) ratio, the team could secure $6.6 million, allowing them to cash out over $4 million. This process ensures investors receive their initial capital plus additional returns, all tax-efficient [34:37].

Operational Insights

Rice emphasized the importance of maintaining strong relationships with brokers, consistent communication, and due diligence in underwriting deals. He also highlighted the benefits of sharing investment activities on platforms like LinkedIn to attract and engage potential investors, growing his network organically [13:17].

Quote:

"The deal doesn't follow money. Money follows a deal." – Brody Fawcett [41:44]

Challenges and Solutions

Mitchell discussed potential challenges, such as dealing with government-paid FEMA vouchers, which provided a temporary income stream but lacked permanence. By securing stable, local workforce housing demands and implementing security measures, the team mitigates risks associated with fluctuating rental income [21:37].

Conclusion

Episode 204 of the Real Estate Investing School Podcast offers a comprehensive look into the process of converting hotels into multifamily properties, showcasing the strategic planning, financial acumen, and operational execution required for success. Mitchell Rice's experience underscores the value of innovative thinking, robust networking, and meticulous due diligence in real estate investing. Listeners are encouraged to apply these insights to their own ventures, emphasizing that knowledge coupled with action leads to substantial rewards.

Key Takeaways:

• Innovative Strategies: Converting hotels to multifamily can unlock significant value through lower cap rates and stable income streams.
• Financing Flexibility: Seller financing can provide advantageous terms and foster long-term partnerships.
• Due Diligence: Understanding local market cap rates and conducting thorough appraisals are crucial for accurate property valuation.
• Networking: Building and maintaining strong relationships with brokers and leveraging social media can uncover exclusive deals.
• Capital Structure: Structured share classes with preferred returns can attract diverse investor pools while ensuring fair profit distribution.

Notable Quotes with Timestamps:

• Mitchell Rice: "The first hurdle with converting a hotel to an apartment is zoning..." [00:00]
• Mitchell Rice: "He became the bank, which is awesome..." [09:17]
• Mitchell Rice: "Commercial is figure out how to increase the income and you just create value just like that." [28:34]
• Brody Fawcett: "Everybody knows somebody with money. Everybody. And if you have a good deal, money will find you." [41:44]

This episode serves as an invaluable resource for real estate investors seeking to explore alternative investment strategies and expand their expertise in multifamily property development.

Transcript

[A]

The first hurdle with converting a hotel to an apartment is zoning. You've got to get the city on board, and a lot of them shut it down immediately because cities get more taxes from a hotel than from an apartment. We like Houston because Houston has no zoning. It's a little bit Wild west.

[B]

What's up, everybody? Welcome back to the Real Estate Investing School podcast. This is your host, Brody Fawcett for today, and we have a Real Deal episode. So today we're going to dive into one real real estate deal, go into the numbers a little bit, how they found it, how they funded it, and how they forced it, meaning how they got creative. All of this is so you can get some more tools to add to your tool belt, get some more experience in understanding deals other people are doing so that you can go replicate it as well as when a job comes up, you want to make sure you have all the tools necessary to complete it. So this is your chance to learn from mistakes other people have made, learn from success that other people have had. Also, you don't have to go and make those same mistakes yourself, and you can accelerate the process. So thanks for tuning in today. Today we have an awesome guest. Mitch Rice is in the house. What's up, Mitch?

[A]

Hey, Brody. Thanks for having me.

[B]

Yeah, man, thanks for. Thanks for being here. Thanks for being on. I'm excited. You and I, we. We just. We've been jamming for a little bit this morning, but we also got to hang out a couple weeks ago at Investor Con or Post Investor Con, which was awesome. Love that. Love that you were there. We had a small group that got together the following day, and we did, like, a little mini mastermind session.

[A]

So fun.

[B]

It was a blast, dude. And I got to talk to you even more. So on a lot of the deals you're doing, which are amazing.

[A]

Yeah, I appreciate that. I'm excited to jump into them.

[B]

Yeah, dude. So we're. We're picking out one today just to jump into. I think listeners will like this because it's a little bit. I'll say higher level, and it's a. It's a unique strategy, a unique process, a unique deal that it's not hard to wrap your head around, but it's something that not a lot of people are doing, and it has potential to be a huge payout. Right. Which. Which I love. Like, side note, just how do we accelerate the process within real estate invest school? I. I coach, like, a. A club. You have to apply for it within the school, but it's only for Experienced investors, but it's called scale bigger, faster. And so we meet like once a month as a group. And that's the whole kind of concept is, is like how do you go, you know, 10x the process and not necessarily 10x the, the energy and effort or the work, but how do we think outside the box. And so that aligns, I think perfectly with, with a deal like this. So let's dive into it. Dude, give us, give us a 30 really quick, just about the deal and then we'll dive into the details.

