America’s great spectator sport is front and center with the Super Bowl taking place this past Sunday.  In professional football, serious resources go into the process of putting a good team on the field.  Each team has three smaller teams; offense, defense and special teams. Every good property manager needs the same structure.   Is your property management pro-active?  Are responsibility centers clear?  Who is responsible for marketing,  for emergency maintenance, for answering the phone?  Are you fielding a good team?

An arrow is a precision weapon built to pierce its target.   Armour is blunt, big and bulky.  Armour does little except deflect.  Arrows are light and nimble, armor is heavy, hard to move around. These two instruments are seldom used by the same individual. 

What does this have to do with property management?   

Let’s segregate tasks into arrow and armor categories as writers tend to do (Men are from Mars, etc.), but let’s start with a broad premise; arrows are built for distance and amour is for close encounters. 

ARROWS – A GOOD OFFENCE IS YOUR BEST DEFENSE

Arrows represent a good offense, a proactive stance on leasing, maintenance and systems.   Arrows represent marketing, customer service and tactical strategies for interaction with the public.  Note, arrows that miss the target are wasted, delivering zero benefits and costing money.  They are meant for precision strikes and can be moved to selected targets rapidly.  With a good offense you keep the other team off the field (chasing you around the field of play versus concentrating on their business).

ARMOR – PROTECTING HOME BASE

Armor represents having a good defense, being able to protect the asset with appropriate insurance, good policies and procedures, keeping the asset safe from attack.  That means having safety lighting where needed and a 24 hour number for residents to call for emergency maintenance (so a one ounce leak has no chance of turning into a 500 gallon leak). Like “real armor” you cannot move your asset, really.  Armor assist you in making a stand where you are- protecting home base.

SPECIAL TEAMS ARE IMPORTANT

In football the kicking game is fully one third of the plays in a typical game.  Ignoring the kicking game will have your offense and defense reeling for lack of field position.  Our “special teams” are our people with multiple skill sets- they are crossed trained to do more than one role when called upon.      

Certain areas of property management absolutely require cross-training.  Customer service, for example.  A uniform method of addressing our customers, with respect, with listening and attention.  Simple enough yet sometimes difficult to implement.  For example, every member on staff should be able to pick up the phone and greet a customer or potential customer.

Like in football, a missing or weak element in any of these aspects (offence, defense, special teams) of your property managment team weakens the entire team.  When budgets are tight “training” gets kicked down the list of priorities.  There are no shortcuts to building a quality portfolio or property management team.  There is just no replacement for good people — well trained good people.

Photo: Stephen Luke

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Property Management: Offense, Defense and Special Teams

A man and his realtor walk down the street and the man says “Realtor, I want to buy that house,” pointing to a beautiful 3 bedroom 2 bath home, “What should I offer?” The realtor responds, “Well, I’ve looked at the comparable sales in the neighborhood and it looks like another 3 bedroom, 2 bathroom home sold for $100,000 just last month. I would offer them $100,000.” The man agrees and buys the home.

The next week, the same man comes back up to his realtor and says “Realtor, I love my new home, but I had a great year at work and have some extra money that I want to invest. I heard that the retail center up the street is for sale. I saw the one across the street just sold for $500,000 and was identical. Should I offer $500,000?” The realtor responds, “Let me check the sale price.” The realtor makes a few calls and comes back to tell the man the news. “Well,” says the man, “Can I buy it?” The realtor then tells the man the news, “That retail center is for sale for $1,000,000. Maybe we should look at something else?”   The man, looking confused, thinks for a minute and then says, “how could that be? They are identical in size and just across the street. Why is that one worth twice as much?”

We’ll get back to the realtor’s answer in just a minute.

Before we answer his question, let’s take a quick look at how property values are determined.

Let’s first take a look at residential properties.

We define residential properties as single family homes. Homes are traditionally purchased as a place to live by their owner. They can also be purchased as rental properties. But, because the percentage of homes purchased as rentals is relatively small when compared to the single family home market as a whole, their valuation is based on the same methods.

Home prices are determined by using a few different comparable sale methods. These comparable sale methods are done by using cost per square foot, cost of construction, or floor plans.   These valuation methods are also applied for duplexes and four-plexes.

For instance, let’s say a home sells in your neighborhood for $100,000. It has 2 bedroom and 1.5 baths. It is similar in style and size to your home. When you go to sell your home, the realtor will probably tell you that it is worth $100,000 after looking at the comparable sale.

Determining residential home value is straightforward and relatively easy to do. You look at similar homes and what they sold for, then adjust for any differences, and you can quickly determine the value.

Commercial real estate is different.

