Inversion Thinking For Apartment Investing

Charlie Munger, Warren Buffett’s partner at Bershire Hathaway, says that one of his best mental tools is reversion thinking. When he was young and in the service, he was a weather technician. His job was to monitor the weather for military aircraft. How he approached this was unique and effective. He got out a piece of paper and wrote down everything he could do to make the planes crash. Once he wrote out everything he could think of, he knew what not to do. He made a checklist and made sure that none of these possibilities could happen.

Similar to monitoring the weather, this way of thinking can be applied to investing. Think up all the ways that a deal could fail and all the potential threats of losing money. Then choose to invest in the deals where the risk of these threats are zero, close to zero or you have properly prepared for them.

For instance here are some ways a deal could fail:

• People migrate out of the city and occupancy drops. NOI drops below debt service and you go into default

• The deal doesn’t cash flow day one and you have to feed it from external funds. You’re banking on there being appreciation, but the appreciation never comes.

• The majority of the tenant base is employed by one employer. The employer goes out of business and the majority of your tenants lose their job.

• The majority of your tenants are enlisted in the military. If there is a deployment, legally they can terminate all their leases with no penalty. You lose the majority of your tenants and can’t pay the debt service payments.

• The deal you invest in is student housing. The schools shut down for some reason, for instance COVID, and no one stays on campus anymore.

• You get floating rate debt and interest rates rise significantly. You have a rate cap, but it expires at the wrong time.

• You have short term debt on the deal. The market crashes and the NOI increase you did to the property doesn’t make up for the drop in market conditions. You’re forced to get new debt, but are either underwater or don’t have enough equity to make the minimum down payment on the new loan.

• Crime increases in the neighborhood and people don’t want to live there anymore. Tenants move out and no new tenants want to move in.

• You hire third party managers who mismanage the deal. They are experienced in a different asset class or size of property that isn’t the one you hire them for.

• The manager doesn’t pay the bills they’re supposed to and one day you get a massive bill for all the accrued expenses also the manager stops working so your income collections drop.

• You have deferred maintenance on the property that creates a hazard. A tenant is injured and files a lawsuit against you.

• You use the cash flow from the deal for your renovation budget instead of raising it upfront. People move out during the renovations because of the noise and your cash flow goes away. Now you don’t have the budget to finish the rehab. More tenants don’t want to live in the building because the unfinished construction. NOI drops below debt service payments.

• You have a lease contract with an Airbnb company for all the units. Instead of having 100 tenants, you have one. The company does well with your property, but poor with several other properties you don’t know about. Because of the companies finances, they can’t pay your lease. You lose 100% of your income and still have to make the debt service payments.

• Overleveraging a deal and something goes wrong in the market.

• You invest with a sponsor who doesn’t know what they’re doing and mismanages the deal.

• You buy a deal where the numbers weren’t what you expected.

• You buy a deal with huge deferred maintenance that you missed in due diligence.

By writing out this list, you can also better define your own deal criteria by eliminating what you don't want.

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