[A]

Yeah. So what we're doing right now is we're buying hotels and converting them to apartments. So there's obviously a big demand for cheap housing, especially in a high interest rate environment like this. Rates go up, people can't buy homes, everything gets more expensive. Rent is also going up. And then the problem is you have these real estate developers who they're going out and they're building lots of class A, but class C, you know, as it gets older, it gets demoed and there's less and less of it to go around. So we find extended stay hotels, which an extended stay hotel is a hotel that already has the kitchenette. It's got a sink, it's got a kitchen to cook. So you can, you can stay in these units for months at a time. And we changed, we literally changed the use of the asset from a hotel to an apartment building.

[B]

Amazing. So super simple explanation. I love that a lot of people are probably thinking that sounds cool. Probably easier said than done. Yeah, I've spent, I've spent a lot of time in extended stay hotels just in my former like sales. Sales life. We do like time, so. Exactly. So I get that. And then I love, I love the concept of, you know, right now. Yeah. A lot of the newer stuff is being built which the A class. Great. But it also costs a lot more money. Right. You have development, you have acquisition, you have, you know, the land. Just all of the pieces that go into it, it adds up quick, especially with rising construction costs. So I like that concept of finding something that might need a little bit of love. And, and yeah, that's what we did with this deal. So kind of we'll dive into a little bit deeper. But tell us like where this deal that. Tell us what you, you purchased it for and yeah, of like rehab costs and, and then also like the arv when it's all said and done now.

[A]

Sure.

[B]

With. Without getting too deep too quick. I know your strategy is really cool because it's different than someone that might Come in where they're going to buy it and hold it for the rest of their life here. Just to kind of set the stage for you. You're capitalizing on like this refinance piece where you can cash out up front and then also the cash flow piece where you can hold it for, you know, a couple of years and then the exit piece later on as well. Right. So maybe just touch on some of those.

[A]

Yeah, I'll try to hit on everything. Just chime back in and ask me again if I, if I forget any of those things that you asked. But we found a deal in Houston. We really like Houston because the first hurdle with converting a hotel to an apartment is zoning. You've got to get the city on board because you're changing the use of the asset from a hospitality zoning to multifamily zoning. And a lot of them shut it down immediately because cities get more taxes from a hotel than from an apartment. So sometimes you've kind of got to schmooze the city, you know, build them a sidewalk, donate to a park, or designate a certain percentage of your units as affordable to get them on board. We, we like Houston because Houston has no zoning. It's a little bit Wild west. So we found a property over by the port. It's in an area called Channel View and it's pretty much blue collar heaven. And there's a big demand for workforce housing there. And the seller of this property, so he, it was, it was his retirement, he actually lived on site. He's lived in one of the units. He like vamped up one of his own units, knocked out a couple walls. So he had a really nice spot in there and he's been living there for years and he was. So right now it's called Relaxin. It's just a no brand hotel. He was going down the process of actually bringing in a flag. It's a, he was trying to get a hometown studios at Red Roofs onto the hotel. That way it wasn't just his own property, but he actually had a brand to market it with and to bring. So when you go out and sign a franchise agreement for a hotel flag, you typically have to bring your units up to their specs. So he had to pretty much renovate every unit, put about 20,000 per door into all of them. So there's 100, so 2 million overall. And he was about to sign on the dotted line. But throughout the process of the renovations, he just got behind on the bills. So we had networked with a broker down there a Hotel broker. And they knew we were sophisticated, they knew we had investors and they knew that or he knew that this was our strategy. And so that was kind of our opportunity to find the deal. It was off market, so it was never listed. And we were able to go under contract, you know, to take out this, this seller.

[B]

Yeah, cool. So, so just like zooming out so people that are following along, this is what's so cool about real estate. Like you, it's easy for people to get lost, I think in, in all of like the detail, detail, detail. And it's like, oh, well, that's not going to apply to me in my situation. Whatever. What you just explained was, was how you found it and why the seller was motivated. Right. And that, and that's going to be a different motivation for different people, period. So it's not going to be necessarily the exact same motivation or you have to go find the exact same seller that's trying to, you know, converted into a franchise or, and has to bring it up to par. And there's more work that's going into it and they realize, right, it's, it gets to this point where like the, the more pain that there is, right, the more need or the more realization for a solution to the problem. And that's what we're doing. We're finding distressed sellers, we're finding people that we can create a win win scenario with. Well, guess what? Like, that pain was really big, right? It's on his mind. He's like, oh, I need to go from here to here. And there's a lot of friction to make that happen. And so in that moment, he realizes, okay, maybe there's a solution to get me there. It's the same thing. Like, yeah, you go, you go to the doctor when your pain gets really bad. If it's not that bad, you're like, oh, I'm good, it's fine. I don't need, I don't want to spend the money on the co pay or whatever. You can kind of cruise by when the pain gets bad. You need a solution.

