NATIONAL REAL ESTATE INVESTOR
(MARCH 22, 2014) Excerpt
When we think of LEED, we typically think in terms of class-A office buildings in the CBDs of our nation’s top-tier cities, such as New York, Los Angeles or Chicago. But what about the vast stock of existing buildings outside of that profile? What are the sustainability options for class-B assets in the outskirts of St. Louis, or an existing multifamily property in Oklahoma City? Where do they fit within the relatively narrow spectrum of potential LEED ratings and programs?
The fact is that LEED certification fails to address our nation’s huge inventory of multifamily buildings. Neither does it allow for many assets that are not class-A or better.
In fact, our research shows that, of the total commercial real estate stock in the United States—roughly 84 billion sq. ft., according to CoStar, not counting specialty, sports and entertainment facilities—LEED certification addresses only 3 percent of the inventory. That essentially excludes something on the order of 81 billion sq. ft. nationwide and renders the program of no relevance to the vast majority of industry practitioners. LEED was and remains groundbreaking. But its scope is narrow and the math is inescapable.
By Omar Ruiz via Real Estate Investor Beat
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.
The U.S. apartment market continued to see robust growth in 2013, but investors are keeping a wary eye on looming changes going into 2014, including the impact from rising supply, rising interest rates and the prospects of restructuring the nation’s two biggest government-sponsored enterprises (GSE’s) Fannie Mae and Freddie Mac.
When supply increases; demand decreases. Buyers should remain sensitive to overpaying for multifamily properties in low cap markets, as the market continues to turn.
Don’t be the Greater Fool!
“Being overly optimistic in your forecasts can lead to artificially inflated NPVs (net present values). Thus, when in doubt, always look first to the marketplace for objective information about market rents and expenses, and a market-derived discount rate. A positive NPV may simply be an indication that either something has been left out of normal operating expenses, like reserves and replacements for a new roof or new fixtures, or market rents have been overstated” (Schilling, 2012, p. 142).
Responsibly Underwriting Investment Opportunities is the Key
In markets where cap rates are low, or in any other market, an investor must be diligent in their assessment of operating expenses and how multifamily listings have been underwritten. Operating statements that show no allowance for important expense items, such as, reserves and property management, can cause an advertised or stated cap rate to be inaccurate because it does not take into account these important variables. Likewise, if a property is an older building and the expense ratio is under 40% of its potential gross income (PGI), then chances are good that there is not enough is being allocated to the expenses of operating the property; because–in general–the older the building, the higher its’ maintenance costs.
When I see listings that do not show an allowance for important expense items such as the ones mentioned above, I see an overly optimistic assessment of investment value. When a seller is firm on price based on such deficient underwriting, I see a seller waiting for the Greater Fool to appear; and in a market where cap rates are low, there is a greater chance that they might be successful in finding such a person and/or organization, because there is a tendency in the market to be over-zealous following popular price trends–even when those trends do not make sense under fundamental investment logic; for example acquiring an apartment at a 4% cap rate.
“Price bubbles occur when today’s price depends solely on what other investors are likely to expect the price to be, and not on some forecast of future supply and demand. There is a good deal of evidence that price bubbles exist from time to time in most real estate markets” (Shilling, 2012, p. 38).
While it might be the trend of the day to acquire an apartment building at a 4% cap rate, it would not be the best place to be economically if mortgage rates were to suddenly rise above and beyond 4%. Additionally, real estate carries risk, and a 4% cap rate does not even begin to sound attractive for the level of risk taken to acquire, develop, and/or operate a sizable property. Perhaps this is the reason why more investors are turning to sub and tertiary markets for better yields that make sense. Considering the relationship between risk and return, a 4% cap rate is nonsense. As a rule, the more risk taken, the more return received; and rightly so. If more investors followed this rule, they would think twice before contributing to price bubbles in the inflated multifamily markets they help to inflate.
“Recognizing the existence of a price bubble is important. When an asset’s price exceeds the market fundamental price, rational investors generally will want to sell the asset because the utility gain would exceed the utility lost from holding the property forever. Eventually, of course, such a sell-off will lead to a decrease in demand, causing market price to fall. By contrast, when the actual price of the asset is less than the market fundamental price, investors can increase utility by buying the asset and holding it forever. This increased demand will eventually raise the market price, eliminating the negative bubble” (Shilling, 2012, p. 38).
Shilling, J. D. (2002). Real Estate. Mason: Cengage Learning.
Earlier this year, there were signs that construction would spike in 2013, in the order of 150,000 to 200,000 units. Developers have since postponed many projects to 2014, so that 2013 figures hover closer to 130,000 units – not far off from the pre-recession 10-year annual average of around 125,000 units. The “bubble” now shows up in 2014, but if economic growth ramps up, then additional supply will most likely be absorbed relatively painlessly.
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
LOS ANGELES-With the multifamily market being touted as both white-hot and a safe bet, a new trend is emerging in this industry sector: Small groups of investors who are inexperienced in owning and operating multifamily properties are outbidding savvier investors for these assets and driving up prices in the market. While this is good news for sellers—and who could blame them for shaking hands with the highest bidder?—CRE experts say it may not ultimately bode well for these investors and the market five years down the road, when rents haven’t risen appreciably enough to cover operating costs and mortgage payments, and these owners are forced to sell at a loss.
Apartment vacancy rates, now at a decade-low of 5.2 percent, never fell below 8 percent, even during the lowest point of the commercial property rout, according to data from Reis Inc. The office vacancy rate was 17.3 percent in the fourth quarter, while vacancies at shopping centers average 11 percent in the fourth quarter, unchanged from the previous three quarters.
“It’s a lot easier to hang your hat on something that’s experiencing good fundamentals where values are being supported than if somebody handed you a retail building that sits 60 or 70 percent occupied,” said Ryan Severino, senior economist at Reis.
“’Experienced developers that have pursued ground up in the past are looking now at alternative ways to decrease risk, and tax credits can make development more attractive,’ says Jeffrey Rogers, president and COO of Integra Realty Resources. Including historic, low-income or New Market tax credits in a project’s capital stack makes the entire project seem less risky and more viable, Rogers says.”