Apartment Owners: Are Rising Rents Destroying Your Bottom Line?

Landlords get starry-eyed when rents are going up. Rising rents signify strong apartment demand and can bring in higher revenues. How could they possibly ruin your bottom line?

It all depends on how you’re implementing rent increases.

When vacancy results from normal turnover – the tenant takes a faraway job or experiences a life change like marriage, etc. – you should certainly charge the next tenant whatever the market will bear.

But what about an existing tenant who wants to renew the lease? That question is harder. You want to keep pace with the market, and you need to offset rising expenses. But increasing the rents too aggressively might cause a tenant to move out.

If the tenant is a headache, this might be a good thing. And even if the tenant is a good one, if the current rent is far enough below market, then you might benefit from renting to someone new.

But the current rent must be very far below market to justify losing a good tenant. Otherwise, the new rents won’t recoup the costs of vacancy for a very long time.

Vacancy Costs You More Than Just Lost Rental Income

How does this work in practice? When a tenant leaves, you incur several costs. Obviously, there’s lost rent. Then add in “turn” costs; incidental costs, like utilities reverting to the landlord; and unanticipated costs that can arise when apartments are uninhabited.

For example, imagine your tenant pays $700 in rent – 5% below the market rate of $735. Assume it takes 30 days to turn and re-rent an apartment, a soft turn (painting, carpet cleaning, and light repairs) costs $400 a unit, and utilities cost $25 a month.

In this scenario, if the tenant moves out, you lose $1,125 from your bottom line. At $35/month in increased rents, it would take 32 months – nearly 3 years – to make up the loss! Even if the original rent was 10% ($70) below market, the gap wouldn’t fill for 16 months.

Then imagine it’s a harder turn, where you must replace the carpet for $1000 rather than clean it for $100. Your total cost is now $2,205, which would take you a shocking six years to make up if the rents were only 5% below market!

Now multiply this across several units in your property, and you can see why rising rents can destroy your bottom line if you’re not careful.

Bad Things Can Happen in Uninhabited Apartments

And these costs are not the only ones that can result from vacancies. Bad things can happen when no tenant is present to report problems to management. In cold weather, pipes can freeze and cause flooding. In hot weather, unnoticed leaks can cause mold outbreaks, which can quickly overtake an apartment. Remediation costs can wipe out a whole year’s rent, not even counting rent lost during renovations.

The lesson is to be judicious when raising rents. Work hard to retain good tenants. Raising rents only 2.5% to keep one in place will add $210 in annual revenue versus $1,125 in vacancy costs, a difference of $1,335 to your bottom line. It could even make sense to renew the lease at the original rent, if the alternative is the tenant moving out.

Normal turnover and natural vacancy are facts of life in the apartment rental business. Good operators budget adequately for these costs. But good operators also know that the key to maximizing profits is minimizing unnecessary turnover and its associated costs.

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Armchair Due Diligence

You just signed a contract for your first multifamily property, and you are super-excited to start life as a professional investor. You’re incurring legal fees and you’ve just sent the bank a five-figure good faith deposit so it can start paying lawyers, engineers, and environmental specialists to start work on the deal. You’re committed now.

You start interviewing management companies, and when you mention the property, you hear someone sucking breath on the other end of the phone.  Oh, that property.  You know about its reputation, right? And you read about that huge drug bust there last year?

What am I getting myself into, you begin to wonder . . .

Then the bank calls to tell you that, because the flood maps were recently updated, you will need expensive flood insurance on the property, even though the seller did not.

You relied on the seller’s financials to calculate your expenses . . .

A week later, the lender mentions that the annual property tax escrow is going to be 40 percent higher than you underwrote. “Wait a minute!” you say. “The property tax on this property is only $25,000 a year.”  The county will re-assess the property after sale, and according to the formula, property taxes will now be $40,000 a year, the banker tells you.

There goes my entire first-year profit!  (And I sound like an ignoramus to my lender.)

The expenses on this property are way more than you thought. It’s really worth less than you’ve already agreed to pay. And, even if you terminate the contract now, you’re still out of pocket for costs.

Is there any way that you could have learned about these matters before you signed the contract?

Well, yes. And, thanks to modern technology, you can do most of it for little or no cost from the comfort of your living room chair!

So, before you incur legal fees or write a big check to a bank to start due diligence, be sure to follow this Armchair Due Diligence checklist.

Get As Much Financial Information As Possible from the Seller Up Front

Some sellers provide only a year-to-date or trailing twelve-month financial statement and a current rent roll. While this may be enough to do a quick-and-dirty underwriting, at the very least you want to get 2-3 years of operating statements and 12 months of rent rolls. This will help you understand the property’s historical occupancy, any seasonal fluctuations in revenue, and the annual expenses.

Often the analysis stops here, because the picture this information paint tells you not to waste any more time.  But assuming that’s not the case, proceed to the next steps.

Check If The Property’s In a Flood Plain

It’s critical to research whether your property is in a flood plain, even there’s no obvious source of water nearby. If it is, your lender will likely require you to purchase flood insurance, which adds to your costs. Do not rely on the seller to provide this information, because the Federal Emergency Management Agency (FEMA) revises the flood maps from time to time, and the maps may have changed since the seller purchased the property. Don’t wait until after you have set a contract price for the property to find out that your insurance costs will be higher than you expected!

