via Brandon Turner, BiggerPockets.com[April 24,2014] “On today’s episode of the BiggerPockets Podcast, we sit down and chat with a real estate investor who wasn’t seeing a lot of action in his business – until a friend challenged him to take his investing seriously and start treating it like a business….Our guest today, Tim Gordon, accepted the challenge…”
Have you been searching for an alternative to the ups and (mostly) downs of the stock market? Are you interested in the growing trend of using retirement funds to invest in real estate, tax liens, precious metals or other alternatives, but feel intimidated by self-directed IRAs?
National Education Specialist John Bowens from Equity Trust Company will provide an easy-to-understand overview of self-directed IRAs, which will include:
• How to tap into IRA and 401(k) funds to make more deals than you thought possible
• How investing with self-directed IRAs equals tax-free or tax-deferred profits
• How to possibly qualify for large tax deductions
If you’ve been thinking about taking control of your retirement savings, now’s the time to start!
Deeper Analysis of a Potential Apartment Purchase
By Les Goss
After using a property’s annual income and expense data, combined with the local cap rate to determine value, most offerings will be set aside as the unrealistic dreams of a deluded seller. Occasionally, however, a property will pass our first scan and deserve a second look. So what are the next steps to determine if we’ve really found a keeper?
The first step is to dig more deeply into the financial reports released by the seller. The critical thing to watch for here is to separate the actual figures from the pro forma numbers. Every seller, with the help of their broker, will attempt to paint the rosiest picture possible. You’ll do the same when it’s time for you to sell.
As an example, I’ll use information pulled from the most recent offer to cross my desk via Loopnet, a 28-unit C class apartment in Colorado Springs, offered at $1.3 million.
The Annual Property Operating Data (APOD) is a one-page summary of income and expenses. It calculates the Net Operating Income (NOI) as well as the cash flow before taxes. This particular APOD shows a cap rate of 8.79%, certainly within the current range of 8-9% expected for this class of apartment in this town in this year. It also lists the cash flow as $114,280 per year, or just over $9,500 per month. Assuming you paid the asking price of $1.3 million and put down 25%, or $325,000, the cash-on-cash return would be 114,280/325,000 or 35.2% So far, the numbers look promising.
But let’s look a little deeper. One of the easiest tricks to play is to merely leave some lines of the APOD blank. It’s easy to overlook something that is not even there. On this APOD there is a line for Management Services, but there is no number next to it. Even if you choose to manage it yourself, you should put a value on your time and effort. As it turns out, last year $8,300 went to this line item, which represents a 7.2% charge, reasonable in this market for this size property. Of course, underestimating your expenses, in this case by leaving one out, has the effect of increasing the NOI, which drives up the property value.
The other sin of omission occurs here by neglecting to include the annual debt service. Using the broker’s assumptions of 25% down and a 4.5% interest rate, the total mortgage payment is $60,800 per year. This is subtracted from the NOI to get the actual before-tax cash flow, which now drops to $53,480. This makes the actual cash-on-cash return 16.5%, definitely decent but less than half of what was shown on the APOD. Leaving out the management fee and the debt service has the effect of making this deal look much better than it actually is.
Now let’s look more closely at the income assumptions. The APOD has a note indicating that the current market rent for one-bedroom apartments is $495 per month. Since all the units in this apartment are one-beds, it’s easy to calculate the Potential Rental Income as $166,320 per year (495x28x12). However, in another part of the sales package labeled Income Summary, we find that less than $110,000 was actually collected in rent last year. Why the huge difference? Well, the current rent roll shows that 17 of the 28 units are paying $425 or less per month and only 2 are paying the full $495. What gives? Is the current owner asleep at the wheel, or is there something lacking in this property that prevents him from getting market rent? This is definitely something a potential buyer needs to explore in some depth. In fact, using actual numbers from last year, the cap rate at the asking price is only 4.7%!
Moving on from the financial analysis, we need to envision all the ways we can add value to the property. One of the easiest and most obvious ways is to improve the curb appeal. Potential renters won’t even slow down if the place looks like the owner fell asleep in the 70s and never woke up. A new top coat on the parking lot, well-trimmed and manicured landscaping and perhaps a new exterior paint job can make an apartment look like new almost overnight. Of course if the property has been a low-vacancy eyesore for a few years, changing the name and putting up new signage lets people know a new owner who actually cares for the property is now in charge.