[A]

Absolutely. And, and speaking of win win, like, we didn't want to discount the fact that he had put all this money into the building. You know, we want our sellers to win because a lot of the time sellers have, have networks with other sellers. You know, you treat a seller good, you're going to get more deals. So what we did is a, you know, we're kind of moving on to step two. He actually agreed to sell or finance half the property to us. So he became the bank, which is awesome. Like, to do that with a big commercial deal like this. I would say it's a little more rare than to do with like, single family. Yeah. But yeah, he agreed to carry 2 1/2 mil for us, and so total.

[B]

Purchase prices was 5 mil and he.

[A]

4.75 million.

[B]

Okay.

[A]

So about 44,000 per door.

[B]

2 1/2. Okay. And did he have a note on it?

[A]

No, he owned it free and clear.

[B]

So this is also. What's. This is what's crazy. Like, just in general. There's so many people out there like that where literally he lived in a hotel.

[A]

Yeah.

[B]

And is a multimillionaire. Right.

[A]

Yeah.

[B]

Just anyhow, that concept, living on site. Yeah. Crazy. And you stop and like, think about it, you know.

[A]

But yeah.

[B]

Oh, go ahead, go ahead.

[A]

Oh, no, you go.

[B]

I just say backing up before we keep going that finding piece too, I think, without like skipping over that too quick. I love, like pulling out these gold nuggets where it's easy to skip over for people that just listening. But like, like you said, it was off market. There was work that went in on your part and energy and effort. It wasn't just like, oh, some random broker called me out of the blue and said, yeah, hey, I found you and do you want to buy a deal? I have a distressed owner. I have.

[A]

That doesn't happen. The best deal is they're not reaching out to anybody.

[B]

It's.

[A]

I mean, I mean, they will, but they're gonna go to those two to three groups that they, that they have in their mind. Oh, this is perfect for this group. And they already have the relationship 100%.

[B]

So is there anything, is there anything like touching on that really quick on that finding side or establishing that relationship with the broker or what did you do there?

[A]

I mean, first of all, you got to pick your asset class. And then you've got to know what markets you're buying in. So you got to know what your buy box is. And then you've got to go pick brokers in those markets and you need to call them every quarter and say, hey, what have you got? You need to tell them the deals that you're doing as well, so they know that you're staying busy and you're getting stuff done, you know, because it's. It's two ways with the broker. If they're going to give you a deal and go under contract, they need to have confidence that you're legit.

[B]

Yeah.

[A]

So. And then when they do show you a deal like, never goes to broker, underwrite it and give them feedback. Even if you're not going to close, tell them why you didn't make an offer. If you're making an offer, maybe you make it an loi, but you didn't get to psa. Like, keep them involved and like, tell them what's happening.

[B]

Yeah, I love that, dude. Yeah, that's, it's, that's great advice. Like all those pieces right there. And just, just the more you kind of done your homework and due diligence beforehand, knowing your buy box, knowing, you know, even coming down. We talked a lot, a lot about this a couple weeks ago with Brandon and stuff too, as he dove dove deep. But like, like your brand, your social media, your.

[A]

That matters too.

[B]

It does, dude. Like, even on a smaller level of, you know, like single family deals or different things and opportunities that come up, I can't tell you, like, you don't have to have a crazy huge following, but people seeing what you're doing and you talking about it just like calling them quarterly, it's staying like top of mind. They're seeing that. Not even just brokers, but if you're sharing stuff, even if you're not even doing deals, but you're putting in the work and you're, hey, I'm underwriting this deal today. Or like, awesome, I learned this thing today. People see that if it's friends, family, whatever, and then guess what, when you need to raise money for a deal, when someone's grandma wants to sell their house, they're thinking of you and you all of a sudden make a post, hey, anybody want to sell a piece of real estate or know someone that does an investor and they'll get deals. Like, doesn't have to have a huge form. They get deals because they talk about it.

[A]

Yeah, talk. Just. I mean, I think that's one of the biggest mistakes people make is not sharing what they're doing. Especially like my background. So I kind of went through the corporate route when I first got out of school, I went and worked for these big developers and I was an analyst, so I was a W2 employee. I would underwrite the deals. And for some reason in that culture, it's like you don't really share what you're doing. And I love the entrepreneurial culture because everybody's always talking about the deals that they're getting done.

[B]

Right.

[A]

But like, all these analysts should always be sharing what they're underwriting, what they're learning. And that's what I started to do about four years ago, I just started. And I didn't even do it with like raising money in mind because I, I didn't catch that vision yet. But thank goodness I started doing it on LinkedIn. I just started posting my learnings and I've got like over 7,000 followers today. And now I realize that that's a tool because now when I have a deal, I can post it, you know, assuming it's 5,6C and it's advertisable and investors see it.