Research the Property Tax

Property taxes are one of the biggest costs of multifamily housing ownership. And what you will pay after you close often differs from what the seller has been paying.

Even if the seller provides you with historical property tax bills before contract, you must do your own research. Often property tax bills are posted online. Otherwise, call the taxing authority and ask for the past 2-3 years’ tax bills.

More importantly, make sure you understand how the jurisdiction calculates property taxes. Some jurisdictions re-assess taxes after a sale, while others re-assess on a set schedule. The property tax clerk is often happy to walk you through the entire process.

Without accurate property tax information your underwriting will be unreliable. It’s vital to understand how taxes will change after sale to ensure you don’t overpay for the property.

Get on Google Maps

Google maps can be very helpful, especially when you are researching a faraway property.   The map feature tells you what’s nearby. Is it close to schools, supermarkets, or popular retail? Is there major road access nearby? How about major employers? You can even use the map feature to calculate how many minutes’ drive the property is from major landmarks in the area, like schools and employers.

The satellite view provides information about the blank spaces on the map. Is the property surrounded by other apartments? Or is it the only multifamily property in an area dominated by single-family homes? Are those houses small, or are they mansions with backyard pools? This is vital information about the surrounding neighborhood.

Finally, review street view. Even though the footage may be slightly out of date, it will provide a picture of the property and its surrounding neighborhood. You might be able to see in street view whether the area is well-kept or strewn with garbage and cars up on blocks. You should also check out the competing properties on street view.

Learn the School District

Being zoned for a strong local school is a very valuable attribute for an apartment property. Good schools attract good tenants. An affordable apartment in a top school district will maintain higher occupancy under all economic conditions.

Do Your Demographic Research

Avoid markets with declining populations. Over time, apartment supply will rise relative to population, even if no new supply enters the market. Conversely, all things being equal, a growing population means higher occupancy.

Population statistics on the metropolitan statistical area (MSA), county and town level are available at the U.S. Census Bureau’s website (U.S. Census Bureau QuickFacts). Websites like the US Hometown Locator (Hometown Locator) can provide population data down to the zip code level. Many states, counties and municipalities also publish their own demographic and economic data on a regular basis.

It’s important to review population growth rates on multiple levels because sometimes cities exhibit population “growth” that really resulted from annexing the surrounding areas. The area population is not really growing in this case; more of it is simply coming within the city limits. Researching on both the MSA and zip code levels can bring population-growth-by-annexation to light.

Ideally, you want to see past and predicted population growth at all levels, from zip code to MSA. You want to make sure that people are coming to the overall area in general and to the property’s specific neighborhood in particular.

The only exception to this rule is rapidly gentrifying areas, where young, single people and childless couples are replacing families, and homes that had once been divided up into apartments are being re-converted into single-family homes. But understanding that population decline is resulting from gentrification will be difficult to determine just from the numbers. It requires intimate knowledge of the neighborhood.

Research the Local Apartment Supply

You must understand the supply of apartments in the local market. The Holy Grail is a market where the population is rising faster than new apartment supply, as is happening in certain areas of the South and West. This could be the result of high construction costs, zoning that limits new multifamily supply, or simply the time new construction takes to reach the market.

Brokers, particularly at larger companies, often subscribe to data services such as REIS, Axiometrics or CoStar, which compile data on existing apartment supply and apartments in the construction pipeline. If the broker won’t or can’t share this information, it may be worth the $150 or so it will cost you to download the property report from REIS. However, REIS, etc., only maintain data on larger, professionally managed properties. If you are buying a small apartment building, it may be harder to come by this data independently of the broker.

It’s also worth calling the local building department, which may tell you the number of multifamily building permits on file – which indicates the pipeline of apartments coming on line in the next couple of years.

Determine the Local Vacancy Rate

Understanding the local vacancy rate is very important to accurate underwriting. You don’t want to use a standard vacancy assumption of 5% if the local vacancy rate is really 10%. Brokers can provide you with vacancy rates, but for independent verification you should go to a provider like REIS, Axiometrics, or CoStar. Keep in mind that, statistically speaking, larger professionally managed apartments have lower vacancy rates than self-managed “mom & pop” properties, so if you are buying a smaller property you may need to assume a higher vacancy rate than that shown by a REIS report.

Determine the Real Asking Rents at This Property and Its Competitors

While a current rent roll is the best starting place to understand rents at the property, you must verify the rents independently. The best way is through a lease audit, where you compare every actual lease to the rent roll. But, since you generally cannot access the lease files pre-contract, one way to verify the asking rents (“market rents”) is to pose as a customer and call the property. Don’t just inquire about rents. Ask if they are offering any “specials” to new tenants. This will help you understand whether the property is really getting the “market rent” or whether “market rent” is just a number the seller made up.

Then call the property’s competitors and ask the same questions. This will help you understand where the property’s rents are relative to its competition. If your rents are substantially below market for units of similar size, amenities, and location, you know you can probably raise rents after you purchase the property.

