Seems like a deal, right? Need a nudge

17 Replies

I am new to multi-family investing.  Since finding Bigger Pockets earlier this year, I've been focused on learning more about analyzing property.  I started out with looking at single family but after listening to the podcasts and reading more, I decided I needed to enter the game at a higher level in order to get where I want to be.  My W-2 job is engineering and I own a small real estate brokerage that focuses on residential.  Commercial is very new to me.

I was having breakfast with a friend of mine recently and I was telling him about my interest in multi-family and asked if he knew much about them, he didn't.  However, he did have a client recently pass away and his 70 something widow was looking to sell two 9 unit buildings (without a broker) that they have owned since they were built in 1984.  He asked if I want him to ask about them.

Long story short, I have had a meeting with the current owner and her two sons.  She prefers to be completely out of the apartments, but is warm to the idea of owner financing.  I have ran these building several different ways and have settled in on making two offers.

Basics:

Scheduled Rent:  $151,600

Garage Income:  $1,800

Laundry:  $3,600

Effective Gross Income (assuming 10% vacancy):  $141,840

Taxes:  $20,800

Insurance:  $8,000

Electric:  $1,436

Water/Sewer: $6,073

Gas:  $600

Trash:  $2,700

Lawn/Snow Removal:  $3,360

Capex/Maintenance (15%): $21,300 (Probably high since most of capex items are less than 7 years old)

Total Expenses:  $64,300

Net Operating Income:  $77,540

Am I missing any other expenses else besides PI payment?

Asking price is around $1million.  Without broker fee and some negotiations, I hope to settle with one of these two offers:

Offer 1:

$950,000

Owner Financing:  10% down, 5% interest, 30 year amortization and 5 year balloon.

Year PI:  $55,080

Income:  $22,460

Offer 2:

$900,000

Bank Financing:  25% down, 5% interest, 25 year amortization.

Yearly PI:  $47,352

Income:  $30,200

Strong job and rent market.  Occupancy can be reduced to 5% with some cosmetic improvements to freshen up the apartments.  I plan on reinvesting the capex budget of $22.5k/year back into the units for the first 5 years.  Rents can be increased from the $700 average to $750 average based on product in the market.  The older couple that owns them hasn't done much true management to the buildings to keep them running like a business. 

I know I am new to this, but this seems like a good deal right?

A little nervous to make the big leap financially, but the time is right.  I lost a lot of confidence about 12 years ago due to losing two children and still working to get it back.  Any and all input/encouragement would be greatly appreciated.  Thanks. 

Kelly, 

Without digging too deep, your numbers look ok,  with one VERY BIG exception, management.  Put it in at 10%.

That drops your net to 62380. At $1mm it's about a 6 cap. 950k is a 6.7 cap. Both of those leave little room for error. At an 8 cap you're looking at 780k. 

Also, if you are driving for owner financing,  your spread between the owner financing and bank offer is way too low. 

Hope that helps.

Good luck, 

Jim 

@Kelly Farley , although commercial is very new to you, it should only have taken one hour of reading up on it to know that you need to get a complete grasp on the local area market cap rate, right? Could you please share that number, here? James has given a useful response regarding the cap rate you'd be buying them at, if you paid $1M, $950k, or $780k.

But neither of those figures helps you, or helps us to help you, if we don't get told the market cap rate! You need to be very sure of that figure (range)! [Don't ask the Seller].

Your post shows you have a good head on your shoulders. All the best. Welcome to BP...

[Hint: Your offer should relate to current rent/return, not theoretical improvements you'll add!]

Hey,

First, I believe you should underwrite expenses a little more conservatively (50-55% of income). Next, use any blend of financing that will allow you to put the least amount of money down. If that means using both a bank and seller financing then do that. You may need to offer a lower purchase price based on your new calculations if you factor in higher expenses. Make sure to get an inspection and use that as leverage to negotiate a lower price if some deferred maintenance is uncovered. Sounds like you're in a great place - get that confidence! Good luck!

As suggested cap rates are important to know in your area. The deal is tight at the value you suggest. If cap rates are on the 6 range I would pass but it is a personal decision based on your risk tolerances and goals.

My risk tolerances are very high but I require significantly higher returns for my risk than you are seeing.

Why are you using 15% for capex/maintenance? Can they not provide the actual numbers? Having the actual numbers will help you know if there's going to be a lot of deferred maintenance, too. 

