Expandability – any tool, technique, term, or approach implementation of which allows an investor to either improve upon the investment returns on a given investment or portfolio of investments, or to facilitate a transaction which would otherwise not be possible.
Since I would rather not to speak in hypothetical terms, in this article I will provide you with an example – let’s call it the Symphony Drive Deal (this is the transaction I mentioned in Podcast 14).
The principals and application of expandability cover everything from financing clauses, to physical repairs, closing dates, income expandability and management efficiencies. However, within the confines of this article I will only focus on two aspects: down-payment requirement, and the income potential.
Why the Down Payment
As I indicated in the above definition, aspects of expandability serve two main purposes, one of which is to enhance returns, and the other is two facilitate transactions. I think everyone reading this would agree that the down-payment requirement is one of, if not the most debilitating requirement in any transaction. We would all do more deals and attempt bigger transactions if access to capital was unlimited. In fact, if you could finance every deal 100%, then in principal you could do an unlimited number of deals – wouldn’t you agree?
Thus, any circumstance which limits our exposure to the down-payment requirement can and should be seen as an expandability item since it facilitates the deal which might otherwise be out of reach. Furthermore, although this should not be relied upon as the definitive metric of worth in any transaction, the math does indeed bear out the reality that the less the down-payment the higher the cash on cash return.
Why the Income Expandability
Those of us who buy income-producing real estate do so for one reason – income. Income is ultimately what creates worth and establishes value in an income-producing acquisition; we are buying a revenue stream represented by the real estate. Income and capacity to expand income is what this is all about for me and many of you. Therefore, any conversation relative to expandability has to address income.
Additionally, although in a distant second place, one fortunate side-effect of expandability as it relates to income is that by improving the NOI we effectively back into a higher valuation, which has great implications for our investment returns. Therefore, in context of a fairly short article which requires that I isolate the most pertinent points, it seems appropriate to discuss expandability as it relates to income.
A Bit of Background
The Symphony Deal is a 10-unit apartment building, actually two 5-units sitting next to one another. I closed on this deal on February 4th, 2013. The buildings were built in 1980. They are situated in a desirable area – I will not discuss the definition of “desirable” here since I addressed this in some detail in an earlier article entitled It’s Not My Fault They Keep Trashing My Unit – Actually It Is.
These are 2-story buildings. The units are all-electric. Both electric and water services are separately metered. Both buildings showed some amount of delayed maintenance, but most of it was cosmetic. However, there were a few plumbing issues to be addressed right away as well as the shingles on one of the buildings were original and needed to be replaced in short order.
How it Came to Be
I first became aware of this opportunity about nine months prior to closing when a local Realtor brought me the deal. This was not a listed property – the realtor was trying to help out a friend who needed out. At that time, the asking price was about $475,000. The three of us met to discuss options.
Food for Thought: The simple reality is that in order to cater a solution to the seller’s problem I have to discover what that problem is. Some sellers need equity, while others want income; some want out, while others desire to maximize their returns; some have emotional trauma associated with the property which may need to be addressed, while others have no emotional attachments whatsoever. Bottom line is that in order to cater a solution I have to be face to face with the seller. This can be difficult to accomplish when working with sales agents, but it is virtually a must in my version of real estate investing!
Having discussed options with the seller, we were unable to come up with a workable solution. But, we did manage to establish a good working relationship of mutual respect.
Nine months later the same realtor mentioned to me that the seller was ready to sell at a lower price than originally discussed – he wanted out! I told her that at around $350,000 I would be interested to discuss options.
At around noon, or about an hour following this conversation, the three of us met one more time. I made the seller a verbal offer of $350,000. I knew that he had paid $400,000 a decade ago and that accepting my offer would mean walking away from equity. However, $35,000/unit was a respectable place to start based on the current income structure, condition, and tenant base and knowing that the underlying mortgage on this building would have had to have been a 20-year amortized loan, I projected by working the numbers backwards that the outstanding balance on the seller’s underlying was low enough to enable him to take my offer if he chose to do so. As you know by now, in the end I met him half way at $373,500.
Food for Thought: When structuring a deal it is usually advantageous to allow your counterpart to feel as though you have done absolutely everything that you could do in order to accommodate them. This makes it more palatable for them to accept the outcome. There are numerous ways to structure offers in ways which ensure that the forthcoming negotiation will be perceived in this way. In the Symphony Deal, I “gave in” considerably on the price, but my capacity to do so was teed up by my original offer being low enough. I am never afraid to make the offer too low – and this is saying a lot from a guy who on occasion has paid more for property than I knew it to be worth.
If you ask for more upfront, you’ll have more to give back throughout the negotiation.
The financing package on this acquisition showcases my ever-present desire to achieve as close to 100% financing as possible. As I mentioned earlier, not having a requirement of a down-payment, or at least not a large down-payment, enables me to do more and bigger deals than I otherwise could, which makes it an expandability item. It is important to mention as well, because a lot of you may wonder, that even though the acquisition was practically fully financed, this was not to the detriment of the cash flow.
Most seasoned investors would agree that in a multiplex long-term hold situation the measuring stick is $100/door of cash flow – this is the level where most investors will pull the trigger. However, while in stipulating this guideline a lot of investors assume a substantial down-payment, usually 20% – 25%, this is much too generous for my taste. In my opinion and based on my experience a solid acquisition should cash flow minimum of $100/door under 100% financing, with expandability options to improve upon that, which, as you will see, I achieved here.