When you “shop” the properties this way, ask as many questions as you can to get an idea of how the properties stack up against one another. Pretend you are from out of town coming to take a job and you want to know about the size and layouts of the apartments, the rents, any specials, the property’s amenities, what restaurants, shops, and supermarkets are nearby, whether anything is in walking distance, and what the zoned school is.

Research the Property’s Local Reputation

Unless you’re planning to do a major repositioning of the property, you probably want to avoid an asset with a terrible reputation in the market. One way to research the property’s reputation is to read online reviews. You should take these with a grain of salt, however, because people who aren’t upset about anything tend not to take time to write apartment reviews. Watch out for a high volume of bad reviews, as opposed to just one or two. And pay attention to the date of the reviews. Are they from years ago, very recent, or consistent over time? Recent reviews could be evidence of current problems, while only old reviews could show that a property has fixed its issues, perhaps with new management or ownership.

Local property management companies may be a better source of information.   Good managers will know all the properties in the neighborhood, so they are an excellent source of information on the property’s past and current reputation. They also understand the local neighborhood and market. Ask to interview them as a potential client. Once you’ve established that you trust them, ask their opinion of the property you’re targeting and its competitors.

Research the Local Economy

You must understand the local economic situation before you invest. Is unemployment rising or falling in the local market? The U.S. Bureau of Labor Statistics (BLS) publishes a monthly report on each metropolitan area, which can be found here: BLS. In addition, many states, counties, and municipalities publish their own employment data.

Don’t just review the local unemployment rate or whether it’s rising or falling. You must look at the actual number of jobs in the market and whether jobs are rising or falling. This is because the unemployment rate depends on how many people are looking for jobs. Even if the number of jobs stays the same, if more or fewer people are looking for jobs it will change the unemployment rate. You should look at several months of data for your market.

It’s also helpful, especially when you’re looking in a new market, to search Google and the local press for economic news.   This way you can learn about major local economic events, like factory openings and closings.

You must also understand the local economic drivers. What are the biggest employers in the area? Is the area overly dependent on one or two employers or industries? How diversified is the local economy? Local city and county governments often publish lists of the largest local employers. Get back on Google Maps and find out how close these major employers are to the property you’re researching.

Understand the Sales Comps

Review recent sales of similar properties to be sure that your offer price is not out of line with the market. Brokers usually have this data at hand, but beware of them cherry-picking comps that make it look as though your deal is a good one. It may be worthwhile purchasing the REIS or CoStar report, though the problem here is that the data may be several months out-of-date. Talking with multiple brokers about sales they’ve closed recently may also help you get this information.

Research the Prevailing Cap Rates In the Market

The capitalization rate, or “cap” rate, is the unleveraged return on property. In other words, it’s the return an all-cash buyer would receive. It’s calculated by dividing the net operating income (i.e., before mortgage payments and capital expenditures) by the purchase price. Cap rates provide a basis for comparing the price of one transaction to another without regard to the transaction’s capital structure.

Conversely, if you know the prevailing cap rate in the market, you can get a back-of-the-envelope idea of what the sale price will be. All you do is divide the net operating income by the sale price. For example, if the prevailing cap rate is 7%, then a property generating $100,000 in net operating income should sell for approximately $1,428,600 ($100,000/0.07). (Base the net operating income number on your underwriting and not on the seller’s numbers, since your cost structure will likely be different than the seller’s because of property taxes, insurance, etc.)

Cap rate information is imprecise and somewhat hard to come by. Yet it’s good to have an idea of what the prevailing cap rates are. REIS and CoStar have cap rate information but it tends to be slightly out of date. To obtain current cap rate information, ask multiple brokers in the local market. Of course, brokers have an incentive to tell you the cap rates are lower than they really are, because lower cap rates translate to higher sales prices. But it’s good to have a ballpark idea in any case.

Call the Fire and Police Departments

Calling the local fire and police departments is an important due diligence practice. The fire department will tell you whether there have been any fires at the property (so you can investigate possible cover-up work by the seller) as well as whether there are any outstanding fire code violations on the property. It can also tell you how far away the property is from the local fire station, which can affect your insurance rates. The police department can tell you how often they are called to the property and the reason for the calls. If they tell you that the property has a reputation for gang or drug activity, it’s best to stay away (unless your business is turning around troubled properties). You should also ask the police the immediate neighborhood’s reputation for crime or safety.

*          *          *

Even some professional investors follow these steps after going into contract, as one of their last due diligence items. That makes no sense. If any of these items were a deal breaker for you, like the property being in a flood zone, the population declining, or the presence of drug activity, you should know before you spend a dime on the transaction. Checking these items off your due diligence list before you go into contract will save you time, aggravation, and money in the long run.

 

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Jonathan Twombly/The Mortar Featured on A Student of the Real Estate Game

Jonathan Twombly and The Mortar were recently featured on the popular blog, A Student of the Real Estate Game, run by investor Joe Stampone.

  • Want to know how I made the transformation from miserable Wall Street lawyer to a happy and fulfilled real estate investor and blogger?
  • Want to see how losing my job was integral to fulfilling my dreams and freeing myself from the corporate grind?
  • Want to know a bit more about my investment philosophy?