[B]

Yep. Yeah. So cool, dude. Yeah. I don't know, I don't even know if you remember this, but we talked probably, it's probably three years ago. @ least you remember that maybe where was. Was on Zoom. I'm like, I'm like vaguely remembering this.

[A]

Okay.

[B]

And you were, you were like, head down in your, in your corporate stuff, right? And yeah, it's crazy actually that I think about that because I totally forgot about conversation. But like, just like, like I'm looking at it from like an outsider perspective and I'm like, dude, you're, you're doing the hard stuff. Like, you understand you have this skill set and you're not getting paid enough for it. You know, you need to go bigger. Like, think bigger, do something bigger with it. And it's just cool seeing like the. There, there was, there was a lot of like, scarcity and maybe you disagree with me, but.

[A]

No, I agree. I agree. Absol. I've had to change my whole mindset over the last 12 months, dude.

[B]

It's, it's just so cool to see where you're at now. We're just talking to you, you know, conversation wise. I'm not even talking about where you're at, like situationally. That too, but just, just in the confidence and conversation. And it's, it's cool to see that growth.

[A]

I appreciate that.

[B]

Yeah, man. Okay, so back to this deal. Awesome nuggets. How you, how you found it, how you financed it? Did you, when we're talking about this, like, how did you come to a purchase price? Did you negotiate back and forth? What was that process like? And did they bring up that he's willing to sell or finance? Did you ask him for it?

[A]

Yeah, I mean, we asked for it. We knew he owned it free and clear. And so we asked and he was willing. And one thing we did to motivate him to say yes to that is we actually gave him some of the, some of the promote. So promote carried interest. These terms are just a fancy way of saying ownership in the deal.

[B]

So you said you'll set if you're willing to sell or finance, which, which once again, I think it's easy to brush over. How did you know he, how did you know he owned it free and clear?

[A]

Yeah.

[B]

Listening. They're like, how do you find out that out? Is that weird to ask? Is that, how do you know that stuff?

[A]

I don't think it's weird at all. I think that's, I mean the buyer has every right to understand the current situation of the financing on the property. You know, if there's already a note they need to know because maybe it's assumable, maybe it's not, and that affects the negotiations process.

[B]

Cool.

[A]

Right. So not bad at all to ask.

[B]

Cool. Love it. Okay. And so you basically said, hey, if you're willing to sell or finance this certain amount, 50% or whatever, we'll give you a percentage of the ownership and you can still stay involved in.

[A]

Yeah. And then he can keep his retirement. You know what I mean? Like some of these hotel owners are sophisticated enough to realize that an operator like us who's coming in and doing a conversion is going to create a ton of value. The asset is going to be worth more after than it is as a hotel. Because you. So I mean, let me take one step back. So we had an, we got an appraisal for this property based on, after market completion. So we had a multifamily appraiser come in, look at the comps and say here's the worth of the building after you leased up with 12 month leases. And it's, and it's multifamily nine years.

[B]

During the, this is during the due diligence process or before you, during the due diligence process. So you go under contract, give or take. And then, and now, now and this is important for people to know and you probably did obviously projections beforehand to a certain degree to get a good enough idea. But then you go under contract and now you're like, okay, we're getting it appraised, we're doing our due diligence to make sure correct what we think it is.

[A]

Right. And so like, so this deal. So we had an appraisal in hand showing that it's going to be worth 4 million more than what we're buying it for. So like hotel operators know that like we're buying it 44 grand a door on this going to be worth almost 100 when we're, when we're done. And that's just because multifamily is worth way more than a Hotel. It's, it's like the income on a hotel can go to zero overnight. We saw that during COVID Right. But with an apartment, it can't. So that's why multifamily is viewed as the least traditional or the least risky asset class. Traditionally. It has, it has, it's on the lower end of the spectrum as far as yield goes.

[B]

Yeah.

[A]

A hotel can Yield, you know, 10 to 15% per year, but it's risky. Yeah. So, so my point being is some, some hotel owners, they'll see what we're going to do with it and they'll ask for a higher price than if we were just going to operate as a hotel. Yeah, but he knew we were, he knew we were an operator and that was kind of our way of compensating him for carrying that financing.

[B]

Yeah. And how, and how much ownership does he retain?

[A]

12%.

[B]

12%. And does he have roles associated with that?

[A]

Nothing.

[B]

Okay, got it.

[A]

Yeah.

[B]

So cool. Great, great deal for him, that seller is he getting.

[A]

And he's getting payments. Yeah.

[B]

We're paying interest or just. Okay, absolutely. So amazing deal, which, you know, eight.

[A]

And a half percent interest only is what we're paying him and it's a 24 month term. And what's also nice is because he has interest in the deal, like say we got to 24 months and we weren't done yet with our conversion process. Like he's going to be motivated to give us the time we need to do our thing because he makes money from it. So it's a win, win for both sides.

