So you are thinking of buying your first Multi-family or commercial property – now what? There is a ton to think about. First is do you really want to own a building, deal with tenants, property managers, maintenance and all the other drama that comes with it? Do you want to find the deal (looking at hundreds of crap deals to find a good one), analyze it, negotiate it (offer on 10+ to get 1), inspect it, get a loan on it, then manage it or the manager, deal with it while it’s operating and then figure out the best time to sell it? If not, then become a limited partner in a syndication find an experienced investor and partner with them or put your money into a crowdfund. If you still said yes, then follow along because in this blog and many more I will go through the entire process.
Finding a deal in a sellers’ market can be difficult. You will want to talk with all the commercial brokers in your city as possible in you specific niche. Tell them exactly what you’re looking for and have them start sending you deals, which will be mostly overpriced. You should also send out letters to property owners, talk to property manager, banks and lenders and let them know you’re looking.
Now let’s say that you’ve found the deal. The broker sent you a deal in a neighborhood with some solid growth and opportunity and the deal looks solid on the surface. The broker tells you that this is the one. It’s a great building with tons of potential, rents are low (they always say that) and there is a big “value add.” Ok, sounds great, right? Well, maybe, but you want to be sure that it’s as great as it sounds, so let’s dig in.
First, don’t pay too much attention to the Offering Memorandum (OM)/Listing package. It may have some good info in it, but the pro forma numbers that the broker gives you in that are to be taken with a grain of salt. Don’t buy based solely on that. You want to get the real numbers and what you’re looking for is the T-12 (Trailing 12 months of profits and losses), current rent roll, unit mix (1 beds, 2 beds or in commercial sqft size and type), Profit/loss for at least the previous full year, but it’s best to get the past 3 years. This will allow you to look at the deal with a clear lens. If it’s possible get a property condition report as well.
T-12 and Profit/loss part 1: We are looking for the gross rents possible to collect, the gross rents collected and any other income (laundry, utility reimbursement, parking, etc). For gross rents you will want to find out the current market vacancy rate, which can be found by asking local property managers and brokers. You will want to use that number or the sellers number whichever is greater. Let’s say the possible rent is $100,000/month and the seller collected $98,300 on average. That is a 98.3% occupancy rate or a 1.7% vacancy rate. The market vacancy you have been quoted is at 4.5%. I would then adjust the vacancy to the market rate bringing the income/month to $95,500/month on average. You also have vacancy due to non-payment of rent and move outs, which will relate to between 1-5% depending on your market and the area the property is in. As a good rule of thumb use between 6-10% as your vacancy rate for B and C properties. Again consult with property managers and brokers to get an accurate number. Also, look at historical information as well. If you’re in a hot market and the historic vacancy rate in your city is 8% and you are analyzing on a 5% vacancy you could be in trouble when things cool off.
T-12 and Profit/loss part 2: Expenses are a big part of the equation. I will start off by saying in a 20+ unit building the general rule is that the expenses will be 50-60% of the gross income. If the seller is giving you numbers that are much lower they could be hiding something or have been skipping/shorting important repairs. You will be closer to the 60% if you pay for the gas and electric and closer to 50% if the tenant pays for it. What are the typical expenses? Property taxes (found on the assessors office web site – please be aware that if the seller bought for $2M and you are buying it for $4M your taxes will increase drastically), insurance, utilities, attorney fees(evictions), administration fees (bookkeeper, accountant, etc), Maintenance (usually 8-12% of gross income), apartment turn over (usually 2-3% of gross), advertising (1% of gross), property management (4-10% of gross rent depending on building size). Landscaping/mowing/snow, Replacement reserve (I use 3.5% of gross, others use $200-$300/unit/year). See example:
Income:
Year 1 $808,800.00
Vacancy/non pay ($80,880.00)
Laundry/Other Income $3,540.00
Total Income $731,460.00
Expenses
Property Tax $68,000, Insurance $26,200 Utilities $75,377 Mowing/Landscaping $26,400 Accounting/Book keeping $8,088 Advertising $9,600, Sponsor Expense $6,000 Payroll/On-site $36,000 Maintenance/Repairs$73,146 Caretaker/Management fees-$36,573 Legal $3,072 Replacement Reserve $28,308
Total Expenses $434,504
Net Profit $296,956
On this deal you can see the expenses are within the 50-60% rule, sitting at about 59%
Looking for “value add:” We can add value 2 ways: 1. Raise rents 2. Decrease expenses. Our goal is to do both. First talk with your property manager and real estate broker to give you a market rent comparable or a survey. You can do it yourself by looking on craigslist and other rental sites for comps, going to rentomenter.com, or buying an underwriting report from CoStar. Use the rent survey and I suggest “shopping” the comps to see what their rental is like to compare it and get a feel for upgrades you need to do to achieve you desired rent. The other valuable item is tenant retention and tenant placement. If you have units vacant for a month vs a few days that makes a world of difference. Also, if you can keep your tenants that helps as well.