Then check it out!  Just click the link!  A Student of the Real Estate Game

Your Home Is Not a Real Estate Investment

Home prices are rising again. Should bullish economic predictions bear out, this trend will continue, to the benefit of homeowners and the US economy at large. Rising home prices are good for your net worth, your ability to borrow, and your mental health. But before you rush to get in on this good thing, remember: your home is your castle and where your heart is. But it is not an investment.

Yes, Buying Is Better Than Renting. But That’s Not What I’m Talking About

Let me clarify one thing first. I am not advocating renting over buying. In many markets – and most markets if you live in your home long enough – owning a home is far better in the long run than renting. Considering possible home price appreciation and the tax deductibility of mortgage interest, you will likely come out ahead if you buy, and the equity in your home is an asset you can access if need be.

What I’m talking about is whether you should consider your home an investment. The answer in almost every case is an emphatic no. All too often, I hear people say that they don’t need to diversify their portfolio with real estate because they are already “exposed” to it through their “investment” in their home. This is mistaken thinking. No professional real estate investor would buy a property with the economics of an owner-occupied single-family home.

“Wait a minute,” I can hear you objecting. “I bought my house ten years ago for $1,000,000, and now it’s worth $1.5 million! I’ve made $500,000 in profit!” If you think this statement is true, then you’re making a classic error: comparing the current value to the purchase price and declaring a “profit,” while neglecting to factor in the very substantial costs of owning a home.

As An Investment, Your Home is a Loser

Let’s imagine a couple that purchases a 2 BR/2BA apartment in Park Slope, Brooklyn, for $1,000,000.   The apartment appreciates at 4.7% a year, and after ten years the couple sells the apartment for $1,582,949. After deducting the remaining mortgage principal ($638,660) and 3.5% of the sales price ($55,403) for broker fees and closing costs, they’ve made a cool profit of $688,885. Right?

Wrong. Let’s assume the couple put $200,000 (20%) down and financed the rest with a 30-year fixed rate mortgage at 4.4%. Even at this historically low interest rate, their total interest payments alone would consume $319,390, or 46%, of their appreciation! And that’s not their only expense. Let’s assume that, after five years, they spent $10,000 on a new bathroom, and before selling they invested $5,000 to repaint. (These estimates are probably low for this work.) Along the way, they also paid $1,000 a month for maintenance (including physical upkeep of common areas, common electric charges, water/sewer fees, custodial salaries, and property taxes); $1,800 a year for insurance; and $2,400 a year for electricity and gas, all subject to 3% annual inflation. When all of these expenses are properly accounted for, the couple’s profit after ten years is a whopping $7,441. Calculating this as a return on the couple’s original investment of $200,000, it works out to a total return of 4%, or 0.4% a year over ten years.[1]

Here’s how it breaks down.

Sale Price $1,582,949
-Total Maintenance/Tax $(137,567)
-Total Repairs/Improvements $(15,000)
-Total Insurance $(20,635)
-Total Utilities $(27,513)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(55,403)
-Original Down Payment $(200,000)
=Profit/(Loss) $7,441

Fig. 1. Park Slope apartment profit/loss at 4.7% annual appreciation.

Even this meager profit, however, is probably unrealistic to assume going forward. According to The Economist, New York real estate did appreciate 4.7% annually from 1987 to 2013. But that period included an extraordinary boom from 1991 through 2006, when New York experienced a dramatic decrease in crime, rapid gentrification, a stock market boom, a real estate boom, and a relentless climb in prices that resulted in real estate values nearly tripling. But a $1,000,000 home purchased at the end of 2003 and sold in 2013 would have appreciated only 7.5% in total, to $1,077,583, resulting in an actual cash loss of $480,238, all other things being held equal. (And these examples assume the current low interest rates!)

Going forward, it’s far more realistic to assume price appreciation consistent with long-term inflation of around 3% a year. In that case, our homeowners’ would suffer an overall loss of $223,226, for a total return of -112%, or -11.2% annually:

Sale Price $1,343,916
-Total Maintenance/Tax $(137,567)
-Total Repairs/Improvements $(15,000)
-Total Insurance $(20,635)
-Total Utilities $(27,513)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47037)
-Original Down Payment $(200,000)
=Profit/(Loss) $(223,226)

Fig. 2. Park Slope apartment at 3% appreciation rate.

Of course, both scenarios are still better than renting the same apartment. Assuming an initial rent of $3,000 a month, increasing 3% a year, ten years of renting the same apartment would cost $412,700, so you come out several hundred thousand ahead by buying in either case. But that still doesn’t make your home an investment. After all, would you invest in something practically guaranteed to lose money, simply because it was less bad than something else? Of course not! You’d put the money under your mattress or in a shoebox instead!

Renting Out Your Condo: A Long Wait for Your Returns

So what makes a property an investment? That’s easy: collecting rent! It may seem self-evident, but, in a home, cash only flows out. In an investment property, it flows in, too. The investor’s primary inquiry is whether cash in will exceed cash out by enough to produce an attractive return on her down payment.

Let’s explore how this works. We’ll use the same assumptions for down payment, mortgage terms, maintenance/taxes, insurance, closing costs, and inflation. Unlike the homeowner, however, the investor receives rent and can pass on utility costs to tenants. The investor will also have vacancy losses and incur costs in repairing the apartment between tenants. Since our hypothetical 2-BR/2-bath apartment is in Park Slope, we will assume the rent is $3,000 a month to start and will rise 3% a year from there.