We define commercial real estate as properties that produce income. They consist of apartment complexes of 12 units or more, or office, retail, and industrial buildings. These buildings are primarily owned by investors. These investors do not live there, but rent them out to tenants who pay rent each month for their space.

Commercial real estate value is determined by the income it generates.  Income is calculated by taking the rental income and subtracting out the operating expenses. You do not factor in loan payments or income taxes. The amount that is left is called the Net Operating Income.

If you want to invest in commercial real estate, you must know how to calculate the Net Operating Income.

Commercial property value is determined by how much an investor is willing to pay for the Net Operating Income. The investor trades their investment dollars for the property’s income. The rate that the income pays back to the investor for their investment is called the return on investment. The sales price is determined by how much the investor is willing to pay for projected Net Operating Income.

Value = Net Operating Income/Desired Return

Let’s look at a quick example.

Let’s say that an investor is considering purchasing a retail center or apartment complex that has a Net Operating Income of $100,000. In that area, investors are willing to buy properties like this for a 10% return on investment.

In this case, the property would be worth $1,000,000. The value is determined by taking the Net Operating Income divided by the desired return on investment ($100,000/10%= $1,000,000) for investors in your area. This means if an investor were to invest $1,000,000, he would expect to receive a 10% return on his investment each year ($100,000).

Now that you know how values are determined, let’s get back to the realtor’s answer to the investor’s question on how the two property’s values could be so different.

“The reason,” the realtor answered, “is because this property has better tenants and generates more income than the one across the street.”

What the investor initially failed to see is that he wasn’t just investing in the buildings as you do in residential real estate. The buildings were identical. He was actually investing in the tenants, the leases, and income that is generated by them, not the buildings themselves. Once he realized that, he looked again and it was easy to see why the values were different.

When he looked again, he noticed that the second building had higher quality tenants, a thriving restaurant, and was obviously doing more sales. “Oh, I see… because that retail center does more in sales, it can charge more for rent. When it does, it produces more income. Right?”

“Yes” said the realtor. “Why don’t we go grab some lunch and we can talk about locating the right property for you?”

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Investment Property Valuation: Residential vs Commercial

“I want to start investing in apartment complexes. How do I get started?”

If that is a question you have asked yourself recently, you are not alone. It’s something I hear on a weekly basis from both new and experienced real estate investors. They all want to know the keys to get started in multifamily investing the right way.

If done correctly, investing in multifamily apartments can be one of the most rewarding and best ways to grow your net worth and increase your income. However, one of the most important things you need to do when getting started is avoid making big mistakes that can take you years to recover.

It is important to get started right.

Below are keys to getting starting in multifamily apartment investing.  You can start doing these things today to shorten your learning curve.

Educate Yourself

The most important thing you can do as an investor is educate yourself. Find out all you can about multifamily investments. Learn how they work. Learn how value is determined. At first it’s like learning a new language, but with a little practice it will become second nature. If you are serious about being a successful multifamily investor, it is important to build a strong foundation. That foundation should be built through your investment education.

Evaluate Properties Every Day

After you have educated yourself on the basics of the industry, including how to evaluate properties, you are ready to take the next step. One of the best ways to learn about commercial real estate is by actually evaluating as many properties as possible. Determine what they are worth. Evaluate the areas they are located in and what needs to be done to fix them up. Figure out what you would pay for them to get your desired return. My first year in the business, I personally evaluated over 100 investment opportunities, and what I learned was invaluable to my current investment career.

Start small, build a strong base, and grow

This is where my advice might differ from many of the gurus out there. We’ve all seen the excited investor run out of a seminar and start telling people how they are going to go out and buy a 150+ unit apartment complex without ever owning a single multifamily property. It does happen, yes, but that is definitely the exception to the rule.

Don’t get caught up in the numbers game. Start small, where you are comfortable, and grow as you learn the business. Investing is not a sprint, it’s a marathon. Build a strong foundation stepping up a little in size with each investment and you will grow your business the right way.

Getting a good investment education, evaluating properties every day, and starting small will help you get started in multifamily investing the right way. These steps will cut your learning curve dramatically and help you to avoid making big mistakes. Once you build a strong foundation, you will be on your way to building wealth and massive cash flow.

See you at the top!

Photo: Ben Ostrowsky

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Keys to Getting Started in Multifamily Apartment Investing

Most potential tenants make their decision to lease your property within the first 30 seconds of entering the apartment.  It is critical to capture their interest and make a great impression as soon as they enter your building.  You need an effective leasing strategy to help you do this.

A “mini-model” apartment is one of the best leasing strategies you can use to capture your prospect’s attention and make a great first impression.  It will help you fill your rental property fast by increasing your closing percentages.  It is easy to move from apartment to apartment and will also save you money.