For expenses, look for ways to reduce monthly bills, maintenance, etc. Replacing all common area lights with LED’s on timers, dimmers or motion could save you thousands/year. Having a central boiler replaced or using a controllable stat with zones may bring major bucks into your pockets. Going to the RUBs system, where you are charging your residents their portion of the utilities or sub metering will not only save you money, but also conserve energy. Thorough background checks can avoid move outs and evictions and the list goes on. By looking at the seller’s books and operations, you may be able to find ways to increase the rents and save you major money. Take a look and the following example:
Purchase Price: $3,500,000 on 100 units
Actual Income:
Year 1 $808,800.00
Vacancy/non pay ($80,880.00)
Laundry/Other Income $3,540.00
Total Income $731,460.00
Expenses
Property Tax $68,000, Insurance $26,200 Utilities $75,377 Mowing/Landscaping $26,400 Accounting/Book keeping $8,088 Advertising $9,600 Sponser Expense $6,000 Payroll/On-site $36,000 Maintenance/Repairs$73,146 Caretaker/Management fees-$36,573 Legal $3,072 Replacement Reserve $28,308
Total Expenses $434,504
Net Profit $296,956
Capitalization rate 8.33%
Now let’s increase rents to market +$50/month/unit and decrease the utilities by $10/unit/month
Pro Forma Income:
Year 1 Rental Income stated $868,800.00
Vacancy/non pay ($86,880.00)
Laundry/Other Income $3,540.00
Total Income $785,460.00
Expenses
Property Taxes $78,200 Insurance $26,200 Utilities $67,377 Mowing/Landscaping $26,400 Accounting/Book keeping $8,688 Advertising $9,600 Payroll/On-site $60,000 Maintenance/Repairs $78,546 Caretaker/Management $39,273 Legal $3,072 Replacement Reserve $30,408
Total Expenses $427,764
Net Profit $357,696
Capitalization rate 9.85%
Our net profit just shot up by $60,740/year. Let’s say the market Capitalization rate is 8%, meaning apartments sell at an 8% return on total purchase price (Cap Rate= Net Operating Income/Building value). At an 8% income in example #1 above my building is worth $3,711,950 and in example 2 it is worth $4,471,200. Just raising rents $50/month and reducing expenses by a mere $10/month/unit gives us an increase in value on our property by $759,250. That is the power of rent increases.
Be cautious though, because it can go the opposite way just as quick. If you look at the sellers numbers or pro forma and buy based on assumption then you can stand to loose a great deal. Let’s say you bought the 100 unit apartment in the examples and the last example is the pro forma you used to buy on. You bought based on pro forma numbers at market cap of 8% and you ended up not being able to raise rents or reduce expenses. Your building is now worth $3,711,950 and you just lost $759,250 in equity. Now your great investment is crap and you want to go crawl in a hole!
You can now see the reason we use current profit/loss statements vs hypothetical. In some cases you will have to use a hypothetical to help guide you, but if you do make sure that is conservative and you are buying below market cap rate. Some scenarios where you may use mostly pro-formas: A building that is vacant or has high vacancy, a building with extremely low rents and a building with extremely high expenses.
To your success!
Todd Dexheimer