[B]

Is he, is he willing to like do no payments for the first six months or year or anything like that?

[A]

No, he wasn't.

[B]

Cool. I was like curious on that stuff, you know, or.

[A]

Because I always ask. Because sometimes sellers say yes, right?

[B]

Yeah. You're like, hey, like we're, we're partners on this thing. Like the first six months there's not, you know, a lot. There's not income coming in on this thing as much. So, like, what if we just paid you this fixed rate and then, you know, your interest payments will start at this date, something like that. On a higher, a higher number, especially when they feel like they're partners. All of a sudden your cash on cash returns through the roof because. Because you literally saved a couple hundred thousand dollars right out the gate.

[A]

Yeah, that's a good point. Because, yeah, I think our debt service to him is about 18 grand per month right out the gate. So. Yeah, if we could have got 12 months of no Interest payments then. Then. Yeah, I mean one thing to caveat with these, with these hotel conversions, typically your negative cash flow in the first year anyways. Yeah. So usually you raise above and beyond your purchase price and your capex budget for your renovations and your fee for sure you raise a reserve, you know, because while you're, you're taking the occupancy for the hotel down to zero and then back up to 90% plus as an apartment, typically you have a cash burn.

[B]

Yeah. Yeah, that's good to like understand that, realize that and talk about just in general for people to, to be aware of.

[A]

That's the, that's actually the other amazing cherry on top to this deal. We didn't even know once we were already under due diligence, we came to find out that the hotel was 60% occupied with FEMA vouchers. So FEMA vouchers are people who are displaced by her. And the government was essentially paying for them to live in these units indefinitely until they could find somewhere else to live. Yeah. So it's not guaranteed income. Like it could go away, but they're.

[B]

Paying like three, like usually six months at a time. I have some stuff I rent to FEMA right now and. But they'll pay a premium for it, which is, which is great.

[A]

Three grand a month for these 300 square foot studios.

[B]

Yeah.

[A]

Absurd. So that helps.

[B]

Yeah, that's. Yeah, that helps. It helps a ton. So. So with all of that and the other thing too, just while we're on that point because there's like a lot of, lot of nuggets to pull out, you know, like if you do negot something that's different or you know, no payments until, until this amount of time or what I've done a couple of times with like a bank is like, hey, even though this project is, is finished and we have a co on on this date, can we carry interest only payments out for another six months or another year? And you know that saves like depending on the project, but save a couple thousand dollars a month on that and that gives you, you know, an extra whatever amount that goes, you know, against like trying to say the amount you have to raise, but it just gets you better returns or gets your. Yeah, there's better returns. Doesn't mean you don't still raise for that reserves. Right. But it does mean that everybody's getting a better return at the end of the day.

[A]

Yeah. 100.

[B]

Cool. So a lot of good stuff there. Okay. So going, going back to this thing. So he's on Board, which. Which by the way, all these pieces too. Like, who do you think a seller is going to go with? Somebody who understands. And I'm sure there was. There's a lot of conversation in there with, like, hey, like, you figure out why they're motivated, what they want. Like, you knew those pain points of getting it to that next level. You knew that he had the property paid off. You knew that he wanted a retirement. Right. Like, all these things you start to understand, like who's going to win over a negotiation battle. Not that it came to that, but you. That understands all of that and is willing to give him some ownership for doing the deal. And even though he is seller carrying it or some of it, or somebody else who comes in and offers, you know, an extra 500 grand on a deal like this, you know, he probably still going with you guys, right? So.

[A]

Absolutely.

[B]

It's just important pieces to understand for people.

[A]

Yeah. I mean, maybe we were too generous. You know what I mean? But it got the deal done. And like you said, if there were other people who were. Yeah. Who were bidding, maybe there were.

[B]

Yeah.

[A]

We may not have won. So.

[B]

Yeah. Yeah. Cool. No, that's good stuff. So. So with that, now this is this next piece that I just want make sure people understand. And like we told you guys, this is a little bit higher level, but there's so many concepts you pull out and you put into any. Any deal, really. Explain the appraisal process, because most people, I would say most investors, they're thinking of like a residential appraisal where you're looking at comps in the area, you're looking at square footage. Maybe explain why this is completely different when all of a sudden it goes to multifamily as opposed to a hotel. Like what, how. How are they comping that? How are they coming up with that appraisal? What do they do?

[A]

Yeah, so these appraisers use the income method. So they use what's called a cap rate. So they go to the market and they look at what multifamily is trading at, you know what cap rate's trading at. And to explain what a cap rate is, it's noi divided by purchase price. So if you hear that for the Houston market, multifamily cap rates are six and a half across the board. It means, on average, you pick any given multifamily property, it's going to be generating 6.5% of its value each year. So that's what a cap rate is. So with our property, cap rate's More.