If you have never heard of the “mini-model” strategy before, you’re not alone.  Chances are, however, that you have heard of its parent, the model apartment.  In the model apartment, you “stage” the apartment as if someone is living there.  The model apartment shows the potential tenant what is possible with the space.  This allows the potential tenant to picture himself living there, as well.

Model apartments have been used for a long time to help lease apartments and are very effective.  They’re decorated with pictures, couches, and beds.   Every detail is covered down to place settings at the table and smell of the room.   However, they are cumbersome and expensive to set up.  They are also difficult to move from unit to unit.

The mini-model apartment is very similar to a model unit, but it has been strategically stripped down to the bare essentials.  It eliminates the bulk and expense while still delivering stellar results.  The mini-model includes just enough items to give potential tenants the same feeling as a full model apartment.

How the Mini-Model Apartment Works

The mini-model delivers 90% of the results of a model apartment at a fraction of the cost.  The apartment can be “staged” very easily for under $200 at any local shopping center.  It can also be used over and over again, saving you time and money.  The key is to focus on small items that will make a big impact.  Leave the big, expensive items behind.

In your mini-model unit, focus on small things that are appealing to your prospects’ senses: a welcome mat when they come to the door, small plants in easily-moved vases, hand towels, a cookbook, light music, a toothbrush holder, small side tables, or even the smell of bread or cookies baking in the oven.  All of these items can be purchased cheaply, moved easily, and will allow your prospect to feel at home.

You want to avoid expensive items.  You also want to avoid items that are hard to move or will have to be repaired when you change units.  For example, you do not need to have a bed set up in the bedroom.  Most prospects can still picture their bed in a bedroom if you place a small side-table beside the space where their bed would go.  For extra credit, you could even leave a pair of reading glasses on the side-table with an open book.  The key to setting up a successful mini-model is to give little hints, without trying to tell the entire story.

The mini-model is designed to be easily moved from unit to unit.   This is important because your prospect will want to lease the mini-model unit itself eight times out of ten.  By having items that are easy to move, it allows you to rent the prospect the mini-model.  This will make the prospect happy and will make you look like a leasing hero.  It also keeps your maintenance guys happy because they no longer have to move all of the furniture and pictures out of a full model apartment.

The mini-model unit can be one of the most effective leasing strategies you can use to fill your vacancies fast.  It is cheap to put together, can be moved easily, and will allow your prospects to picture themselves living there.  It is a leasing strategy you will want in your arsenal.

Photo: Austin Simple Staging

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

“Mini-Model” Leasing Strategy will fill Vacancies Fast in Multi-Family Apartment Buildings for Under $200

In Part I and II of Techniques to Speed Up Your Decision Making, we covered two basic measurements to quickly estimate value of an apartment property.

These two were:

1. Price per Unit
2. Gross Rent Multiplier (GRM)

We learned that Price Per Unit is the simplest to calculate but provides little investment insight because income is not accounted for. Gross Rent Multiplier is a step up because it incorporates the rental’s income but is also flawed since expenses are not taken into account.

Exploring Capitalization Rate

In this article, we discuss the subject of Capitalization Rate, often referred as Cap Rate or just Cap. It is similar to GRM but can be more precise because it considers vacancy loss and operating expenses.

Cap Rate = Net Operating Income / Price

Net Operating Income (NOI) is the sum of all potential income less vacancy and operating expenses. NOI does not consider debt payments, depreciation, or capital improvements.

Example: A 10-unit apartment building is offered for sale at $1 million. Its annualized rent roll is $100,000 with operating expenses totaling $40,000. What’s the Cap Rate if average vacancy rate in the area is 5%?

Capitalization Rate = ($100,000 – ($100,000 x 5%) – $40,000) / $1,000,000 = 5.5% Cap

If you know the going Cap Rate for the area, then you can also derive the property value from the NOI.

Cap Rate addresses the limitations of Price Per Unit and Gross Rent Multiplier by including income, vacancy loss, and expenses in its calculation. However by doing so, other problems are introduced.

Precaution #1 – Are the numbers accurate?

Cap Rate isn’t flawed, per se. The problem is with Net Operating Income. More often than not, NOI is inaccurate, which distorts Cap Rate and consequently, misrepresents the estimate of value.

The inaccuracies stem from three primary reasons: 1) misrepresented expenses , 2) excluded expenses , or 3) improper expenses factored into the calculation.

Common expenses include insurance, property management, real estate taxes, business fees, maintenance, trash removal, electricity, gas, and water. While reviewing each expense item, confirm the validity of each number. Try and obtain the actual amounts rather than estimates. Are items inappropriately labeled as operating expenses? Remember that depreciation, capital improvements, and mortgage payments are excluded.