Once you get a prospect inside, they will compare the perceived value to that of other apartments they’ve looked at. This is where your personal market research comes in. What amenities do other properties in your rental range have? Will you need new kitchen cabinets or will a paint job and new hardware be sufficient? Will you opt for new carpet or will you try the linoleum that looks like a hardwood floor? New lights in the kitchen and bathroom can add pizazz for very little cost.
Windows are a controversial topic among owners. If the residents are paying for utilities, it doesn’t directly help the owner to put in new ones, which is why you see so many older buildings with original windows in place. On the other hand, new double pane energy-efficient windows, along with uniform new blinds, can instantly improve the curb appeal. You can also tell prospects that their utility bills will be lower and their apartment quieter and more comfortable. It’s also one more thing the person who buys from you won’t have to pay to replace. In addition, there may be utility rebates available that lower your net cost if you choose to install them. Needless to say, all these expenses must be accurately estimated and still have all the numbers work. If a property has a lot of deferred maintenance, you must factor that into your offer or it’s not worth buying.
The bottom line for all this is how much can you raise the rents? Can you raise them enough to justify these expenditures? Can you buy it cheaply enough to allow these upgrades? You’ll definitely want an experienced member of your team to help you make these decisions when you’re first getting into this.
Finally, you need to look at the operating expenses to see if there are ways to reduce them. Running a more efficient, smarter operation can lower expenses. Do you need a full-time employee or can you outsource many of the operations? Can you charge back your residents for common area water, gas and electricity? Are they being charged for their share of trash pickup? Your market may put limits on how much of this you can do. You might also experiment with a lower rent plus these utility chargebacks versus a higher, all-inclusive rental figure to see which is more enticing to your prospects.
Once you’ve done your quick 5-minute evaluation of the numbers, most properties will be revealed as the duds they are. The ones that pass that first screening are ready for this more in-depth analysis. Once they pass this, it’s time to submit a Letter of Intent and let the negotiations begin. Have fun and good luck!
Les Goss is a real estate investor and syndicator in Colorado Springs, Colorado. You can learn more about investing in apartments and the Colorado Springs apartment market specifically by visiting his blog at http://www.ColoradoSpringsApartmentInvestor.com
The Great Sub-Market Debate
Experienced real estate investors know that the investment value of a property is predetermined by the cash flows generated from the property. These cash flows are both incoming and outgoing. If the demographics surrounding the property are strong, this helps to reduce vacancies, thus improving the rate of uninterrupted cash flows during the holding period.
These are basic fundamental real estate principles. They are real, and they are timeless. It makes no difference if a property sits in a core market, or a sub-market. If the market is vibrant with strong employment, demographics, and the numbers make sense, then you know you have a deal worth considering. Oddly enough, many REITS shun properties located in sub-markets without even a second thought.
A Brief and Generic Case Study:
What if you found a property that could generate enough cash flows to produce a 34% return on investment within five years?
Let’s take a closer look at this scenario:
Here are the cash flow projections for this particular property:
The CASH FLOWS:
Initial Equity (Year 0) ($3,400,000.00)
Year 1 $405,404.00
Year 2 $477,993.00
Year 3 $549,149.00
Year 4 $625,329.00
Year 5 $706,891.00
Resale Value $23,843,379.00
PV @ 15% $22,621,466.24
Less Mortgage Bal ($12,552,132.00)
Net Present Value $10,069,334.24
Return on Investment of $3,400,000.00: 34%
Big Buyer Group Think: Location over Profitability
For all accounts and purposes, this looks like a profitable scenario. However, many institutional investors–including REITs–would not even look at this deal because it is located within a sub-market. I understand the perspective that asks the question, “Why should we pay a 6% cap rate for a property in a sub-market when we can purchase property at a 6% cap rate in a core market?” However, I would like to point something very important to all the smaller real estate investors out there. Leaving money on the table without consideration is a big mistake.