[B]

Referred to in commercial, I mean a little bit residential. Sure, you can use that. But like really commercial deals is where you're going to hear a lot of the cap rate and that's how things are going to be advertised as well.

[A]

Yep, exactly. So like if you see a, if you're looking at a on market property and it says it's, they're selling it for a 4 cap, it's like you, you know right away that's going to be really hard to pencil. If debt's at 7% but your yield is at 4% in place. It's like so, so whenever I'm doing a really quick back of the napkin, I know that my purchase cap rate needs to be close to where the current cost of debt is.

[B]

Yeah. And, and also with that too, anytime. And maybe it's just me of being more like skeptical, conservative. Whenever it's a really good cap rate, I'm always like, okay, how long have rents been where they are? You know, are people month to month over here? Like is it, has that been established for a while or is that something that you. Is a recent thing that's not sustainable and it just is used to kind of fudge the numbers.

[A]

Yeah, absolutely. And like brokers, their job is to get the property sold right. And get the highest value for their, for their seller. So a lot of the times you'll see like it'll say cap rate but it'll say broker cap rate. So like, I mean, and there's, there's a lot of honest brokers, but there's a lot of dishonest brokers and like they'll figure out how to juice the numbers. So yeah, you always got to dig in and do your own due diligence for sure.

[B]

So, so this is really good because this like concept, when I started to understand it, it changes the way you look at investing. Especially if you've been used to, you know, buying like single family and small multifamily. This, this thing alone where like I think I came from the world of okay, I'm buying this house, like I can put $5,000 and renovate this bathroom and the value is going to go up to $15,000. Right. So now when I get it appraised or we talk about like the BRRRR method a lot right now when we go and refinance it, it's worth a lot more than what we actually put into it. And now there's equity in this deal, but in order to do that, it's not going off of the Income approach. Right. Like if it's a single family, even small, multifamily, they won't look at it that way. But this income approach is insane because even if you don't do anything to the property as far as renovation rehab goes, but you know, rents are super low.

[A]

Yeah.

[B]

Say you go buy a hundred unit apartment complex or a 50 unit and you know you can go in and raise rents by a hundred dollars in every single unit. That's where it gets absolutely insane because even though you didn't renovate it, and even though like the comps were this before and you purchased it for this, now they're looking at it based on the new income it generates and they're going to loan money based on that and they're going to appraise it and give it a value based on how it performs now. So I know that obviously you know that, Mitch, but just people that are listening, that was one of those concepts. When like I started to grasp it, it was crazy because you're not just relying on putting some money in and how you're going to rehab it.

[A]

Yeah, exactly. It's. Yeah, that's the beauty of commercial. It's figure out how to increase the income and you just created value just like that. So I mean, that's exactly what these appraisers, you know how they're looking at this. So they go out to the comps, okay, what is this comparable property two miles down the street? What are they renting their studios for? And they use that amount, they come up with an annual net operating income assumption and then they'll cap it at that local multifamily cap rate. And that's how they come up with their value. So like, this might be a little technical, but I'm going to give you some numbers. So the in place noi on this property was 611 grand. And we bought it for a 12.8% cap rate. So if you take 611, divide that by 0.128, you get about where we were on our purchase price. So we bought it for 4.75 mil. Now assume that that 611,000 doesn't change at all.

[B]

Maybe like you did the 0.128, because that's the cap rate you bought it at.

[A]

Yeah, that was, that was essentially the purchase cap rate we got it for. Now, say converting it from a hotel to apartment, we don't actually increase the income, which is the scenario you and I were discussing. Say income stays totally the same, but now it's not A hotel anymore, it's an apartment. So now instead of trading at a 13 cap, we can sell it a 7 cap. So if you take that same noi and now divide it by 0.07, so 7 cap, boom. Look at the new value. Almost 9 mil. So that's exactly what the appraisers are. That's kind of their methodology.

[B]

Yeah. So. So just so people followed that. Just so people followed that. This is almost a little bit different than what we were talking about. Just fairly. Right.

[A]

Like, it is there. It's. It's like the flip side of the equation.

[B]

Yeah.

[A]

The denominator instead of the numerator.

[B]

Yeah. Which is. I just want to make that distinction for people that are following along where like. Yeah, that's one way to do it. Right. Is you come in and you actually boost the income. Now there's the other way of doing it, which, which what you're talking about and breaking it down on a simple level, you're not even necessarily increasing the income. In fact, and you already talked about that, right, where it's. It's a little bit less risky. Because now, multifamily, you're not relying so much on this transient, you know, housing market. Right. Or Airbnb, and the yields are different, but with that, the market is going to pay a different price for that. Right. So now, because it's multifamily, you know, the market's willing and the appraisers know market's willing to buy that at a 7 cap, whereas if it's a hotel, they're only willing to buy it at, you know, a 12, 12 and a half cap, for example. So just because of those things, you know, you can sell it for so much more without increasing the income on the property.