Sale price $1,343,916
+Total projected rents $412,700
-Vacancy losses $(16,942)
-Maintenance/Tax $(137,567)
-Repairs/Improvements $(35,000)
-Insurance $(20,635)
-Utilities $0
-Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47,037)
-Return of Down Payment $(200,000)
=Total Profit/(Loss) $180,046

Fig. 3. Renting out the Park Slope apartment.

Looks much better, doesn’t it? Over ten years, the investor has nearly doubled her money – a profit over $180,000 on an original investment of $200,000, for an overall return of 90%, or 9% a year. Pretty good, huh? Where else can you get 9% a year on your money these days?

But did you notice anything about the calculation? Mortgage payments alone exceed total rents![2] And the investor must also bear the cost of vacancies, maintenance/taxes, repairs/improvements, insurance, and closing costs. On an operating basis, this apartment loses $278,174 over ten years. That’s $27,817.40 that the owner must pay out of pocket each year just to keep this apartment long enough to cash in on the appreciation – if there is any! This is what’s known as “speculation”: you’re willing to pay cash out of pocket now because you speculate that you’ll make it back later on the appreciation.[3]

Buying a Small Rental Building – A Better Financial Bet, But Worth the Effort?

If you’re like me, you probably don’t want to finance possible future appreciation with cash from your pocket. So, what are your options? The key to making money in real estate is economies of scale. As you add units, your total revenue goes up faster than your costs. In New York, you need at least three units for the investment to begin to make sense, and for the same $1,000,000, with a $200,000 down payment, you could purchase a brownstone in Bedford-Stuyvesant with three 2 BR/1 bath units, each renting for $2,000 a month. This works out to $72,000 in gross revenue in the first year. At this level of revenue, your returns would exceed the condo scenario and you would be cash flow positive (barely) from Year 1. Because 3-unit buildings are considered personal residences and appreciate at the same rate as single-family homes, we will assume the same 3% annual rise for both property appreciation and rental income.

Let’s see how it works in this scenario.

Sale price $1,343,916
+Total potential rents $825,399
-Vacancy losses $(24,762)
-Repairs/Improvements $(68,783)
-Taxes $(57,319)
-Insurance $(22,928)
-Utilities $(68,783)
-Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(47,037)
-Return of Down Payment $(200,000)
=Total Profit/(Loss) $560,313

Fig. 4. Bed-Stuy 3-unit rental building.

This scenario looks much better, doesn’t it? Your total return of $560,313 represents a 280% (28% annualized) return on your original $200,000 investment. Best of all, rather than taking cash out of your pocket to pay for operating expenses, you would make $2,767 in the first year. What an improvement over shelling out $28,000 a year waiting for that Park Slope condo to appreciate!

This rosy scenario requires one caveat: it assumes that you are managing the property yourself. You have to collect rents, pursue deadbeat tenants, and take the 2:00 am phone calls when the upstairs toilet overflows into the apartment below! You may want to hire a management company to do all this for you, but beware: for a building this small, they are likely to charge 10% of top-line revenue, reducing your overall profitability by $80,064 over ten years. And, worse yet, all of this comes out of operating profit, meaning that you’ll be shelling out money to cover operating costs until Year 5, when you finally make a profit of $1,287 bucks for the year! But, for the price of about $8,500 over the first four years, you’ll have peace of mind from knowing that someone is dealing with the hard part of your investment. And, by year ten, even with property management in place, you’ll be putting almost $10,000 in your pocket each year without doing much of anything. If you now have an eight-year old child, that amount should just about cover the cost of their first-year college textbooks!

The Best Real Estate Investment Bet: Bigger Properties, Farther Away

In the professionally managed brownstone scenario, you would run small losses in your first few years and put extra money in your pocket after that. That’s better than paying money out of pocket for the entire holding period, but it would not be of much interest to a serious real estate investor. To produce the kinds of real estate returns that a professional real estate investor expects, you would need to buy a building with far more units, in a place where the cost of real estate is lower relative to rents than in so-called “gateway” cities like New York or San Francisco.

There are markets in the US, particularly in the South and Midwest, where you can purchase a 25-unit building for the same $1,000,000 as a Bed-Stuy brownstone. And when you own this kind of property, even with a management company in place – which will be necessary if you are owning property far from where you live – the expected returns will be far greater than you could ever get at the same price point in a gateway metropolitan area.

Let’s assume that you purchase a 25-unit property in South Carolina for $1,000,0000 with $200,000 down, and that each 2BR/1 bath unit rents for $600 a month. You will have additional expenses, like service contracts, payroll, and capital reserves imposed by the bank. However, not only will rents far exceed expenses, but you will also be able to pass back some expenses like utilities to your tenants. Over the same ten-year period, your returns will far exceed what you could expect to get on the Bed-Stuy brownstone:

Sale Price $1,132,154
+Total Rents $2,183,869
-Vacancy Loss $(109,193)
+Utility Chargebacks $53,737
-Contract Services $(286,597)
-Repairs & Maintenance $(143,298)
-Payroll $(338,184)
-Insurance $(114,639)
-Utilities $(214,948)
-Management Fee $(148,989)
-Administrative Expenses $(85,979)
-Capital Expense Reserve $(75,000)
-Total Mortgage Payments $(480,730)
-Remaining Loan Principal $(638,660)
-Closing Costs $(39,625)
-Return of Down Payment $(200,000)
=Profit/(Loss) $493,916

Fig. 5. South Carolina 25-unit rental property.