Ensuring that expenses are complete and valid will enable you to estimate a more credible value.

Precaution #2 – Is the calculation based on current or pro forma numbers?

Sometimes sellers or brokers will base their asking price against the future income of the property. This future income is almost always higher resulting in a higher Cap Rate. This tactic is used to lure the unaware investor.

While it’s important to understand the potential upside in rents, projected numbers shouldn’t act as your baseline for estimating value. When estimating value, use current income and expenses. Then evaluate how much premium you’re willing to pay based on projected increases.

Precaution #3 – Financing is not considered.

Investors often use Cap Rate to gauge the potential return of a given investment property during the first year of ownership. Generally, a 10% Cap would indicate a 10% return on investment. Based on expected return, the investor then determines how much they are willing to pay. For investors who pay all cash, Cap Rate enables them to quickly do this.

Since NOI does not consider debt payments, Cap Rate ignores the impact of financing. Cap Rate stays the same whether a property is leveraged or all paid off. If financing is planned, then Cap Rate cannot be used as an estimate of value. Additional methods (ie. cash-on-cash or IRR) are required to assist in that task. However, Cap Rate is still useful as a comparison tool even with financing involved.

Summary

This tutorial has demonstrated when to apply Price Per Unit, Gross Rent Multiplier, and Cap Rate and the considerations to keep in mind. Learning to use the three measurements appropriately will help you to wisely focus your efforts and ultimately speed up your decision making.

Photo: Taber Andrew Bain

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Capitalization Rate – Techniques to Speed Up Your Decision Making, Part III

In Part I of Techniques to Speed Up Your Decision Making, I outlined three basic measurements to quickly estimate value of an apartment property.

These three are:

1. Price per Unit
2. Gross Rent Multiplier (GRM)
3. Capitalization Rate (Cap Rate)

While it’s easy to plug numbers, each technique has its pros and cons. This tutorial’s objective is to help you understand the key advantage and limitation for each measurement.

Exploring Gross Rent Multiplier

We previously explored Price Per Unit. It’s a simple calculation but because income plays no role in the formula, it provides limited insight into the apartment’s investment viability. Gross Rent Multiplier (GRM) is also easy to calculate but unlike Price Per Unit, GRM does incorporate the property’s income.

Gross Rent Multiplier = Price / Gross Scheduled Income (annual)

Gross Scheduled Income is the potential income a property would generate if it was 100% occupied. You can think of GRM as the number of years it would eventually take for the property’s gross income to total the price.

Example: A 10-unit apartment building is offered for sale at $1 million. Each unit is 2Bd/2Ba and is renting for $1,000. What is the Gross Rent Multiplier?

Gross Rent Multiplier = $1,000,000 / (10 x 1,000 x 12) = 8.33 GRM

As long as you can get your hands on the rent roll, then the Gross Rent Multiplier measurement is preferred over Price Per Unit. Generally speaking, properties in prime locations have higher GRMs versus properties in less desirable locations.

Advantage – It’s More Useful and Reliable than Price Per Unit

Pop quiz, what are you buying when acquiring an apartment? You’re buying income stream. Given the fact that GRM accounts for income into its formula automatically makes it a more reliable method for evaluating investment properties compared to Price Per Unit. Additionally, by taking into account income, property features are automatically factored into your evaluation. It’s reasonable to assume that rents reflect unit size, amenities, location, and even external factors such as general market conditions that may add to or deduct from its price level. Rents are market driven – you can only charge as much as a tenant is willing and able to pay. By factoring in a market-driven data point (income), GRM is more reliable as a measurement for comparing properties. In areas where operating costs can be expected to be uniform across properties, GRM is especially useful for comparing and selecting investment properties for further analysis.

Limitation – Ignores Vacancy & Operating Expenses

Gross Rent Multiplier serves to indicate what the market is paying as a multiplier of the gross income. As explained above, gross income is generally a good data point because its market driven and accounts for enhancements and deficiencies of the property as well as general rental demand. But because it is gross instead of net income, GRM fails to differentiate properties with lower or higher operating expenses and vacancies. Tenants may pay for some, all, or none of the operating expense. For example, a landlord may pay for all utilities because the building is master metered. This will result in higher rents compared to an identical property where those costs are directly passed to tenants. If you were estimating the price between the master-metered versus the individual-metered property using the same GRM number, then this would result in a very questionable value.

As with Price Per Unit, it’s important to understand the reason to use Gross Rent Multiplier. Always keep in mind the above limitations and remember that its purpose is to get a quick feel for the potential market value of the apartment.

