First Building - Looking for Advice

15 Replies

After looking for a building local to my area with a decent potential cash flow, I have found a 19 unit building in a rather remote northern suburb of Detroit (Northern Macomb County for those of you that know the area).  Upon working with a buyer broker who is a friend of your family, we have a verbal agreement to draw up PSA based on a set price point.

There are some questions that I have regarding the process, thus far, and what to demand in the PSA regarding the due diligence period.

In this market, is it standard for a seller to refuse to release the true profit and loss documents until after a PSA is signed?  Of course, the due diligence would have plenty of provisions for obtaining and analyzing the P&L (Tax forms, utility bills, service contracts, etc), but I of course would have liked to have seen these numbers before spending the time, effort, and money needed to determine what the seller is holding back.  I have a rent roll but, the expenses are based a combination of pro forma numbers, adjusted to my version of what they should be, and research that I could do ahead of time (County property tax records, insurance quotes from my agent who insures my SFRs, asking service providers for an opinion, etc).  Should I demand seeing the P&L before entering into due diligence?  

I don't want to end up getting a reputation for retrading after the face, but I'm sure that I will find at least a few surprises, when I go through the documents and the physical inspections.

  • Numbers
    • Purchase price $875,000
    • Units 19 2 Bedroom
    • C Building, C Neighborhood, Low crime, Rural within driving distance to metropolitan jobs
    • Gross Rents (Rent Roll) - $10,600/month
    • Less 5% Vacancy  - $120,480/year
    • Management @10% = $12,720
    • Legal, Marketing, Administrative (My Estimate) - $1500
    • Landscaping and Snow Plowing (Pro Forma) - $2,631
    • Other Maintenance and Repairs (Estimate based on 10% total M&R) -  $11,481
    • Utilities (Common areas only Pro forma) - $1,069
    • Total Operating Expenses - $52,013
    • Expense Ratio 41% of gross scheduled
    • NOI - $68,827
    • Operating Cap at Purchase Price - 7.87%
    • CapEx Reserves (Not included in NOI) - $300/unit per year

Does anything seem out of place, based on these numbers?  The expense ratio may seem low, but it is a newer building and currently 100% occupied (rents are being held low to keep occupancy up, relative to surrounding propeties).

Any input would be greatly appreciated.

    @David Calme - I agree with @Michael Ohara , the utilities seem low.  Even if tenants pay water, sewer, and trash, that would probably be a bit low as you'd be paying for utilities in any vacant units. 

    I'd increase vacancy, especially given the size of the property with only 19 units.

    I think an expense ratio of 41% for a property of this size is a bit low.  It's tough to say without seeing historicals but I would probably beef up the expenses a bit more.  If the owner pays for water/sewer, I would think you'd be closer to 50%.

    @David Calme congrats on finding a property that fits your criteria. Not an easy task these days. 

    From a quick glance:

    • utilities seem low
    • Vacancy seems low
    • missing: loss to lease, property taxes and insurance expenses 
    • Most banks require the reserves to be above the line (in the NOI)
    Good luck 

    @Michael Ohara - Thank you for your input.  Tenants pay utilities for the units.  Individual gas forced air furnaces with A/C condensers.  I have several local property managers that tell me that they will do 19 units for 8%.  However, I like to be conservative in regards to PM.  

    @Brendan Kelly - Good point about vacancy as it relates to utilities. I should beef up the utilities a little. If I allow more for vacancy, it will probably get closer to expenses 45%-50% of gross. Thank you for your insights. I will see how it plays out when I see the actual expenses. Is it common for a seller to refuse to show at least a T12 before having a PSA or could they be hiding something that they hope I would chose to ignore during due diligence?

    @Joseph Gozlan - Thank you for pointing the taxes and insurance.  Sorry, I had them in the analysis and total, but neglected to put them in the post.  Taxes are indeed the largest single expense in my area.  I am relatively secure with those number as they are taken from county records and from my insurance agent that I work with on other properties.  If I lump loss to lease into vacancy and bump it up to 8-10% do you think that would cover it?  Thank you for the good advice.