[A]

Yep, exactly.

[B]

So good. Okay, amazing. Well, kind of tying this one all together. So what, what are you doing on the rehab? What's. What are, like, the rest of the numbers that are all said and done? Like, how much did you raise total on this thing? What does that kind of look like?

[A]

So as far as the Capex plan on this one, so to bring it up to the code for the city, we had to install fire sprinklers. So these units did not have fire sprinklers. And so to design that, it was about eight grand. And right now, now that we've closed, we're actually installing fire sprinkles throughout the whole property. So it's going to be about 200,000. The other things we needed to do were convert the lobby to a leasing Office. There's some space for some storage and laundry that we also are going to knock out and add eight more units. So even though there's 100 units right now, it's going to end with 108, which is pretty sweet. So that's going to be additional income to juice that value on the back end. You know, we'll repaint and restrip the parking lot, we'll put up a gate. I mean, you know, with, with workforce housing like this, typically it is in higher crime areas, so put up cameras and, you know, we'll also probably do the trick where we give a big concession to a cop, you know, to come live in one of the units. And, and that helps with crime. But yeah, that's, that's pretty much everything we had to do. The only other thing we needed to do is the railings of the balconies were technically spaced too far apart for residential code. So we're just going to like slap some pretty, some of that slat wood across it, you know, to minimize those openings. And so all in, all in, our capex budget is only about half a mil. Again, normally these hotels conversions, they can be, you know, way more than that if they don't already have a kitchen and if they're. Because a lot of them are pieces of crap, to be totally honest. Again, this one was interesting. It was mostly turnkey because the seller was going through that process of signing that flagship. So, yeah, about a half a million is all we needed to do on this.

[B]

Cool. Yeah, that's not bad at all.

[A]

And as far as the capital raise goes, 3.1 mil was the number to hit. You know, we charge a 2 1/2% acquisition fee on this, which came out to like 110 grand. So we have to raise for our fee. We have to raise for that half a million in capex budget, we got to raise for the purchase price and then the reserves. So all in 3.1 mil is what we had to go out and get from investors.

[B]

And what are you factoring for your reserves?

[A]

This one we only factored in three months reserves. We're doing another deal right now where we're actually getting a bridge loan and they wanted a whole year. So because this was a seller finance deal, there wasn't that requirement to have a reserve. So we just made sure we had three months.

[B]

Yeah. And you paid cash for the property, essentially, or sorry, I shouldn't say paid cash for the property. You don't have any bank debt on the property. So aside from your seller finance Payment. There's no, there's no other payment, Right. That you're at this time until you go and refinance it.

[A]

Correct. That's it. And thanks for bringing up the refi. So.

[B]

Yeah, thank you.

[A]

The plan with this is, you know, as soon as it's leased up, we'll go and get a government loan on this. So HUD or Fannie, those are kind of the two options. And now they'll look at that new appraised value that the appraisers have given us. So and then the difference between our first loan of two and a half million and our new loan, which may be if the, if the new value, let's say is 9 mil, let's actually call it 9 and a half million. And let's say we can get 70% loan to value. So 6.6 million. So the difference between that and the original loan is cash out proceeds that we then return to our investors. And if you remember, our full raise was 3.1 mil. So 6.6 minus 2 and a half million is over 4 million. So not only are we going to be able to get all of our investors capital back at refi, but we're going to get them their capital and some. And it's not taxable. The other option is we just take it to market and we sell it. Take everybody full cycle, you know, because if we refi, it's great. They all get their money back, they go do something else with it. But then we're going to hold for three more years to make it worth it. And there's still going to be some prepayment penalties because with those government loans, they kind of want you to hold them for at least 10 years. Yeah. But you know, the pros outweigh the cons of getting everybody's money back, you know, at the, at that refinance.

[B]

Yeah, man. So cool. Like such like a. It's like simple but complex at the same time. Right. It's nothing crazy when you start to like just look at it and break it all down. But at the same time there's a lot of like working behind the scenes and everything that goes into it.

[A]

Yeah.

[B]

But if you can go hustle and you go out and do something like this, I mean essentially it's, it's, you know, because how much time do you factor in before you refi.

[A]

24 months is what we underwrite to. To be safe. We think we can do it in 12.

[B]

Cool. So, yeah, it sounds. That sounds like pretty.

[A]

Yeah, yeah.

[B]

Good.

[A]

We think we can lease up 50, 15 to 20 units per month, you know, once we have CVO. So for 100 units, you know, we're seven months to being fully leased up and then we'll start the process that gives us another five. But I mean if worse comes to worse, we're underwriting two years just to be safe.

[B]

Yeah, yeah.

[A]

If we really do hit a year, the IRR goes out the roof.