Photo: Jeramey Jannene

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Gross Rent Multiplier – Techniques to Speed Up Your Decision Making, Part II

If you’re evaluating many apartment investment deals, oftentimes you need a quick way to determine ones that warrant more detailed analysis. After all, your time is valuable and any time spent analyzing deals that don’t make sense from the very beginning may result in other lost opportunities. What you need are techniques to act as filter mechanisms and help you quickly decide if the investment deal will really work.
Three general metrics are used for this purpose:

1. Price per Unit
2. Gross Rent Multiplier (GRM)
3. Capitalization Rate (Cap Rate)

Each has its own way of illustrating to the investor if the apartment requires more detailed analysis based on the asking price.

The purpose of this tutorial series is to provide investors a better understanding of each measure and how to apply them when evaluating apartment deals.

Exploring Price per Unit

The most popular of the three metrics is Price per Unit. It’s often used because it’s simple and quick to calculate.

Price per Unit = Price ÷ Number of Rental Units.

What makes it popular is that it’s easy to gather the necessary information to run the calculation. All that’s needed is the asking price and the total number of units.

Example: A 10-unit apartment building is offered for sale at $1 million. The property has a total of 20 bedrooms and 20 baths. What is the Price per Unit?

$1,000,000 ÷ 10 units = $100,000 per Unit.

If the general price per unit rate is $50k per unit, and the property is offered at $100k per unit, then red flags should be raised immediately. If evaluating multiple deals, this might be one you choose to set aside.

Precaution #1 – Neglecting to Factor in Property Features
What if the general rate in the area was $75,000 per unit? Will you still be quick to discount the property? One precaution to take with Price per Unit is that it doesn’t take into account property features such as amenities, location, or floor plans. Each of these can add or subtract to the Price per Unit value. Let’s say the 10-unit subject property’s 2bd/2ba units are generous in size at 1400 sq ft each. Other surrounding properties have outdated floor plans with only 2bd/1ba models and average 800sq ft each going at the general rate of $75k per unit. The higher price per unit of the 10-unit apartment would then be warranted because of its more modern features and larger floor plans. If you were strictly comparing price per unit rates, then you may have dismissed this opportunity by thinking the property was overpriced.

Precaution #2 – Ignoring the Investment Feasibility
Since Price per Unit is based on the physical feature of the property, it’s really a physical measure, not a true financial measure. Because the income is never reflected in the formula, price per unit provides little insight towards financial feasibility of the investment property. You can’t derive from it whether the investment property will provide a suitable return or not. A property could be offered at a low price per unit but still turn out to be a horrible investment because of negative factors such as bad location or problems due to deferred maintenance. Alternatively, a high price per unit doesn’t necessarily mean it’s a bad deal as illustrated in the section above.

Price per Unit is easy to calculate so it’s often a good initial measure to use. However, keep in mind that Price per Unit only looks at the number of units; it completely ignores everything else about the property including its features, location, and income and is limited in its usefulness. Therefore, if the deal passes the Price per Unit test, then move on to the GRM test, which we’ll cover in Part 2 of this series.

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This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Price per Unit – Techniques to Speed Up Your Decision Making, Part I

One of the most overlooked aspects of acquiring a multifamily investment property is adequately accounting for capital expense items and recurring replacements that the investment property needs in order for you to reach your investment goals (See “The Importance of Having a Capital Expense Budget When Buying a Property“). Overlooking these expenses will kill your investment before you even sign the loan papers.

Capital Expense Budgets and Replacement Reserves Defined

The replacement reserve is for recurring replacements that you will have to take care of on a normal basis, such as replacing flooring or old appliances that have reached their end of life, and replacing items such as air conditioners or roofs several years down the road. In contrast, a capital expense budget is a one-time amount that you should budget for when acquiring a property. This is a repair expense or an expense to upgrade key components of the property that cannot be covered by the typical replacement reserve.

To meet your investment goals, you need an accurate capital expense budget and recurring replacement reserve, and you need to use them in your financial analysis and underwriting of the property you wish to acquire. Failing to account for a capital expense budget and recurring replacement reserve will leave you scrambling for cash when items break down, and it will make it very difficult to reach your investment goals when these items break down that should have been targeted for replacement up front.

Accounting for Capital Expense Budget and Recurring Replacement Reserve

One of the first things you need to know is how much should be set aside for your Capital Expense Budget. A good way to figure out the capital expense budget amount is to have a contractor inspect the property with you before you put in your offer, and put together a list of all the items that should be replaced over the next three to five years or your investment timeframe and an estimate of the costs to do so. Then you can take that total amount and subtract out the recurring replacement reserve amount for each of those three to five years or your investment timeframe. The amount left is what you will need to fund your capital budget (Total Capital Needs minus Replacement Reserve multiplied by Years before items need to be replaced).

