[RWS #719] Real Estate Investing: How Ken McElroy is Preparing for a Downturn

Picture of computer on desk for Real Wealth Show Podcast Episode #719

I’m excited for today’s interview with the one and only Ken McElroy. Ken has experienced massive success in the real estate, with over 10,000 doors and over 750 million investment dollars in his projects.

He’s the author of best-selling books, The ABC’s of Real Estate Investing, The Advanced Guide to Real Estate Investing, The ABC’s of Property Management, and his most recent title, The Sleeping Giant, on entrepreneurship.

Rich and I had the great honor of visiting him recently at his lake house, where I also had the opportunity to interview him live. He responded to a lot of big questions related to where we are at the tail end of this economic expansion. My goal was to find out exactly how he’s preparing for what lies ahead, and he offered some great insights that I can’t wait to share with you.

Podcast Transcript : The Growth of a Multi-Family Empire

Kathy Fettke: Ken McElroy, welcome to The Real Wealth Show.

Ken McElroy: Thank you.

Kathy: It’s truly an honor. Since I began The Real Wealth Show, it’s been my goal to be able to interview people that normally I would never have the chance to meet with. Let’s start with just how you got started as a master apartment owner.

Ken: I completely fell into the apartment world as a senior in college.

Kathy: Wow.

Ken: I became an onsite manager. I was living in Seattle and a friend of mine who was working for a big property management company up in Seattle area said, ”Hey, do you want to manage this apartment building?” Well, luckily my dad was a contractor, so I knew how to fix stuff. He was in the construction battalion, a CB in the Navy. I grew up around– he could do plumbing, electrical, framing, drywall and I could do all that stuff too because that’s what I did. I knew that, but I didn’t know anything else right. The guy’s like, ”It’s easy all you got to do is collect rent.” Right?

Kathy: Easy.

Ken: Anyway, and he goes, ”It’s free rent.” I’m like, ”Okay, free rent. ” Actually, I think it was free rent plus $300 a month or something.

Kathy: Wow.

Ken: I didn’t realize that was probably a bargain because there was a lot of work. It was a 60-unit building, tons of work, an owner had bought it and same thing, the guy was trying to make a cash flow, keep the occupancy high, but I didn’t understand all this. I didn’t get it. But I would collect the rents and I would get all the bills and things were happening. Then I started to slowly understand financials and all that kind of stuff. Luckily, I had that real-world education, it was almost like an internship if you will. I was living there and the owner would come up and we’d go over the numbers and just like I do now with my people. Then one day, I remember too, I remember he pulled up in his Mercedes and I knew he was coming. You know how you polish the place up and make it all look good and you’ve got all this stuff together, and I’m like, ”I am on the wrong side of the desk here.” I swear to God. I was like, “I don’t know.” I got my real estate license and I started managing property for a local real estate investor-developer in Seattle. I ended up managing about 20,000 units and I was with them for about eight years.

Kathy: Wow.

Ken: What was great being in that fee management business was we would take on a property and I could see the complexity of it, the debt and the expenses and where it was and where it’s located and the people and all that stuff. I got a great opportunity to be able to run hundreds of properties in that eight-year period that were owned by somebody else. I was hiring people, hiring contractors, paying the bills, looking at the financials, sending them to the owners, meeting with the owners, looking at the distributions and all that kind of stuff. That’s actually how I got it.  That’s actually how I understood.

One day, one of the guys that worked there and I said, ”Hey, why don’t we do this on our own?” These guys, they’re really nice people, these investors. I said, ”This isn’t that hard.” Because we were taking on properties that a lot of times needed lots of work and sometimes they were ground-up construction, sometimes they were really, really old, like hundred-year-old properties and sometimes they were just 50% occupied and sometimes they were 100% occupied. Just all this experience at that time and all over the place, I was traveling to Phoenix and Las Vegas and California and Denver and as our company was expanding, we just decided to start on our own. That was my only job. I ended up starting a property management company basically in the early nineties. From there, I just figured out that I better probably buy these and I started buying them, started buying small ones, big ones and developing and now we’ve got 10,000 units, a billion dollars worth of real estate and 300 employees.

Kathy: Amazing. Today, it’s an interesting market, right?

Ken: Yes.