When smaller real estate investors begin to recognize the money that has been left on the table by the larger institutional buyers. It is indeed a “blue ocean” of opportunity, because the big companies are too inflexible and too rigid to recognize opportunity outside of their normal view of the way things are. In May of 2011, Mortgage Banking Magazine quoted Alan George–the CIO of apartment REIT Equity Residential, “…there were so little class-A assets. There were so few nationwide in core markets that it was a completely useless endeavor,” George said. “There are distressed assets, there still are in some of these tertiary markets, but who wants to buy those?”
I beg to differ by answering the question, “who would want to buy golden opportunities in strong submarkets?” Why, smart and experienced real estate investors would, because they know to look at the numbers and surrounding economic factors of the area. A strong market is a strong market whether it is a core or a sub-market.
To the smaller real estate multifamily investor, I say, there is a blue ocean waiting to be captured. Use the “big-buyer group think” syndrome to your advantage.
Amazingly enough, this question surfaces a lot in the course of the business week.
The answer comes in the form of a question:
Why should opportunities be brought to buyers that are not willing to establish business agreements upfront, which is the only fair and honorable thing to do.
There are two sides to every story. It all starts with the establishment of mutual trust, respect, and professional courtesy. There is a written process in place to accomplish this. We warmly welcome all honorable multifamily investors that respect this process. All others should not waste our time.
For the second year in a row, the Federal Housing Administration is extending a temporary waiver of its “anti-flipping” rule, meaning homebuyers relying on FHA-insured financing will continue to be able to buy homes that have changed hands in the last 90 days.The waiver is a boon for investors seeking to rehab and flip properties, because it expands the pool of eligible borrowers to include those relying on FHA-backed loans, popular with first-time homebuyers and others who lack the cash to make large down payments.
Fannie Mae is implementing a structured sales program involving significant sales of real estate assets in the form of either pool sales or joint venture transactions.
Any structured sales under this program are expected to be significantly larger than our existing pool sales described on our “For Investors” page. Joint venture transactions are expected to allow qualified investors to purchase a controlling equity interest in a newly formed investment vehicle created to hold multiple properties in one transaction. The qualified investor would be responsible for the management and servicing of the assets, and would be an equity partner with Fannie Mae. Pools may be national, regional, or geographically focused, subject to post-closing asset management strategies and restrictions, and consist of vacant and / or occupied (including rented) properties. Sales of controlling equity interests will be limited to qualified investors.
I have read some very inspirational books over the years. A few of my favorites are the 7 Habits of Highly Effective People by Stephen R. Covey, the Speed of Trust by Stephen MR Covey, and the Power Principle by Lee Blaine just to name a few. After many years of reading these books, a new paradigm has taken hold and it became a lens from which certain observations became crystal clear to me. One of my most recent observations is the apparent low trust culture that seems pervasive in the multifamily marketplace where one can spend a significant amount of time getting past time-wasters and getting to the people that work honorably.
This low-trust culture adversely affects the vitality of business, and the continuity of meaningful communication. Operating from within a low-trust culture drains energy and wastes a lot of time for everyone involved. It slows the attainment of effective results, and it cripples entrepreneurial agility. Even in the instantaneous nature of the digital world, the pace of business will slow to a crawl unless people can develop trust and mutual respect in order to create an effective working relationship. It is the single most important thing to have in any working relationship because–without mutual trust and respect–communication becomes trifling, awkward, difficult, or non-existent, “The serious practical impact of the economics of trust that is in many relationships, in many interactions, we are paying a low-trust tax right off the top–and we don’t even know it” (Stephen MR Covey, The Speed of Trust: the One Thing that Changes Everything, 2008, p. 17). Covey (2008) suggests it would be better to build smart trust in order to consciously create a trust dividend instead, “I also suggest that, just as the tax created by low trust is real, measurable, and extremely high, so is the dividends of high trust are also real, quantifiable, and incredibly high” (p. 19).