[B]

Totally. Yeah. I mean you're talking about creating $4 million in a, in a 12 month period. You know, that's $4 million out of, you know, out of, out of, not thin air. But you're, you're turning $3 million, $3 million into, you know, almost like $9 million or $8 million, you know. Yeah, I guess seven is what it would be, but just, just crazy when you look at it from there and thinking like, oh, I can just take this, do a few things, a few pieces to it and turn it into something like this and, and how you've broken that down. And I'm sure it'll, it'll cash flow as well. Like if you, if you held it for four or five years it would.

[A]

And I mean obviously when we refinance we're pulling out as much proceeds as we can while staying above a 1.25x DSCR. So for the listeners, a debt service coverage ratio DCR is pretty much how much your NOI can service your debt. So if say you have a Property that's making 125k a year and your, and your interest payments and principal payments are 100 grand, you're at that 1.25x mark. And lenders do not want you to fall below that. That's when you get into trouble.

[B]

Is that how HUD will underwrite it or these, some of the other government loans will they look at?

[A]

They will, they definitely will. Yeah. So we're going to take as much proceeds as we can and kind of play and kind of dance on that fine line of 1.25x, you know, because the more proceeds you take, your payment is going to go up. Less proceeds you take, your payments stays low. So we're going to take the max proceeds we can while staying right at that mark. So that's not necessarily going to optimize cash flow, but it's going to be able to help us pull out as much proceeds on at that refinance as we possibly can.

[B]

I mean if you've taken all your money out, plus some like. Yeah. And it's still cash flowing even a little bit it's crazy.

[A]

Exactly. Then it's cream. Right. And the goal then is to just wait for rents to naturally rise, you know, over the following three years and then sell at year five and hopefully we get another little bump at that point.

[B]

So cool, man. So cool. And, and so like you're, you know, you're, you're making money on the, on the, the raise, obviously, but then in your fees, but, and then you're retaining. Is it, is it a 70, 30 split or how is it set up? And yeah, you're, then you and your team, you have so much of the.

[A]

We did two share classes on this one. We like to do two, you know, to help bigger fish feel like they get extra compensation for bringing bigger checks. So we had a hundred thousand dollar class share and then a 250 class share for the a hundred thousand. We offered our investors an 8% preferred return and we actually guaranteed them all their capital back before we touched a penny. Most indicators don't do this, so it's called a European model. So they had to make their 8% and get all their money back. And then it's a, and then we did a 70, 30 split up to a 20% IRR return hurdle. And then any of the dollars above and beyond that 20% hurdle, it goes to a 50, 50. For the $250,000 investors, we gave them slightly better pref. So a 9% preferred return also guaranteed their capital back. Their first split was an 80 20. And then once they hit their 20% IRR, then it went to a 60, 40. So better terms to bring a bigger check.

[B]

Yeah. Cool. I love it. So good. Yeah, man. We covered, I mean, we covered so many pieces of this, which is, which has been amazing. I just wanted to make sure we had all the pieces of the puzzle so people can kind of put it together and we don't just feed them fake stuff.

[A]

Yeah. I'd say the last piece is like the capital raising and maybe that's, maybe that's a topic for another time because, you know, we could probably talk about that all day long. Yeah, that's really. The last piece of the pie is going out and being able to effectively pitch investors on this deal, show them the numbers, help them understand how it's going to benefit them, help their portfolio. And, and, and there's a, there's a big difference between getting commitments, you know, soft commitments and getting funds. Huge difference.

[B]

Yeah. Cool, dude. Well, yeah, we need to do a master class on that.

[A]

Yeah.

[B]

One of these days because I love that topic. And I love. I think there's so much power in understanding how to go and do that. Even just the basic stuff of putting together, you know, a pitch deck and, you know, what people are looking for and what they're thinking about and I think just kind of wrapping this thing up. But if you're over there stressing about how to go raise the money, it's. It's not like it's easy at all, but it's easy when you have a good deal like a deal like this, and. And don't so many people just. They get ahead of it and they start stressing about, I don't have those contacts, I don't know anybody with money. And so then they just don't even act. Whereas reality is money follows a deal. The deal doesn't follow money. Money follows a deal. And so go find the deal. Money's going to be there 100%.

[A]

And that is not true. Everybody knows somebody with money. Everybody. And yeah, if you have a good deal, money will find you. I mean, there's still effort, like you said, but it sure helps.

[B]

Yeah, 100%, dude. Well, this has been amazing, man. We'll link your, your info in the show notes. People can connect with you, but thanks so much for, for dropping all of this value. So good. Been fun. Real deal to jam on. Thank you guys for tuning in. Hopefully you've learned a lot from this and you go and do something with it. Go take some action. It's not just about knowledge, but it's about acting on that knowledge and staying motivated. So appreciate you and we'll catch you next time.

[A]

Thanks.