Analyzing the Multi-Family Deal

Kathy: It seems like in 2005, people were really excited about multifamily. Then the downturn happened. A lot of people lost those buildings. Now there’s a lot of people who got in at the right time, right? They learned about multifamily in maybe 2010, 2011, maybe even just a year ago or two years ago and they’ve been riding an upmarket. They haven’t experienced the down market and they’ve learned certain things, important things, but they haven’t learned other important things. What are some of the mistakes you’re seeing new apartment owners making today?

Ken: It’s a great question. I think one of the biggest things, we just sold $300 million worth of stuff in 2018 and early 2019 and we sold 10 properties at an average capitalization rate or cap rate of 4.4, that was the average. What I did before I even put those on the market was I went to my management company and I said, ”What do you think our net operating income growth, our rent growth, and our expense growth and all that stuff, where do you think these are going to cash flow over the next three years?”

First, we went there to my internal management company which we own, and they came back and said, ”We think this is what it’s going to be.” Then I was looking at cap rates at the time which were mid fives. I said, ”Okay.” When you put your cap rate onto your net operating income, you have your value as you know.’ I said, ”Where do we think capitalization rates are going to be based on the investors?” What happens at the tail end of every real estate market is the big money comes in, the institutions, all the managed money, let’s call it.

Kathy: And they have different needs.

Ken: They do have different needs. That happens every time. People like you and I, we’re at the beginning of everything and we’re trying to get the write-up and we’re trying to sell them to those people. That’s when it all gets the hype, it’s later when all the big money comes in. Just understanding all of that, I said, ”Well, let’s package these 10 deals.” We hired CBRE and they did a big national campaign. It was called the MC portfolio and we put it out and we got 45 offers.

It was like sharks, like just going at it. All the cap rates were, as I said, 4.4, and to answer your question, I think the biggest mistake– because we sold all of those at 4.4, period. Somebody bought them. I know how they run, I know if there was a value-add. Obviously, we sold them all, we know it, we understand them. Somebody believes that they can run them better or grow the cash flow, but remember starting at the beginning of the story, I’d already talked about that NOI or the net operating income growth, I already know what those things are going to produce for the next three years, really through 2021.

The Importance of Exit Cap Rates

I said, ”Okay, the biggest issue we have are what I call exit cap rates.” I was just at a meeting with Goldman Sachs in May at their headquarters in New York and this is the entire discussion. What’s the exit cap rates? If you buy something at 4.4 and it goes to 5.4, you have to have a 25% income growth to break even. Exit cap rates are really super important because 4.4 is low and if they go up just 1%, it doesn’t really matter how you run the building, you have to have a 25% net operating income growth just to break even, just to get what the property’s worth. The exit cap rate I think is the one thing that I’m watching the most. To answer your question, I think that’s the biggest mistake people are making.

Kathy: I’m going to ask a really naive question and that is, who determines that exit cap rate? How is that done?

Ken: It’s just the buyer.

Kathy: Just what somebody will pay.

Ken: That’s what I love about it. It’s as natural as the market should be. What is it actually going to be worth? Just as an example, let’s say we sold something at $20 million and the cap rate was 4.4 and our net operating income was maybe $600,000 let’s just say, I’m just making these up, but let’s just say. Even if they grow the cash flow to 700,000, though the property could be worth 18 million.

Kathy: Again, what would cause that cap rate to increase?

Ken: Cash flow.

Kathy: Because rents went down in the area?

Kent: Well, not necessarily. The cost of debt, occupancy, for example. For us, we were like– honestly, a stock market crash or real estate crash or anything like that brings everything down, right?

Kathy: If there was some kind of recession. That would affect cap rates.

Kent: Some kind of something. The way we looked at it was we’ve made enough money, we’d own these properties, five, six, seven, eight, nine years. Maybe we’re not at the top. I never really tried to time the top anyway, we’ll just sell into the top whenever that is, but for sure, we’re going to see some kind of correction. I told the story when you and I were talking before, about the buyer that was buying something that I was selling then I saw their package as they were soliciting me to invest in the new deal, which is a deal that I owned and they had spun it. They said, “We see a $200 rent growth in every single unit.” Well, I had already checked that before. I knew– We were trying to raise rents 30-50, couldn’t. We’ll try the next renter. “Let’s see if we can get 50 bucks.” We were hitting the ceiling in Houston on that particular property, but they were showing it was 200. I think all that’s going to start coming up.