For example, you inspect a 40 unit property that you plan on owning for five years after acquisition with your contractor, and figure out that the roofs need to be replaced, the buildings need to be painted, and half the appliances are in need of replacement; you calculate that the total cost to fix those items is $150K. You decide that you can only set aside $300 per unit per year or $12,000 per year ($300 x 40) into the replacement reserve. Therefore, you know that you will only have $60K over those five years ($12,000 x 5) to work with from your recurring replacement reserve. Now subtract your Total Recurring Replacement Reserve of $60K from your Total Capital Needs of $150K, and you will find that you need a $90K ($150K minus $60K) capital budget to take care of the other items that would be impossible to fund out of the operations of the property without severely affecting the cash flow and investor returns.

Therefore, you want to include that number in your evaluation of the property and adjust your offer accordingly, to make sure you can reach your desired return. If you can’t make the returns you desire after accounting for the capital expenses, you should pass on the opportunity.

Be Sure to Evaluate Each Property on its Own Merits

Each property is different, so it is important to look for these items when inspecting a property and putting together your offer. If you do not feel you have the skills to identify these costs, it’s always recommended to have an experienced contractor on your team who can help you identify them. There are some rules of thumb that we use when evaluating a property. For a capital expense budget we account for at least $1000 a unit on every property. For older properties with a lot of deferred maintenance it can be over $5000 a unit, and for new properties it can be as low as $1000 per unit; but for most properties, we budget $2000-$3500 per unit for a capital expense budget.

How much should I set aside for a Recurring Replacement Reserve?

For a recurring replacement reserve, most lending institutions will make you set aside $250 per unit per year for a newer property and $300 per unit per year for an older property. I have seen as much as $400 per unit in areas such as coastal cities, where assets are exposed to more elements. When you talk to your lenders, make sure to ask them if they escrow for these funds or if you will need to set them aside, and how much they require you to set aside for their financing. Even if they do not escrow for these capital budgets, it is essential that you set funds aside for these normal expenses that arise when owning a property.

When should I fund the Capital Expense Budget and Recurring Replacement Reserves?

We typically find it much easier to fund the capital expense budget when putting together the funding to buy the property. If you are raising money from investors, it is almost always easier to raise this money up front, rather than trying to go back after closing to put this money together. The recurring replacement reserve is funded out of the operations of the property on a monthly basis. For example, if you have a 40 unit apartment complex and a $300 per unit replacement reserve per year, you would take the $12,000 per year and divide by 12 months, setting aside $1000 per month to fund the recurring replacement reserve out of the monthly operations of the property.

Having a capital expense budget in addition to a capital replacement reserve before submitting an offer can help you account for all expenses and necessary capital required to close up front, allowing you to meet your investment return goals. If you do not account for these expenses up front it can leave you scrambling for more cash when large repairs and expenses are needed on your property, falling short of your investment goals.

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This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

How to Determine Your Multifamily Capital Expense Budgets and Recurring Replacement Reserves

The Leap to Commercial Real Estate Investments
The stage is set . . . you’re ready to jump into the world of commercial real estate investments. Maybe you’ve been buying or selling single family homes, and your success is prompting you to think bigger, possibly on acquiring apartments — or, maybe you’re a new investor with initial sights set towards apartments.

Just so we’re clear on definitions, apartments — a type of commercial property — are multifamily buildings with five or more units; anything with four or less units is considered residential, including: SFHs, duplexes, triplexes, and quadruplexes.

Finding Apartments For Sale
You start browsing the MLS searching for apartments. You see a few here and there, but you quickly begin to wonder, “Is this really all there is? There’s got to be more for sale than what I can see here.” Well, you’re right. Unlike residential properties where you’ll find most to be on the MLS, many commercial listings rarely see the light of day. The closest thing resembling the MLS for commercial properties is LoopNet but even that doesn’t come close to uncovering all the commercial investment opportunities.

The Shotgun Approach
Let’s pretend you’ve reached the pinnacle of success in your career. You’re a multi-millionaire, and you own a multi-million dollar mansion that is up for sale, which is stunning, and you want top dollar for it.

You list it on the MLS for mass exposure.

You figure that with more exposure, more competition will drive up the price. Brilliant! Numerous calls come in from people expressing interest and who would like a tour. Naturally, you’re excited and you think “With so much interest, I should have no problem selling it.” But months go by and the only accomplishment you achieved was finding that really expensive house cleaner to keep your property in pristine condition as people come through your amazing property. You did enter escrow a few times, but alas, those well-intentioned buyers just couldn’t obtain a loan. After a while, you’re fed up, “These prospective buyers aren’t even buyers at all. They just want free admission to tour my property and most aren’t even qualified buyers!”

