Create interdependence: No one wins unless everyone wins. Period. This is the best way to get a team to function like, well, a team. It also fosters insights, flexibility, and resilience. Create shared metrics. Partner team members from different disciplines. Have members with similar skills swap tasks often, even in the middle of working on a deliverable. Share responsibilities, ideas, concerns and alternatives. If these principles make sense to you, you might want to give them a try. But I’d like to suggest you do so only on one condition: that all team members voluntarily want to adopt these principles. via Four simple principles for highly effective teams | LinkedIn.
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
Whenever I talk to real estate investors who are just starting out on their journey to financial independence, I encourage them to build their knowledge through the many educational resources available that teach people how to build financial security in their lives.
My specialty is being an advocate for the buy-side of investment property purchase transactions for investor-clients. This has been a mission for me since 2003 when I became truly independent of the buyer/seller representation model of traditional real estate companies. Income property does not serve its intended purpose if it does not produce positive cash flow. The same can be said if the income produced does not meet an investors financial goals. Education is the key.
No matter who we are or where we come from, the road to creating financial security begins with obtaining good information, informing ourselves through the pursuit of financial education, and expanding our financial literacy. As a lifelong student of personal growth and development, I am always seeking out good educational resources to increase and expand my professional expertise and financial intelligence, as well as teach and share my experiences with the people I serve best…my valued clients, family, and friends.
Here is a video from the Rich Dad company with co-founder Robert T. Kiyosaki talking about three types of education. Enjoy!
1. Assess Your Situation
(a) Know What You Need and Want
The first item to consider is whether real estate is right for you. It is not for everyone, but if you find that real estate investment is what you want, then designing a real estate investment plan is the best place to start. From a cash flow perspective, identify what your current monthly expense requirements are and how much income you need every month to maintain your current lifestyle. Once you have this figure, consider where you want to be in five, seven, or ten years, etc. How much monthly cash flow will it take to support this future goal? Then add this to your current monthly expense figure and you will have a starting point for your cash flow goals. This figure will most likely change as you begin working your plan and making periodic adjustments to your goals.
(b) Assess Your Direction and Identify Your Preferred Property Type
Within real estate, there are different property types from which to choose from, for example, single-family rentals, multifamily rentals, office buildings, industrial office buildings, warehouses or public storage, retail properties, etc. Each property type has its own unique considerations and operational requirements.
Researching and learning how to operate that particular property type means having the knowledge to manage the management team from an informed position.
(c) Know What Kind of Financing is Available
While the mortgage market recovers from its recent meltdown, financing requirements will remain tight, but there are still options available to facilitate purchases, such as seller financing and lease options. Learning about the different financing options available is a key factor in planning a real estate investment strategy. Financing can mean the difference between a good and bad deal. Before the mortgage crisis, lenders commonly required a 1.20 DCR or “debt coverage ratio”–meaning, they would require 20 dollars of income for every dollar of debt that the property carries. With this information and a property’s net operating income, you can calculate maximum loan amounts and minimum equity requirements (aka. down payment) for any income producing property. This can also help determine whether a property is overpriced and at what price the property will yield your required rate of return.
(d) Set Your Required Rate of Return
If you want your money to work harder than a savings account or a CD, then determine your required rate of return upfront and use this rate to calculate the investment value of a property based on its net operating income. This maximum amount will be the point where you will draw the line on any particular investment. When a seller is not agreeable to your maximum price, then it is time to walk away and find an investment that will fulfill your investment requirements.
(e) A Word About the Tenant Landlord Law
If you are considering single-family and/or multifamily rentals, then you will need to become familiar, if not well versed, in Tenant Landlord Laws. Having a set system that keeps you in compliance with the law is a wise investment of time and money. Management companies and real estate attorneys can be helpful in this area.
2. Set Minimum Property Requirements and Limits
From a cash flow perspective, the ideal situation is to start receiving rents the following rent period after closing. If you have to gut and rehab a building entirely, there will surely be a period of downtime and you may have to support the property until you are able to lease and begin receiving income. If your goal is immediate cash flow, then a major rehab project may not be the right project type to consider. Instead, a well-maintained property or one that needs a minor amount of cosmetic work with a steady tenant history is the ideal property from a cash flow perspective.
3. Assemble a Stellar Team
Assembling a team of professionals dedicated to your financial success in real estate is a key component in realizing your cash flow goals.
The Real Estate Broker – A buyer’s broker who is also an experienced investor, if you want to avoid dual agency, then find an exclusive buyer’s broker to work with.
The Mortgage Planner – A mortgage planner that specializes in investment and commercial properties
The Financial Planner – A financial planner with a positive perspective towards-and a full understanding of-real estate investments
The Real Estate Attorney – To review all loan and closing documents before signing, as well as any contracts or agreements-this is a CYA (Cover Your Assets)
The Management Company – A professional management company with a solid reputation will free your time so you can live your life and look for more properties to buy
The Property Inspector – This team member should have experience inspecting your chosen property-type.
4. Real Estate Investments Are About the Numbers
Leave Emotions at Home
Buying a real estate investment is about making money with property-not falling in love with property. This is especially bad, if the seller becomes aware of the infatuation. Investment real estate is about what it can do to bring you closer to your income goals, period.
5. Buy Properties Right
List Price Does Not Set Property Value
Regardless of the price, you see on a listing, a property’s investment value will vary between investors because his or her required rate of return will be unique to each situation. Therefore, a list price is just an asking price. Set your required rate of return and make an offer accordingly. If meant to be, the seller will either accept or open up negotiations. If not, then it will be better to walk away than to end up with a property that does not meet your investment goals.
6. Periodically Re-Assess Your Direction and Make Adjustments as Necessary
If you started out with single-family rentals, you may decide to upgrade and own small multifamily buildings. If you own small multifamily buildings, you may decide it is time to buy your first 16 or 20 unit building, etc. The point is to keep your eyes on the horizon for new opportunities to grow your knowledge and portfolio of income properties. With experience comes confidence and with confidence comes new learning opportunities that will continue on a path of limitless growth. When it comes to learning, growing, and evolving we limit ourselves by the barriers we place upon ourselves.
. Cash Flow Strategy: Buy Right and Hold Long-term
The key to building cash flow through real estate investments is to buy properties that satisfy your investment requirements upfront and holding them for the long term–a minimum of five years or ideally ten years. Have an exit strategy in place before the property approaches the end of its holding period. Start learning about 1031 tax-deferred exchanges and speaking to a specialist who can help guide you through the process well in advance. Being familiar with the process will ensure a smooth exchange transaction and preserve your wealth-building strategy when the time comes. Your accountant, tax attorney, or a financial advisor well versed in the area of 1031 exchanges can provide you with more information.
In closing, real estate investing can be a very rewarding experience. It requires planning and knowledge, but the end-result can secure your financial future. Education and motivation are key factors in building wealth and achieving financial independence.