Kathy: I just want to slow down for a minute so people really hear what you just said, that Ken McElroy, that you are the expert of experts when it comes to multifamily, you had a property that you really had squeezed out as much cash flow as you could and you know all the ways to do that, but somebody else bought it from you and told their investors that they could squeeze more cash for it.

Kent: That they could have $200 more per unit in rent.

Kathy: How did they think they were going to do that?

Kent: They were going to put $10,000 a unit into the property, and we had already done that. I don’t sell anything if there’s a value-add. I’d rather do that myself. We actually put in new kitchens, new flooring, new this, new that, made everything amazing and we had market resistance in Houston on the rent. We spent not very much, like 40,000-50,000 bucks on four or five units and we saw that we couldn’t raise rents anymore on that particular asset.

Raising Rents vs. Market Resistance

Kathy: I think you just nailed a really key point there. Market resistance, which in other words, people hit the max of what they can afford, right?

Kent: Yes, correct.

Kathy: How do you know what that max is when you’re buying? Or let’s say the investor who invested in this person’s deal, how would they do their research to know that it’s not possible to raise the rents anymore?

Kent: That’s the greatest question. How does an investor know? The investor has to trust the sponsor and their experience, number one. But what we do is we provide rent surveys and you do have the opportunity to check those out. For us in this particular– this was a nice property, it was built in the mid 90’s. Beautiful, elevatored, really, really nice. You got to go out and look at the four or five comps in the area and see where you fit as it relates to all of those because I’ve done a lot of class A new construction, I’m always afraid because when you’re building something brand new and you’re dropping it in a market and you’re 100-200 above everything else in the market, you better make sure that you hit those numbers.

How do you really know if something brand new is going to be more than something that’s really nice right next door? I’m always watching the market resistance. What we did is we did renovations on the property internally first to see is there any value-add for our investors because why would we want to sell somebody something that we have– I wouldn’t want to sell anybody a value-add project because that’s all I’m looking for. We felt like we had done everything we could to see where the resistance was in that particular market at the time, which was about eight months ago, nine months ago.

What was really neat to see was the whole evolution of it all, that the new buyers said, “We got $200 of rent growth.” You take $200 of rent growth times 200 units, that’s $250,000 in NOI growth. You can make a value-add all day long just by the magic of numbers.

Kathy: Do you know if they achieved it?

Kent: I don’t– Well, it’s brand new. We just sold it. We sold it at the beginning of 2019. So, we’ll see.

Knowing Your Multi-Family Market

Kathy: But the reverse is possible as well, where maybe too many units come online. You got to be aware of who’s building and how many units and there’s a lot of units being built in Houston and Dallas and Seattle and New York and San Francisco. People don’t pay attention to that, but that would affect it

Kent:  100%. That’s why we got out of Austin. Austin is one of the hottest markets in the country for multifamily. I started buying in the early 2000s there and that whole area from the lake up to Congress area, which kind of goes North- well, actually it goes North and South all the way back towards San Antonio, tons of units being built. I owned a bunch of stuff, but when you’ve got three, four, $5,000 or 5,000 units being added to a five-mile square area, it’s definitely going to affect the rents. That was one of the factors too– is new construction was coming.

You think about– somebody opens a 200-unit building, there are a 100% vacant on day one. For them to be able to go one month free, two months free, we just need warm bodies with good credit. They can annihilate a market very quickly by doing lots of these incentives right out of the gate and it’ll affect all the surrounding projects for sure. If you live in something that’s 20 years old, you want to be in something new, especially if they’re doing one month free on a 12-month lease because really now your rent’s the same.

Kathy: You had about a billion dollars worth of properties sold off about 300–

Kent: Yes, we have about 700 now.

Kathy: Why did you keep those? Because you had an offer for all of it.

Kent: Yes, we did–

Kathy: You get to be a billionaire on the lake– [laughs]

Kent: Well, at this point, it’s all about managing your money. For me, we had 7,000 units with super low leverage, like 50% loan value, massive cash flow. We returned a lot of the capital. Most of that money that we raised or syndicated had been returned back.

Kathy: Through a refi?

Kent: Yes. Through cash-out refi, so we don’t really have a lot of debt on it. You got massive cash flow. We have hardly any debt. We can always put new debt on if we need money.

Kathy: Investors have their capital back.