Targeted Marketing Prevails

Whether selling a mansion or a commercial investment property, both require targeted marketing to the appropriate audience. An apartment owner only wants to entertain serious prospective buyers. Property tours must be kept to a minimum to avoid inconvenience to current tenants. Escrows should be one and done. Owners want to only deal with suitable prospective buyers who are serious about buying and are capable of closing. So who’s best suited to assist them?

The Commercial Real Estate Investment Broker
The well-trained commercial broker is constantly out in the market talking to property owners and prospective investors. These brokers know when potential sale opportunities are coming since they are in constant communication with property owners. When these owners do decide to list their investment properties, the brokers have already identified suitable prospects from their list of investors.

The Commercial Investment Broker’s job is, first and foremost, to play matchmaker between the apartment owner and a potential buyer. These investors have previously disclosed their investment parameters and have the capital or can quickly raise the funds needed. It is in the interest of the seller and its representing broker to find a buyer who can close the deal quickly. After all, if you were the seller, would you really want to have a property on the market for months on end?

At times, a broker may exhaust their list of investors; in this case, the property may still not make it to the open market because they may contact other brokers and determine if suitable investors are available. Only when all procurement options are exhausted will the property be made available to the public for all to see.

Finding Those Hidden Opportunities
If you’re serious about apartment investing, then one of the most important first steps you can take is to get to know commercial real estate brokers who specialize in the areas you’re interested in. Find the reputable brokers. Establish relationships. Stay in touch so they remember you when opportunities come along.

By doing this, you’ll learn about those off-market opportunities that you won’t find on LoopNet and other listing services. Just a word of caution, it’s critically important you find a broker who you can trust.

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How to Find the Best Commercial Apartment Deals

Many real estate investors overlook some of the most profitable investment properties because they don’t understand how smaller properties can equal big profits. They get caught up in the “bigger is better” mentality and miss out on some of the most profitable investments right in their own backyards. Contrary to what some real estate gurus say, you don’t have to buy multifamily properties of 150 units or more to make a big profit. Smaller multifamily properties can provide an investor some of the strongest investment opportunities if you know what you are looking for. You can find them everywhere, and often times can buy them for much higher immediate returns and at better purchase terms than larger properties.

We define smaller multifamily properties as those having four to 100 apartments or units. This size of property can be a great fit for individual or a small group of investors. At this size, the income can adequately cover the expenses of the property and factor in management, debt service, and vacancy expenses.

Some of the advantages of investing in smaller multifamily properties are:

• Smaller properties usually have less competition than larger properties. When acquiring smaller properties, you are usually competing against individual investors instead of large companies, institutional investors, or investment groups.
• You can find properties with higher cash on cash returns. Often times you can buy smaller properties that provide higher cash on cash and internal rates of return on your investment dollars.
• They take less equity to purchase. Because they are smaller, they don’t require millions of dollars in equity to purchase, allowing you to purchase them individually or with a small group of investors, and own a higher percentage of the property.
• With smaller properties, you can often make more money per unit each and every month than with bigger properties.
• There are more of them in your backyard. There is a larger number of smaller properties than large apartment complexes which makes them easier to find.
• Many have more flexible sellers. These properties are normally owned by private individuals who have the ability to get creative if they want to and don’t have to go to a large ownership group for approval.
• They are often managed by less sophisticated investors who are scared to raise rents, fearing that their tenants will move out. This provides more opportunities for hands-on owners to achieve management improvements and value creation.
• They can be closed on quicker than larger properties.

As you can see, there are many advantages to investing in smaller properties, where some of the biggest returns can be found. It’s easy to get caught up in the game of trying to compete with larger investors who own more units, but like a mentor of mine told me early on in my investing career, “It’s not how many multifamily units you own, it’s how much you make per unit.”

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This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Small Multifamily Properties = Big Profits

One of the biggest mistakes I see investors make when financially evaluating an investment property is that they fail to include a capital expense budget for the property. When acquiring an investment property, it is critical that you have a capital expense budget as well as a recurring replacement reserve factored into the equity you will need to acquire the property and operate it effectively.

What is a capital expense budget? 

A capital expense budget is a one-time amount that should be budgeted for when acquiring a property. This is a repair expense or an expense to upgrade key components of the property that cannot be covered by the typical recurring replacement reserve that is funded out of the property’s operations. A capital expense budget will help you avoid major expenses later on, or can be allocated to projects that can increase your ability to raise rents, lower expenses, and increase the value of the property. Each property is different, so it is your job to identify these items when you do your evaluations as they can greatly affect the returns on your investment dollars.