These were the numbers at the time of acquisition (rounded down to the nearest 10):
Purchase Price: $373,500
1st Mortgage (commercial portfolio loan): 70%
2nd Mortgage (private loan): 25%
Cash Down-payment: 5%
Monthly Gross Income: $5,800
Monthly Operating Costs: $2,400
Monthly NOI: $3,400
CASH FLOW: $1,000
As you can see above, contractually I was required to contribute a cash down-payment in the amount of 5% of the purchase price, which would have been $18,675. You should agree that this would have been a rather attractive proposition such as it was, considering that a more typical down-payment requirement for a deal like this is 25%, or $93,375. Frankly, if you can not concede that bringing $18,675 to closing is a whole lot better than having to bring $93,375, then there is something very wrong with your thinking process…
However, as good as 5% down would have been, what you need to realize is that after proration of rents and transfer of security deposits, both of which were applied to the closing statement, all I needed was about $5,300 of cash to close. If my math is correct, this is a bit under 1.5% of the purchase price!
About the Private Money
As you can see above, the integral piece of the financing package on the Symphony Deal, and what made it possible for me to achieve such a low down-payment, was the presence of private financing in the amount of 25% of the purchase price. Although now is neither the time nor place to discuss private money in-depth, here are several interesting aspects that need to be addressed briefly in order to put this into context.
Process and Securitization
Bringing private money into a transaction can be accomplished in several different ways, which can include a partnership, an LLC, C-chapter Corporation, a real estate investment trust, a private or public offering REIT or another type of syndication, etc. There are benefits and drawbacks to all.
I chose to utilize a blanket note and mortgage on this transaction, whereby in exchange for money I gave a Promissory Note which sighted 2 properties as collateral and upon which the attorney generated an “umbrella mortgage” which was entered into public record.
Why the Private Lender Went Along and Why the Bank Allowed It
It took years to establish these relationships – GET IT?
Expandability of Income
$1,000 of monthly passive cash flow that was there at closing was certainly good. This amount of money makes a substantive difference in my life and likely most of your lives as well.
However, this was not why I agreed to pay $373,500 for this building. Instead, I bought this building because I could clearly envision ways to grow the Net Operating Income from the then $3,400/moth to $4,100/month, or more – a difference to the upside of $700/month+. Furthermore, as you will se in a moment, while in order to accomplish this I will need to re-invest some cash flow into upgrades, doing so will not create any additional on-going expense, which means that any increase of NOI will flow to the cash flow.
My purchase price of $373,500 relative to the NOI of $3,400/month represented a 10.9% CAP Rate:
CAP = Annual NOI / PURCHASE PRICE = $40,800 / $373,500 = 10.9%
Here are some of the aspects I knew I could improve upon:
- Based on my knowledge of the marketplace I was aware that the rent-roll of $5,800 was too low. The apartments were rented for between $550 and $595 per month, while I believe that having been cleaned up these units can bring-in $625 – $650 per month. This may take a few years, and will require re-investment of realized cash flow into upgrades, however I am certain that I can add $500/month to the monthly NOI of the building by improving rents, may be more!
- Even though the water service is separately metered to each apartment, the previous owner was paying it with the rent. As I restructure leases and pass the expense of the water on to the tenants, which I’ve been able to do with 2 out of 10 units thus far, this will create a savings of about $150/month that will go directly to the NOI and flow through the CF.
- The base value upon which the property taxes are being assessed is entirely too high, resulting in an annual tax bill that is $600 – $1,000 too much. I have filed an application with the county to reduce property taxes and I am currently waiting on a response. I have good reason to believe that I’ll be able to recover $50/month, which will go directly to the NOI and flow through to my cash flow.
As of April, 2013 I’ve turned over 2 of the units. One, as you can see in the pictures, was a complete facelift which included new flooring, new paint, new appliance package, new countertop, and updated plumbing and lighting fixtures. The rent on this unit went from $575/month to $685/month. And of course, the tenant now has the privilege of paying for the water they use. Cumulatively, this constitutes a monthly NOI increase of $125!
The other unit, which happened to be in much better condition, only received a cleaning job with a few odds and ends at a total cost of under $500. The rent went from $575/month to $625 + water, resulting in an increase of NOI of $65/month!
All together, with just 2 out of the 10 units turned over, I’ve been able to add $190/month to the monthly NOI of the Symphony Deal. Thus, I am very much on track to achieve $700+ increase in NOI and cash flow.
Let’s Put This in Perspective…
I’ve bought an asset which cash flowed $1,000/month for $373,500 by financing all but $5,300, and within 2 to 3 years I will improve the monthly NOI from $3,400/month to $4,100/month. This will improve the valuation of this building to close to half a million at 10 CAP, which is the going rate in my neck of the woods for a building such as this:
Value = Annual NOI / CAP Value = $49,200 / 10% = $492,00
And oh yeah, almost forgot – in the process I will push the cash flow up from $1,000/month to $1,700/month, which is the kind of stuff that allows a guy to retire financially free after a few years…
Food for thought: This transaction necessitated an investment of $5,300 of cash, which is easily an amount of money many people spend on coffee and lunch 5 times per week – think about this…
Life is all about choices!!!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.