Kent: They have their capital back. We were looking at a huge capital gain issue, a huge depreciation recapture issue. Also, once you have all that money because I have friends that have done this, they’ve sold their businesses or sold big portfolios or something. Then they’re trying to place it again anyway.

Kathy: Where are we going to put it?

Kent: They’re like, do we give it to a financial planner?

Kathy: You have to trust someone else.

Kent: Right. We’re like, “Well, we got–” Don’t forget, on the ones that have mortgages, all of them have some kind of a mortgage, the tenants are paying those down. I think we calculated that just in mortgage pay-down, our portfolio was growing by 25 million a year. Just in mortgage pay down.

Kathy: Oh, my gosh. Wow.

Kent: Those are tenants paying off all the mortgages that are– You know what I mean? Just in that, we’re getting 25 million a year, our investment, all my investors, just in that. Just by holding it, and then you get all the tax benefits, but then we had the tax issue of capital gain, all of that. At the end of the day, that’s why we decided to stay.

Kathy: I could talk to you forever. We are actually starting a mentor’s– it’s called a Master’s Table. It’s like a mastermind to be able to sit with the greatest of the great to really be able to get wise advice. I hope I’ll be able to talk you into being a part of that.

Kent: That’d be fun.

Kathy: If anybody wants to find out about that, you can certainly reach out to us at realwealthshow.com. What concerns me so much and I’m invited to lots of masterminds and I meet a lot of young people who have raised from millions of dollars and I’ve only been in real estate for a couple of years, what should syndicators really be paying attention to who are new to this? Because I mean you just– You’re already—

Making Money for Our Investors

Kent: I’ll just make another point. I think a lot of times syndicators are in it for the fees. In other words, when you raise money and you put it into something, you get paid a fair amount of money upfront and hopefully, it’s all disclosed, either acquisition fees and stuff like that. I think a lot of people are doing it to pay bills and to get into the industry and understand it. You and I are doing it quite differently. We’re doing it to make money for our investors. I only get paid after our investors are paid back. If I take $10 million and use layman’s side of that too, and I invest it, only when that equity is returned do I make money. So, I don’t make money– I don’t take money while the property is being added value. A lot of these syndicators, it’s not hard to raise money, in my opinion. It’s actually not hard at all.

No, the hardest part is finding the right deal that cash flows and makes money. You got to look at the syndicators themselves and look at their track record. As my good friend, Robert Kiyosaki says, “They’re working for tips, commission.”

Kathy: I love that you brought this up because I didn’t know that. It made sense to me when we started syndicating when developers would bring me these projects and they were amazing projects. The developers that we started working with had ins with the bank. I’ve recently learned how it all works when there’s a recession. If you’ve taken on a bank loan and you cannot make those payments, it’s obvious, but the bank has to foreclose. It’s like by law, they have to. They have to have certain amount of reserves, they can’t have these bad loans on their books. They have to foreclose on you.

After that, they get to write it off, they get to write down the debts. It really doesn’t cost them anything to do that. Then they get to sell the asset. That’s all profit and it’s commission-based. These developers were coming to me who’ve been through this every down cycle, they’re the guys that the asset managers call. Basically, at that point, make a deal.

There was a $160 million property in Florida that we got for 16 million because they didn’t know what to do with it. When these developers came to me with these deals, I hadn’t syndicated, I didn’t really know them, but they had a massive track record, so there was immediate trust there. These are people with private jets and beautiful homes. They don’t necessarily want to lose by doing the wrong deal. They don’t want to start over. The track record impressed me. We were willing to try it out. The first thing I said is, “I don’t want to see you making a penny until the investors make a profit.”

If you say that they’re going to get a 15% return, then let’s put it in writing. Let’s have that preferred return be 15% which basically means they’re going to get their preferred first, you get what’s leftover. Then that split after the investors get the 15%. Then it’s heavily weighted to the developer which is different than other people’s deals. Sometimes our developers will get 70% of the leftover. That’s after the investors have gotten their split.

Whereas you’ll see in a lot of other people’s deals, it’s maybe a 6% preferred, but then the split is heavier to the investor, maybe 70% of the investor, but there might not be anything left because of the fees. All the fees along the way. Then really all the investors getting 6% if you’re lucky. I know we do it a little bit different, but it’s for the same reason. It’s like, “Don’t tell me that it’s going to make this kind of profit. Let’s hope for that. We can’t guarantee it, but let’s assure that nobody’s getting paid till the investor gets what you said they’re going to get.”