Also, is it common to lump these two together? Or should capex be omitted to calculate NOI? From a financial reporting perspective, you wouldn't include capex since by definition it is capitalized and not expensed. Just curious what is commonplace for investors when analyzing deals.

Originally posted by @Sam Grooms :

Why are you using 15% for capex/maintenance? Can they not provide the actual numbers? Having the actual numbers will help you know if there's going to be a lot of deferred maintenance, too. 

Also, is it common to lump these two together? Or should capex be omitted to calculate NOI? From a financial reporting perspective, you wouldn't include capex since by definition it is capitalized and not expensed. Just curious what is commonplace for investors when analyzing deals.

Future cap ex and maintenance expenses can never be exactly known in advance. Yes, for tax and NOI purposes, capital ex and maintenance ex are treated differently, so you have raised a very good point. [For residential properties, cap rate is not seen as the determining factor, and residential investors are well advised to anticipate both figures ie. deduction of all expenses eg. 15% for both]. 

Yes, it's common here on BP to include both in guessing ongoing average costs (whether capitalized or expensed) as a percentage, to be subtracted off 100% gross income. It's annoying to me that cap ex is not included in the official formula of NOI (seeing as how those costs do get paid out of the same wallet as every other one), which I reckon can somewhat skew the real Return On Investment figures - but, it is what it is. I should probably stay out of the commercial cap ex vs maintenance vs "open to interpretation" debate. Cheers...

@Brent Coombs , thanks for the insight. 

Strictly for pricing a property I want to buy, I will only include actual repairs and maintenance. Same goes for every expense line item. Now, I also have minimums for each line item, and a total minimum. Then, if there are any immediate capex issues, I will either deduct those costs from my offer price, or offer the full price and ask for an allowance. I don't ever include future capex estimates in my NOI when pricing mid to large multi-family properties. (To be clear, this is separate from setting aside part of the cash flow each month to cover future capex.)

I'd be interested to know if I'm outside the norm in this. 

@Kelly Farley , is your 10% vacancy just your physical vacancy rate? If so, you'll want to find out what the economic vacancies are in your area for similar properties.

@James C. thank you for your response.  Great point with the management, that is a big item overlook.  Although I plan on doing my own for the first year or two to make sure I understand what it takes, its nice to have the option in case it is not for me.  I could certainly hurt myself if I didn't account for it in my offer/analysis. 

Also, I am going for owner financing.  In your experience, what amount of spread typically gets the sellers excited?  When I present offer, I also plan on showing them the additional interest they will make over the 5 year period.

Kelly

@Brent Coombs , I have a call into a local lender and another investor (name provided by business associate) to determine the cap rates they see in this area.  I will not be asking the seller on this one.

Once I have the market cap, I will post it here. 

My numbers/offer will be based on what they are currently getting, not what I think I can do with it.

In addition to my original question, how often do multi-family investors actually look at the replacement costs for buildings. For example, these buildings are 10,000 Sq.ft each.  If it takes $125/sq.ft (guess) to rebuild the structure, garage structure, concrete driveway/parking and land, It would be $1.25 million just to develop one of the buildings. If I buy at $900k for both, I paying $450k/building. How would a new builder be able to come into the market without charging a substantial amount more in rents. This town doesn't support that rent level. I would be buying at a $50k/unit, do investors take this information in consideration or is it a non-issue. Just curious.  Maybe I'm thinking too much like an engineer here.

@Thomas S. I agree, if the ask price matches the market cap rate I will move on.  I have a couple phone calls placed with local lender and investor to see what they are expecting in the market.

Also, the $1,020,000 price they threw out to me was provided to them from a Commercial Broker who analyzed the property for them.  The number he provided had to be based on what he thinks the first year after getting occupancy from around 89% to 95% AND getting the rents up.  After seeing the responses from all of you on this thread, I need to take a step back and use my analysis based on what it is, not what it can be.  I appreciate your input.

I am excited about doing this, but I don't want to get into a bad deal just to say I did a deal.