    Originally posted by @David Calme :

    @Joseph Gozlan - Thank you for pointing the taxes and insurance.  Sorry, I had them in the analysis and total, but neglected to put them in the post.  Taxes are indeed the largest single expense in my area.  I am relatively secure with those number as they are taken from county records and from my insurance agent that I work with on other properties.  If I lump loss to lease into vacancy and bump it up to 8-10% do you think that would cover it?  Thank you for the good advice.

     I couldn't tell you if it's enough or not. This is super specific to location/property. Never use industry standards for more than initial analysis. When you get down to offers you need to know the details about the specific property and area. 

    If the standard occupancy in the neighborhood is 85% then 8%-10% is too little but if the standard is 100% occupancy because it's the hottest street in town, then 10% might be too much. 

    I wouldn’t worry about not having their specific expense numbers for Repairs and Maintenance, Or Lawn care and snow removal. You always need to put a plug number or put in your own estimate for these numbers. The previous owner may be doing this work in a way you aren’t capable of or want to do. The previous owner could be giving someone a break on the rent to mow, or have a nephew that shovels for cheap on the weekends, or he does the maintenance work himself and doesn’t account for his own labour, or they aren’t doing the R/M to the standard you would.

    The only number I would want to have hard and fast before due diligence is the actual rent numbers and it sounds like you have it through the rent roll.

    What about a live-in super? Had you thought about having one or just go with the PM company?

    @Rod Joseph - I am planning to do bank financing with a safe LTV and DSCR. Trying to put some capital to good use. With the type of deal that I am looking at, there isn't much meat left on the bone to satisfy the ROI that other investors would need to see.

    @Andrew Cameron - Thank you.  I agree.  It is difficult to compare apples to apples when it comes to these types of expenses.  These variable expenses are what I am having a hard time putting numbers to.  I try to be as conservative as I can with respect to those numbers.  Most of the "actual" numbers that I see have some sort of owner management/maintenance reflected in the P/L and thus appear to have very favorable expense ratios.  The properties that I am looking at are certainly small enough to self manage and do much of the work or have friends and relatives help.  I have that in the back of my mind as well for operating the property, but of course I can't factor that in to underwriting.    

    @David Calme  Oh yes, for my properties when I was first starting out we had no direct management expense on our P&L.  This made the look much better!  However, I would never use someone's P&L that didn't have a management expense to value the building.    I would put in a minimum of 5% management fee, and 5% repairs and maintenance if it is older building and not even concern myself with their actual numbers.

    Did you get utility numbers from them?

    Thank you @Andrew Cameron .  I have been trying to come up with a happy medium for estimating those variable costs.   I try to be conservative, but not excessive.  Your suggestions are a good starting point.

    I am still waiting to see the numbers from the utility bills.  This building has tenant paid electric, gas, and water, so it should be fairly low.  However, I should keep a close eye on that as @Brendan Kelly pointed out that vacant units must be heated.

    @David Calme  Glad the suggestion will work for you.  After I look at the property with a 5% management and 5% R/M, I like to run some different scenarios to answer what happens if management is 10% or 3%. Same for R/M.  This just gives me a sense of what will happen if these cost estimates change.  

    @David Calme : with regards to your question about retrading: just be clear to both the broker and the seller, that your offer price is based on some assumptions that you will need to verify during the due-diligence period, and that ability to stand behind that offer is only as strong as the information that you were able to factor into it. You feel pretty good about your assumptions, but without an PNL, you can't be completely confident in them.

    Make it clear to both parties that you don't intend to retrade over minor issues, but if it turns out that your assumptions are way off, it's possible that you'll have to revisit the offer. Fair enough?

    James

    Thank you, @James Kojo .  That is definitely a fair way to play it.  I have made it clear to all parties that the offer price doesn't mean much if the P&L doesn't check out with the assumptions made based on the pro-forma, or if the physical inspection turns up some costly deferred maintenance for that matter.

    Number 1, I don't want to spend a lot of time and money to find out that the seller is trying to hide something that he hopes we will overlook.  Number 2, I don't want to go into a PSA with the intention of retrading.  I would be more than happy to honor the price in the PA if everything checks out.  However, C properties with decent cash flow and light value add opportunity are not so easy to find, so I guess I will have to bend a little to see.

    Thanks again for the advice.  It helps to know that I am not way off base on how I'm handling this.

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