Establishing Trustworthiness is the Key
Establishing trust requires honesty and diligence. Trust is not a “pie-in-the-sky” phenomenon. It is real, but it requires first achieving a sense of mutual understanding along with a degree of professional courtesy. The old adage says that we should become the change that we see in the world, and I wholeheartedly agree. I think when people work to demonstrate trustworthiness upfront, it goes a long way to reaching goals more effectively. The road ahead may be challenging, but the results will be well worth the price paid with effort, perseverance, and determination to achieve the best possible outcome for all.
Mutual Benefit is the Goal
Mutual benefit is the goal, but it cannot happen without honest communication. Without it, getting to the heart of the matter is next to impossible. The whole point is to build understanding and trust. There are many out there that do not believe that win/win relationships can really exist, “Most people have been deeply scripted in the Win/Lose mentality since birth” (Stephen R. Covey, The 7 Habits of Highly Effective People, 1989, p. 207). In order to transcend this, Covey talks about making a “paradigm shift,” (p. 23) in the way we perceive the world around us. It starts with one person, and it grows with every person that commits to the idea of transcending the level of dysfunctional interpersonal behavior that plagues the multifamily market.
Principle-Centered Power is the Way
In his book, The Power Principle: Influence with Honor, Blaine Lee (1997) explained three paths to power Coercive Power or “Controlling others through fear,” “Utility Power,” or “Let’s make a deal,” and “Principle-Centered Honor,” ( p. 15). Of the three, principle-centered power is the THE ideal form of power in which to operate from personally and professionally. The nature of business has a tendency to use “Utility Power,” where the association is good as long as someone has something that is of interest or of value to another, but the experience with principle-centered power is entirely different, “When you operate with principle-centered power, it invites others to feel, ‘I honor and respect what you are and what you’re about. Because of that, I voluntarily commit my life, my efforts, my resources to partner with you in achieving worthwhile things” (Blaine Lee, The Power Principle: Influence with Honor, p. 119).
I have been a Realtor since 1996. One thing I have noticed in my time in business is that—in general– the demand for rental housing goes up when the demand for home ownership goes down. The current economic climate in the housing market stems from a number of issues, but the most obvious is the increased difficulty for buyers to get loans. Loans are increasingly tougher to get because of stricter documentation requirements. This explains why the numbers in the housing market are indicating a growing trend towards renting as opposed to buying.
A recent article reported the increased development activity of multifamily properties (Mortgage Banking 2011), the article attributed the increase of multifamily development activities to the weakness in the single-family market(p. 92-93) and the increased availability of funds in the capital markets. Therefore, the worst single-family housing market in recent history is causing the best multifamily market to occur. The demand for rentals continues to grow stronger as more people begin to give up on the idea of owning. The National Apartment Association confirmed this trend when they reported revenue gains of 5.8 percent in 2011 for the multifamily industry.
In my local market of Kitsap County, things are tough for single-family home sales. The pool of qualified buyers has thinned out so much over the last few years, and it continues to shrink. However, multifamily development activity has increased noticeably in the county within the past few years.
Multifamily capitalizes on weak housing markets. (2011). Mortgage Banking, 71(10), 92-93.
This was my contribution to today’s class discussion in real estate finance:
Yes, it seems that only the most well-funded investment groups are taking full advantage of the current market. There are still a lot of investors sitting on the sidelines, but at some point, they will all need to realize that it still boils down to the numbers and how properties perform over the life of the holding period. Too much frenzy about “off-market” opportunities, and not enough energy spent on considering real potential deals that are out there in this inhospitable economic environment.
I think a distressed deal is a distressed deal whether the deal is on or off the market. Even non-distressed deals can become distressed in this economic climate. Why? Because, sellers of non-distressed assets are going to have to compete with the tremendous volume of distressed assets that have–and have not yet–hit the market. The environment is bad for many sellers, especially the ones that cannot refinance for whatever reason.
Whether on the market, or off the market. All deals are competing for the same pool of investors. I think there is too much focus on finding off-market deals, and not enough energy going into considering the factors surrounding a real potential opportunity; for example, considering the fundamental basics of net operating income as it relates to an after-tax “cash-on-cash” return (the only real thing that really matters in the end is the actual cash flow that makes it into the bank). Taking the current economy into consideration, a savvy investment group knows how to step into a deal to make smart and well-informed decisions in order to achieve record revenue figures.