Kelly

@Rob Beardsley I actually sat down this morning and broke down every possible cap ex item (roof, windows, siding, HVAC, parking lot, appliances, flooring, etc) into costs, average useful life to determine what my monthly cost will be.  It came in around 12% and my misc. expenses came at 4% for a total of 16% so I agree I was off on my expenses.  Although the big ticket items have been replaced within last 7 years, I still want to set the money aside into a separate account for when it is needed.  This exercise and the feedback received here on this thread has convinced me that I need to revisit my offer prior to presenting it.  Waiting on area cap ex before final nail down.

I like the idea of blending the owner/bank financeing if the seller baulks at owner only financing.

I have accounted for inspections (building and environmental) into my closing costs and will certainly use the findings to negotiate a better price if needed. 

Kelly,

It varies. If you only have a 50k spread on 900k, it's only a 5% difference. I'd be shooting for a bigger difference (lower cash offer) to make the owner financing more attractive. I've seen as much as 50%. To do that you really have to know your seller. Your thought about bank/owner is probably easier for the seller to swallow, since they seem to be unsophisticated. Again,  know your seller. 

Also, I read through some of your other responses.  Don't get to hung up on the market cap rate. Cap rates are very compressed at the moment and not reflective of actual cost to run a building. The broker provided price is a pro-forma price and it's a lie. You need to buy the building based on how it's performing now. If the sellers want more, then they need to get the building perfoming better. Don't pay for their incompetence. 

The cost to rebuild isn't particularly helpful in determining a sales price. It's good for determining what level of insurance you might want to have and that's about it.  Cost to build isn't really a barrier to entry for a couple of reasons. One, brand new units will always carry a  premium rent over older units.  Two building new units is a long game for guys with deep pockets where money isn't the object.  Barriers to entry are lack of available land and lack of available permits. 

Hope that helps.

Good luck,

Jim 

@Kelly Farley When calculating NOI you should not be including mortgage payments. This is because the NOI is the unleveraged return (i.e. cash buyer returns).

I would suggest connecting with local brokers to get a comparable list of properties, including cap rates and other info. You should request a capital maintenance log which can help you ascertain when and what type of repairs were done. Your current projection is a high long-term average.

I will echo the posts above by pointing out that you should have a wider spread between your owner and bank financing offers. Furthermore, you are buying on actual performance not pro-forma performance. 9/10 pro-formas are garbage and can be discarded.

Best bet (if you feel this is a good deal):

  • Put property under contract
  • Get: rent roll, T12 P&L, tax records, bank statements and copy of leases (to match against rent roll and leases)
  • Do a thorough inspection of the property including getting a full report on the foundation, water and sewage (including septic tank) and similar issues. Since this is your first deal, you want to avoid dealing with structural issues.
  • Develop a personal relationship with the widow and the sons. This might be the most critical factor.

I would develop a relationship, truly understand their needs (often security of income vs. capital return) and develop a plan with them. Nonetheless, I would not go by the pro-forma. The broker has used pie-in-the-sky, ideal estimates. If everything was great then why would you buy it?

P.S. You are doing a great job and will get a solid deal! Best of luck.

@Omar Khan , thank you for your input.  All great points.  How wide of a spread do you typically use between bank/owner financed?  I want it to be enough for them to seriously consider it but not to much to where I will be overpaying.

I feel the relationship is solid with all three.  They are not in a hurry but would like to close 1st quarter of 2018.  I will be able to see inside of 2 of the units tomorrow.  They have been very cautious not to let existing tenants know they will be selling the buildings.  Exterior has been very well maintained.  I like the fact they were built in 1984 so I should have to worry about asbestos/lead issues. 

Thanks for the encouragement!

Kelly

@Kelly Farley  There is no hard and fast rule as everything is dependent on your market, buyer/seller motivation and other factors. At this point, assuming you are developing a good relationship, don’t commit to any one price. IMO, find out who is the final decision-marker. In Orwellian terms, who is the “most equal” amongst the three.

Once you find that out, actively try to understand their motivations. For instance, the widow might desire security of income whereas the sons might desire getting the highest price. If the widow is the decision-marker, you can explain to her that Offer 1 will help he long-term – income, lower overall taxes and higher cash flow. But if the sons are the decision-makers, you can emphasize that you can quickly close. Finding out the motivators will help you sharpen your pitch.

From a strictly “visual” perspective (how it looks at first), $50K is not enough motivation. By understanding the underlying needs, you can design an offer that caters to their needs. But don’t take too long – pick a path and go with it (unless material information to the contrary emerges).

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