Look at your profit now: $493,916 over ten years. That’s a 247% return on your investment – almost 25% a year on an annualized basis. Even though your sale price is lower in this scenario (because operating income, rather than simple appreciation, determines the price of commercial real estate), your overall profits are far higher because your total rents further exceed your total expenses as a result of adding more units. You make a 7% cash-on-cash return on your investment in the first year – $13,843 into your pocket. And after ten years, in this scenario, you will put away $34,999 a year before taxes, an annual return of 17%. That would put a big dent in college tuition! And the best thing about this scenario: other than buying and selling the property, the hardest work you’ll do is depositing the checks from your property manager.

REITS, Private Equity/Hedge Funds, and Syndicators

Collecting checks on your southern property sounds great, doesn’t it? But there are a few drawbacks and obstacles to investing this way. You’ll need to develop relationships with brokers and local lenders, which could be hard at a distance. You’ll need to learn how to conduct due diligence and invest the time to do it thoroughly. You’ll need to hire experts to do building inspections and environmental reviews, and you’ll have to pay them even if what they find causes you to back out of the deal. Banks may require you (or your partner) to have a net worth of at least the amount of the loan – $800,000 in our example – not including the cash you’re putting down for the down payment. And, even if a bank will lend you the money, the loan application process is very time consuming.

If you don’t have the time, inclination, or net worth to do a deal by yourself, but you still want to invest in real estate, there are still many good options for you: REITs, hedge funds/private equity funds, and syndicators. In all three cases, you’ll be a purely passive investor with no responsibility for finding and executing deals, and, as with stock, your liability will generally be limited to the amount of your investment. Each type of investment platform has distinct advantages and disadvantages.

REITs are a good alternative for most people. REITs tend to invest in multiple properties in multiple locations to provide diversification, and some REITs further diversify across asset classes, such as multifamily, hotels, industrial, office, and retail. Many REITs are publicly traded, so you can liquidate your investment at any time, as with any other stock. Many REITs have long histories and public track records, giving you some comfort that you know who is getting your money. But there are downsides too. Once the REIT has your money, it has complete control; you can’t pick and choose among its properties. In addition, because REITs must quickly deploy the funds they have on hand, they sometimes cannot wait for the very best deals or market conditions. Overall stock market sentiment can also affect the price of a REIT share, so the value of your investment could decline even if the underlying real estate holdings retain their value. Like mutual funds, REITs charge management fees that can eat into your returns. And, finally, if you are the type of person who is excited by the idea of owning a building, you won’t find it much fun to own an infinitesimal piece of a building along you’ve only seen in an annual report.

Hedge funds and private equity funds specializing in real estate operate like much like REITs. They often invest across different geographic regions, and some further diversify by investing in multiple property types. Like a REIT, the investor lacks control over where their money goes. Unlike REITs, shares are not publicly traded and are not liquid assets. The funds charge higher fees than REITs, typically 1-2% of funds under management as a management fee, plus 20% of the profits. Finally, hedge funds and private equity funds typically require very large minimum investments of $500,000, $1,000,000 or more.

Syndicators operate like hedge funds and private equity funds, except that they typically do one deal at a time, so each “fund” consists of a single property. Syndicators have certain advantages for the smaller investor wishing to get into real estate. The minimum investment size is smaller than hedge funds and private equity, typically $100,000, $50,000 or less. Moreover, most syndicators do not look to their investors for funds until after they have found a property and put it under contract, meaning that investors can decline to invest in any deal they don’t like. Syndicators also often take the initial risk, putting up their own funds to pay for due diligence, legal fees, bank application fees, etc., meaning that if the due diligence turns up something bad or the bank rejects the loan, the syndicator is out of pocket. Because they operate this way, syndicators tend to be cautious about the investments they make, limiting them to assets that will be attractive to both mortgage lenders and their equity investors. Finally, some syndicators will provide investors with “major decision rights” over large events like selling or refinancing the property.

However, there are important disadvantages to syndications as well. Your money is tied up in an illiquid asset for 5, 7, or 10 years. In cases of extraordinary uninsured repairs to the property, the investors may be required to fund the repair costs through a capital call. Unless you invest in multiple syndication deals, your real estate investments will not be diversified. Syndication fees are comparable to hedge fund and private equity fees. And, because the track records of syndicators are not public, you won’t have a large company or a “brand” to rely on, so it’s important that you investigate the syndicator and feel comfortable with him or her before investing.