What should be included in the capital expense budget?

When we identify the items to include in our budgets, we look for items that are failing now or that could fail within a 3-5 year period. We also look at items that we can take care of immediately that will help us to increase rental rates or make it easier to lease or manage. Key items to look for and include in this budget are roof replacement, foundation repairs, deck replacements, landscaping, cabinets or appliance upgrades, flooring and paint to name a few. If you have a contractor on your team, they can be essential in helping you identify these items before putting in your offer. Failing to account for these capital budgets and recurring replacement reserves can leave you scrambling for cash when these items need to be repaired or replaced.

How is a capital budget different from a recurring replacement reserve?

A capital budget is different than a recurring replacement reserve because it is for major items that you have identified that you either want or need to take care of immediately, which you wouldn’t have the money to fund out of the operating expenses of the property. The replacement reserve is for recurring replacements that you will have to take care of on a normal basis such as replacing flooring or old appliances that have reached their end of life, and replacing items such as air conditioners or roofs several years down the road. The replacement reserve allows you to set aside money for future expenses that you know will occur so that you have the money to take care of them when they do happen.

Why do I need both a capital expense budget and a recurring replacement reserve?

A capital expense budget and a recurring replacement reserve are extremely important to have on any investment property. They allow you to account for future expenses up front when determining the investments return and offer price. They also allow you to plan how to take care of key items that will help you lease, increase rents, and manage your investment property more effectively and efficiently.

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The Importance of Having a Capital Expense Budget when Buying a Property

This weekend I attended a Multi-Family Investing Bootcamp organized by The Real Estate Investment Network (REIN) and started to learn about how to acquire, manage and exit multi-residential properties. One of the key takeaways for me was the rule of 150 which I will explain here. There are some differences in the way single family and small residential properties are valued when compared against multi-family properties and this creates a powerful opportunity to create equity by increasing a building’s value.

What is the Rule of 150?

The rule of 150 applies to improving the operational profitability of a multi-family property. For each additional $1 in monthly NOI (Net Operating Income), the value of the property is increased by approximately $150. This increase in NOI can come by either increasing income or decreasing expenses.

Why It Works

Unlike small residential properties of 4 or fewer units where value depends on comparable homes, multi-family valuations are primarily a function of the Capitalization Rate. This difference in valuation method means improving the financial operation of a building will also improve it’s value and lead to increased equity. If you don’t know what NOI or Capitalization Rates are, I’ll explain next.

The Math

The simple formula for Capitalization (or Cap Rate) is:
Capitalization Rate = NOI / Building Value

NOI is simply income less operating expenses (this excludes debt servicing costs) and by increasing income or reducing expenses. Because the capitalization rate is typically set for each city or region, by changing NOI, you change building value.

The rule of 150 assumes an 8% capitalization rate. This may be higher or lower in your area, but here is how the math works.

We can rearrange our capitalization rate formula to Building Value = NOI / Capitalization Rate. If we increase our NOI by $1 per month, this is equal to an increase of $12 per year. This $12 annual increase in NOI divided by our 8% cap rate leads to an increase in building value of $150.

So in simple terms, $1 per month x 12 months per year / 8% cap rate = $150 increase in building value.

Examples

Let’s take a quick look at a couple of examples of how this can be put into practice.

Example 1 – Increasing Rent

Increasing rent can be as simple as bringing existing rents up to market level, or can be forced upward by improving the property. For example, by adding a dishwasher we may be able to rent a unit for an extra $10 per month. Using the rule of 150 this translates to a $1,500 increase in building value. If the dishwasher cost was $500, you’re ahead of the game by $1,000. Do this to every unit in a 10-plex and you’ve just added $15,000 in value or $10,000 in profit. By bringing rents up to market value and making some small improvements you can create a significant amount of equity in multi-family buildings

Example 2 – Decreasing Expenses

Another way to improve NOI is by decreasing expenses. One of the easiest ways to do this is to decrease electricity costs by using energy efficient lighting. Replacing light bulbs in a multi-family building is one the best ways to reduce expenses and has an almost immediate payback. Using the rule of 150, there are several ways to improve NOI by reducing expenses.

Whether you add income or reduce expense, just remember a $1 increase in NOI translates to $150 in equity at an 8% cap rate. Just crunch the numbers at your local cap rate and see where you can cut expenses or make smart upgrades that will reward you handsomely. This is a great way to create value in multi-family investing.

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This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Manufacturing Equity in Multi-Family Properties with The Rule of 150