By Summer Gell, Partner Engineering and Science Inc.
(MARCH 21, 2014) Multifamily housing investors’ options for financing sources have been shifting lately, and Fannie Mae’s recent major revisions to the Multifamily Selling and Servicing Guide–which went into effect in February 2014–are adding another layer of complexity to the multifamily lending landscape.
Fannie Mae’s Guide revisions included underwriting standard changes in addition to significant changes to the third-party engineering due diligence required for multifamily mortgage loans, more specifically the policies for Physical Needs Assessments (PNA, also called a Property Condition Assessment by other lenders) and Seismic Risk Assessments (SRA) for properties in high risk seismic areas.
The due-diligence or inspection period is a very important time when purchasing a property. The period allows you to access to the property onsite and makes records available so you are able to verify the information and perception you have about the property you’re about to purchase.
Before purchasing a property, it’s critical that you take the necessary actions so that you can make an informed decision on whether the condition, operations and financial picture of the property are as you were made to believe.
Many sellers these days are waiting to trade their properties at–or above–the asking price. When demand is up, the asking price is typically influenced by an over-enthusiastic market environment. This is especially true in multifamily right now, because it’s in demand. When demand increases, so does the willingness to pay a higher price; it’s the law of supply and demand at play. In support of the highest possible sales price, a broker–with input from the seller–will put together a proforma income and expense statement to justify the asking price. A proforma is only as good as the assumptions used to create it.
The problem with most broker proformas:
The biggest problem with most broker proformas is that they typically do not take into consideration the total cost of acquiring, operating, maintaining, and selling the asset when the holding period ends; without this information, a true assessment of investment value will be difficult to achieve. The success of a real estate investment depends on 4 major things (1) it’s basis, (2) it’s financing, (3) it’s management, and (4) it’s cost at disposition. Because of these facts, the risk profile of real estate—as an asset class—is higher than a treasury bill, for example.
With a higher risk profile, a higher rate of return is justified for taking on the increased risk. Therefore, an internal rate of return of 14 or 15% before taxes is a reasonable expectation for properties like multifamily; unless you are reducing your returns in order to accommodate an equity partners’ required rate of return. An investment that offers a low return for higher risk is an investment not worth undertaking because of its inadequate compensation.
Games people play
Brokers will give you proformas without taking into account the true cost of ownership including acquisition and disposition costs. It is a half-ass approach, and half-baked idea, and yet brokers–along with some sellers–do this all of the time. In my own deals, I make it a point to explain why my offers are not where they want it to be. Typically, when I do this, they can see the logic. The reactions I get will vary depending on the character and personality of the person I am dealing with; for example, one broker’s voice suddenly went up an octave as he started talking really fast to get off the phone with me, and then never returned my phone calls or emails.
In another instance, a broker blatantly lied to me arguing that she had already received an LOI from an interested buyer at the “minimum price” the seller was supposedly willing to accept. When I withdrew my company’s interest, the truth came out. For this reason, we have had to incorporate a policy to only deal with decision-makers directly in order to avoid the greedy and costly games that some people will play in the middle of a deal to milk the most fees and commissions they can from it.
Today, I found a real estate article by ILYCE R. GLINK AND SAMUEL J. at the Washington Post concerning the need for buyers to be careful when considering the purchase of a bank-owned property. The information is timely; as there seems to be a sense of entitlement and expectation among banks that believe buyers should pay close to market price for properties requiring significant rehab work and/or serious environmental remediation like mold, asbestos, lead paint, etc. The way banks have been, they would prefer to transfer some or all of their losses to a buyer, if they could. Bank REO departments would not be doing their job if they did not try to do this. However, there is a line that often gets crossed where it concerns fixers that require a significant amount of repairs. This article is right on point by warning buyers to beware when considering bank-owned foreclosures by pointing out that when homes sit vacant for a long time, this is the time when new problems can develop. Mold is one problem common to vacant homes in regions where there is a lot of rain. Mold can be a costly problem; especially when there is a bad roof, or if water is seeping through the walls into house. These things are not always visible, but a certified inspection report can alert you to the need for a more specialized inspection.
When there are severe problems, these problems should be accounted for in the sales price; otherwise, there is a risk of overpaying on account of significant rehab costs, and resulting interest expense. The result of overpaying for properties is–at best–a break even scenario; or it can mean the assumption of a portion of the banks’ losses. Proper investment fundamentals say that an investor should earn more of a return for the increased risks taken. Some fixers are higher risk than others; especially environmental issues that require the investor to deconstruct a house to the frame in order to treat and eradicate a serious mold problem.
“When you buy a bank owned property, you take risks. The bank has not lived in the home and the bank doesn’t have knowledge about the home’s history. You, as the buyer, must take extra care when buying a foreclosed home” (Glink and Tamkin, 2013).
The Point of Sale Inspection required by many cities in Cleveland is a way for cities to keep their aging housing stock from falling further into disrepair which affects all house values in the neighborhood. Here’s how it works: As a condition of transferring title at closing, the seller must either show evidence that the violations have been corrected or escrow enough money to have the buyer fix the violations shortly after closing. A couple of examples of violations would be peeling paint on the outside of the home or a chimney that needs re-pointing. The Point of Sale Inspection has proven to be a very effective tool in keeping houses maintained and house values high. Other cities around the US should learn from Cleveland’s success and adopt a similar policy to help maintain the value of their housing.
Of course you want to minimize your expenses throughout the entire acquisition process, especially during the first thirty days of the due diligence. In reality, you may end up going through the property inspection process several times before you find the property that you are eventually going to own, so best to keep your costs as low as possible every time you evaluate a dealHere’s the first rule: Don’t write a check during the first two weeks of the due diligence process except for the earnest money deposit – but that’s a given.Just don’t do it.