Real Estate Is a Great Investment, But Your Home Is Not

J.P. Morgan[4] recently concluded that, from 1977 to 2012, US commercial real estate produced “bond-like” stability with “equity-like upside.” Moreover, because properties collect rent even during downturns, $100 invested in commercial real estate for 5 years only during down periods would have grown to $110, while $100 invested in the S&P over its down periods would have declined to $94.  Because rents rise with inflation, commercial real estate provides an excellent inflation hedge, and it also tends not to be correlated with other assets: multifamily occupancies rose as a result of the Great Recession. For these reasons, real estate is an important asset to add to your portfolio.   But don’t let the real estate sirens seduce you into “investing” in a new home. There are many reasons to buy rather than rent, but never mistake a home for an “investment.”

 

[1] Even if the couple paid cash for their apartment, thus eliminating all interest payments, their total return after expenses would be $326,831, or about 3% annually.

[2] This is typical in the “gateway” metropolitan areas like New York, Boston, and San Francisco, where rents and mortgage payments are so far out of balance. It is not true in other metropolitan areas, where they tend to track each other more closely.

[3] Now you’re thinking, “Aha! What a juicy tax deduction!” But even if you’re in a 50% tax bracket, the government is only picking up 50% of that out-of-pocket loss.

[4] J.P. Morgan Asset Management, “Real Estate: Alternative No More” (2012).

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Maximize Your Credibility To Get Your First Multifamily Deal

Everyone who has successfully broken into multifamily real estate (MFRE) investing will agree on one thing: Your first deal is the most important. Why? Because brokers, sellers and lenders will not take you seriously if you’ve never owned multifamily property. You’re a newbie, a tire kicker, a waste of their time. This situation presents a real problem: no one will do business with you when you’ve never closed an MFRE deal, and you can’t close a deal when no one will do business with you. In a very difficult profession, getting your first deal could be the biggest obstacle of all.  But you can overcome it.

The Problem: Newbies are Risky

Very few MFRE professionals want to do business with new investors because most newbies will waste the professional’s time, money or both.

The risk for a seller is that a property goes into contract but the deal does not close. Once a deal goes to contract, a seller must expend significant time and effort providing due diligence materials to the buyer, lender, and third parties such as surveyors, title insurance companies, and appraisers. It must deal with irate tenants upset over disruptions caused by the inspection process. The seller will incur unrecoverable expenses connected to the transaction, like legal fees. And, most importantly, the market may move against the seller while the property was off the market during the contract period. Thus, sellers are wary of new investors, who may not have the resources or qualifications to close the transaction. For this reason, a seller may reject a higher offer from a new investor in favor of a lower offer from a buyer with a history of closing deals.

For brokers, the buyer’s ability to close trumps everything else. Brokers spend significant amounts of time and money preparing and marketing a property for sale. Once a deal goes under contract, they will also spend significant time helping the seller provide due diligence materials to the buyer. Most importantly, brokers are only paid if a deal closes. And almost as importantly, brokers risk their reputations with their clients, the sellers, if they bring unqualified buyers to the table.

Lenders also see significant risks in dealing with new investors. A very important consideration for them is the buyer’s ability to operate the asset properly and maintains its value as collateral for the loan. Lenders favor buyers with a history of successfully operating multifamily properties, and some lenders will even require a borrower to have two or more years of prior operational experience, regardless of the deal’s inherent attractiveness or the buyer’s creditworthiness. Sellers and brokers also know it may be tough for new investors to qualify for mortgage financing, and for this reason as well, they may be resist doing business with them.

In reality, sellers and brokers have very few ways of determining whether an investor really has the resources and qualifications to close the deal. (Lenders will get your balance sheet, so they will know.) So, sellers and brokers have nothing else to go on but your past history. Even though closing prior deals is no guarantee that a buyer will be able to close this deal, sellers and brokers usually feel that a buyer with a track record is less of a risk than a new investor, whose ability to close is unknown.

The Solution: Build Your Credibility With Stakeholders

Just because you have no history of closing deals and running MFRE properties, don’t give up hope! Everyone in the business got past this hurdle. So can you. The key is to develop credibility as an investor even though you don’t have a track record. These steps will help.

You’re An Investor: Own It

A typical mistake new investors make is not to believe they are investors until they close a deal. If you don’t believe you are really an investor neither will anyone else. If you are devoting substantial time and effort to learning this business, then you are an investor.   Believe it, be it, and own it. Doubt yourself, and so will they.

Develop Your Knowledge and Learn the Lingo

For anyone to believe you are an investor, you must sound like one. You must master the essential concepts of multifamily investing and understand the profession’s vocabulary. If you don’t know the meaning of “cap rate” or “economic vacancy,” you had better learn now.

Fortunately, many educational resources are available, from books to websites to full-blown certification courses like CCIM. Broker packages are an excellent overlooked resource. Many brokerages allow anyone to register on their site and receive all of their offering materials. These materials are a treasure trove of information about how brokers and investors think. And while broker materials should be seen for what they are – sales materials – they are a terrific resource for helping you learn the lingo.

Leverage Your Own Credibility

Just because you don’t have a background in MFRE doesn’t mean that your background is irrelevant. In fact, it can greatly enhance your credibility with people in the real estate field. Did you graduate from a well-know university? Do you have an advanced degree? Do you have a prestigious professional job such as doctor, lawyer, banker, consultant, etc.? Have you successfully built a business in another field? Have you already built a portfolio of single-family homes? Whatever your background, you can mine it for elements that make you stand out as professional and accomplished, and these elements will help you establish credibility with people in the MFRE business.