“Waterfall” Returns for Stakeholders

Kent: That’s actually– the most successful syndicators out there put the investor first. In our world, it’s called a waterfall. The first person that gets paid is the bank or the loan. The second person is the investor. Then you get paid after that.

Kathy: When you’ve proven it.

Kent: Correct. I like that model. I think it’s fair because you’re using other people’s money to make money and you got to put your money where your mouth is. The other thing that we do is we put our own money in. Now, I’m sure you do too. If we raise 10 million bucks, we’re right alongside that as an LP or a limited partner on every single deal. We’re invested in our own cash, but we’re also on the GP side. The GP side is where all the upside is.

We’re only investing in things that really have a big upside on the GP because that’s actually where I make all my money. I want to have my investment along everybody else’s, but if it really kills it, which we’ve had some happen, then that’s where the big money is. It’s over here on the GP side after the waterfall or at the end of the waterfall.

Kathy: I hear a lot of people say that they’re doing a 70/30 split with no preferred. They’re like, “Hey, `we’re in it with the investors and we’re just going to make money together.” What are your thoughts on that?

Kent: Well, that’s where we are in the market. I think that in the beginning of raising capital, it wasn’t like that. You’ll find that money at a small level. At the non-sophisticated accredited investor, let’s say, might do something like that. I like the preferred return model personally. It puts pressure on me, it puts pressure on my management team, it puts pressure on the business plan. I’ve seen those and nothing wrong with that, I guess. It’s a goofy way for an investor to invest.

Focus on Fundamentals, Cash Flow

Kathy: It seems unnecessary, but anyway. Any last tips for where we are in the cycle and how people can just be prepared for what’s coming and what do you think is coming?

Kent: Well, I think we’ve got about 10 years of expansion. Interest rates are going down again. I think we’ve probably got a little more life in the real estate market personally. I think people should always just focus on cash flow, not necessarily capital gain. I’m a big proponent of that. I teach that. I’ve been through a couple of downturns and we were in the condo business where we did several thousand condos projects.

When the buyer stopped, it was like within a month, gone, and it goes really quickly. It’s here like that. I would just say, “Be careful of personal guarantees, try to get in and out like you said or have it set free and clear. Then set yourself up on a cash flow basis so that you don’t have to do deal to survive.” I feel like that’s what a lot of syndicators are doing is that they’re raising money to pay bills and they’re overhead, all that kind of stuff. They’re not really focused on the financial returns of the actual deal and maybe they are, maybe they really believe it.

Kathy: I don’t know. I’ve talked to a lot of institutional people and it’s all about fees. They have to constantly be–

Kent: It appears to be.

Kathy: Well, you get an acquisition fee and you get a disposition fee. That means you’re going to want to buy and sell, that’s where you’re making the money. I think you even mentioned that there was an institutional company that came to you, wanted to buy, and you’re wondering why they’d want it.

Kent: Blackstone. They were huge, obviously huge. They’re going to be close to a trillion dollars under management before long and they’re massive. Goldman Sachs brought us to them. I was like, “Okay, I know a lot about what I’m doing, but what am I missing?” I’ll tell you, I got the best advice ever from a friend of mine in this white PO group that I’m in and he’s an M&A guy. He’s like, “Just know one thing.” He goes, “When you’re sitting in a room with a bunch of guys from Blackstone, you’re the dumbest one in the room.” [laughs]

He said that and I go, “Really?” He’s like, “Absolutely.” He goes, “They know more. You got to figure that out. What is it that they know that you don’t know?” That whole experience was great. Going to New York and figuring all that and getting an NDA and working through and we had a war room and we were negotiating and all that kind of stuff. I always had that in the back of my mind. At the end, we walked away from it. What they wanted was the appreciation, they were stepping into a huge cash flow portfolio. What they wanted was what we already had and what everybody wanted.

Kathy: So, you are like, “Why am I selling?”

Kent: Yes, why would I sell? Just to get that equity, right? Then pay tax overall. In the end, we walked away from it.

Kathy: All right. Ken, well, thank you for doing this and thank you for inviting Rich and me to your beautiful home here.

Kent: That’s awesome. You guys are the best. We’ve had some fun.

Kathy: Super fun. Let’s go. Let’s go do that. Let’s go have some fun.

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