Build A Team

If you really want to build your credibility before you go out and try to find deals, you must build a team of professionals. In addition to the management company, you will need a real estate lawyer to help you negotiate the purchase contract and close the deal and the loan; a real estate accounting firm to prepare tax returns and prepare financial statements; a surveyor; a title insurance company; and, if you are using investor money, a corporate and securities lawyer to prepare the proper legal documentation for investors. Having these professionals in place in advance will show brokers, bankers, sellers, and investors that, even though you are new, you are well prepared and serious about this business. It will enhance your credibility, as well as make it much easier to close the deals you do find.

Cloak Yourself in Others’ Credibility

If all these steps fail, you still might be able to gain credibility by borrowing the credibility of an experienced partner or mentor. If you can show deep knowledge and real dedication, you may be able to find a veteran who is willing to help you. But be forewarned: this is not easy. Most newbies know nothing, are unreliable, and frankly are more trouble than they are worth. And an experienced investor will be very reluctant to risk their reputation on you. So you will have a great obstacle in convincing someone to mentor you. At the very least, you will have to do all the hard work on the deal and give away a very large piece of the upside. You might even be left with only a tiny sliver of the equity in your own deal. But, if you can pull this off, the mentoring, experience, and credibility you receive along the way – and getting that all-important first deal done – will more than make up for it.

Cultivate Relationships with Brokers Ahead of Time

Brokers are the gatekeepers in the business, as well as enormous sources of information, and you must make them your allies before you actually need them.

  • Brokers are like everyone else: they prefer dealing with people they know. Build relationships with brokers before you start looking seriously at properties, so when you’re ready to buy they are already on your side.
  • If you can, meet brokers through personal introductions. Ask your network if anyone knows a commercial broker. An introduction from the broker’s business acquaintance is helpful, but an introduction from a mutual friend outside the business is even better. Either will provide you with a level of credibility that a cold call never can.
  • Do your homework before you meet a broker. Make sure you speak the language of the business. Google the broker, learn about his background, and study his current listing materials thoroughly. Demonstrating deep knowledge of him and his business will help you overcome any resistance he has to working with you.
  • Once you’ve met a broker, don’t wait until you need a deal to call him again. Build the relationship now! Take him to lunch or coffee periodically. Tell him about your plans and demonstrate that you understand the business and the market. Most importantly, show a personal interest in him. Learn about his family, interests, and personal problems you may be able to help solve. It’s Networking 101, and works with brokers too. If you show interest in their success, they will take an interest in yours.
  • Try to solve a lingering business problem. Ask the broker to show you old deals that never got any offers or fell out of contract – in short, deals he had given up ever making money on. Even if he’s not yet willing to trust you with one of his sweet deals, he may take a chance on you with one of the dogs. Put together a creative offer that shows you understand the difficulties of a dead deal; if it’s good enough, he will become your advocate with the seller. And, if you close the deal and make him money he never thought he’d make, you will become a go-to client.
  • Don’t waste the broker’s time! Don’t overstay your welcome and make them think you are a time-sucker. Keep your meetings short. Leave the broker wanting more.

Demonstrate Your Credibility to the Seller with Proof of Funds

A seller may refuse to deal with you if he doubts your ability to close the deal. One way to overcome this doubt is with “proof of funds.” If you, your partners, or your investors have the funds available for the equity portion of the purchase price, offer to get a letter from an accountant or bank attesting to this fact.   If a seller sees proof of funds, it may put their doubts about dealing with you at rest.

Demonstrate Your Credibility to Lenders With A Professional Management Company in Place

Having the right team in place can help you overcome lender resistance as well. Lenders may feel it’s too risky to lend to a new investor with no experience running a multifamily property. One way to overcome this is by having a partner with experience operating properties. Another way is to install an approved professional third-party management company to run the property’s day-to-day operations. If the lender knows that the asset is in professional hands, it may be more likely to lend on your first deal. Depending on the size of the property, you will have to pay somewhere between three to ten percent of revenue to hire a qualified manager, but on the other hand you won’t need to take the 3:00 am calls about backed up toilets.

 A Word About Lenders and Your Personal Net Worth

Another issue faced by multifamily investors is qualifying for a mortgage. MFRE is considered commercial property, and, unlike residential mortgage lenders, commercial lenders require a borrower to have a net worth equal to or greater than the size of the loan they’re making, regardless of the value of the deal. If you’re seeking a $500,000 loan, you will need a net worth of at least that much to qualify. If you do not have the requisite net worth, then you will need a partner who does. You will have to share equity in the deal, but bringing on such a partner will help you get the deal done. You will need to have financially strong partners in all your deals, and give them equity, until your net worth has grown to the point where banks will lend to you on your own.

In the End, It All Comes Down to Networks and Teams

You’ve probably heard it before, but real estate truly is a relationship business. If you are serious about investing in MFRE, then you must spend the time and effort in developing a team of professionals and a network of brokers, bankers, and potential investors in advance. The time and effort you invest in building your network and your team will not only help you find that first deal, but it will also help you to close it, finance it and operate it successfully.

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