I am practicing analyzing MF deals in small cities in Georgia, such as Columbus, Macon, Griffin, etc.. These properties are mostly in B and C neighborhoods. What are reasonable cap rates I should plug in for a fast estimation on their values using Michael Blank's 10-min method? I am using 8% and found that estimated values for many on-market deals are only about 70% of what is being asked. Basically, I am using 10% of the current potential income as the vacancy rate and 55% of the rest as repairs and maintenance, i.e., NOI = current_potential_income * 90% * (100%-55%). Does this fast estimation have any value in serving as the first pass for analyzing small MF deals ( < 20 units)?
Thank you in advance!
That's great that you are practicing. I hope for your sake, the practice eventually translates into a deal.
For your smaller deals (less than 30 units) using a 10% vacancy/collection loss factor and a 55% expense ratio is a pretty good place to start the analysis (might be a little conservative from a V&C standpoint). Your 8.0% cap rate is also in-line with B-C product of this size in second- & third-tier markets (7-9% OAR is a good range for B/C product in tertiary markets). That said, and depending on location/property, you can probably lower your cap rate closer to 7-7.5% and still be within the range of reason.
You also have to consider that you are looking at asking prices, not sale prices. There is a growing disconnect out there between buyer and seller expectations. I think this mostly falls on the shoulders of unrealistic seller expectations.
Yes, we are at the top of the cycle. Yes, we are turning into a nation of renters pushing user demand for multifamily product to historic highs. And yes, there is growing demand from investors. But these are macro-economic trends primarily attributed to the Millennial and Baby Boomer demographics who typically are not leasing at this type of property. As such, the noted trends do not necessarily trickle down to class B/C properties in tertiary markets. Only buyers can bring sellers back in-line.
The properties you are likely seeing in these markets usually do not have separately metered utilities. They also tend to have elevated levels of deferred maintenance. These characteristics push expense ratios closer to 60-65% (maybe even 70% - be careful!). Additionally, as alluded to above, this class of property typically does not have the best clientele and comes with tenant issues that are not easily (or cheaply) solved.
In summary, stick to your guns and be careful with smaller, class B/C properties in tertiary markets. Your "quick" test underwriting isn't too far off the mark. Whatever you do, don't compromise your requirements just to get a deal done. Stay with it - it is worth it when you land a good deal. Best of success!
Thank you for your information, which is very helpful!
I am glad to see that 10% vacancy and 55% expenses based on potential rental income is not too far from the mark for these small MF properties in tier three markets. I will keep using this quick method to scan through the on-market properties before I dive into a few of them for more in-depth analyses. Then, I will be able to validate many numbers by calling the broker for rent rolls and the property manager for cap rates in the area.
According to you, who are typical tenants for these apartments in small cities in GA? Are we experiencing increasing vacancy in these properties as Millennials and baby boomers tend to cluster in larger cities? Will the overall population of these cities be a good indicator of what future trends will look like for these small MF properties?
Thank you for reminding of possible challenges in owning B/C class MF properties in tier three markets. I am aware of them (although I have not personally dealt with such clienteles before). I currently own several SFHs in metro atlanta area. Although they usually attract high-quality young professionals who have well paid jobs and easy to manage, I found the cash flow is just not as good as what I expected (which means a longer wait for financial freedom) and I will take me a while to accumulate enough to not have to work. Also, lack of economy of scale is another major reason that made me decide to focus on multifamily properties. I have waited too long before finally realizing the importance of economy of scale in RE investing. Due to the large amount of fund required for large MF buildings, I really don't see many other options here. My strategy is to get my foot in the world of MF investment by first owning a small MF property and then go from there (i.e., networking with property managers and RE brokers). Feel free to advise if you have different opinions.
Yeah, I am pretty positive that I will get my first MF deal in 2020. The main difference will probably be in the size of the deal.
Thank you again for your insightful comments!
You’re welcome and I am certain you will persevere if you persist. Please keep me updated as to your progress and feel free to reach out with specific underwriting help when you find something worthy of a deeper dive.
After reading your questions and re-reading my initial response, I hope I didn’t paint with too broad a brush when it comes to the clientele for Class B-/C properties. We have some very good tenants in our property that falls into this class. That said, it only takes a few to make for big headaches. My experience is that we simply have more problems with the tenant base at our class B-/C property as opposed to the Class B+/A- asset we own. This despite a very thorough tenant application/screening process.
At the Class B-/C property, we experience a higher level of incidents and-or disputes between the tenants, more occasions of requests for rent payment extensions (i.e. “hard luck” stories), a lower level of caring with respect to the rules and the surroundings, etc. etc. In general, a more transitory environment where we more often than not, run into the “professional” tenants who know how to game the system. This is not to say we don’t run into these problems at the Class B+/A asset, it just doesn’t occur at the same level or frequency.
I don’t think there is increased vacancy in Class B/C properties as a result of Millennials and Boomers being absent, or in short supply, in tertiary markets. In fact, I actually see Class B/C assets out-performing a lot of Class A properties in a lot of secondary markets. While supply plays a part in this dynamic, in my opinion the increased exposure to vacancy will be at Class A properties in tertiary markets, not Class B/C assets. This is primarily related to there being a limit to the number of higher paying jobs in non-major metropolitan areas.
Finally, it’s pretty well accepted that jobs and population growth go hand-in-hand. People go where there is work. Follow and analyze a market’s employers (or lack thereof), and you will be off to a pretty good start towards having a grip on the type and level of housing that will be in demand. In turn, you will then have an idea of what to expect in terms of your tenant base. As a rule of thumb in the MF world, with better paying jobs comes better performing tenants.
My advice is to partner-up with someone who has done a MF deal or two. To meet this person, you should try to expand your network as much as possible. Start by attending REI groups in your area (or start one if absent from your market). You can also travel to areas that have established REI investment groups. Continue to be active on BP forums. Check out Michael Blank's programs and join his Slack group. Join a mastermind group. Basically, do as much as possible to get yourself "out there".
While expanding your network, I would also be thinking about your approach to the people you will be meeting. You really want to figure out a way that you can add value to someone else’s goals and pursuits. If you can identify a way to help other people do any of the following, you will be much more likely to find a MF partner: sourcing deals, sourcing capital, securing debt, underwriting and due diligence, execution of a value-add program, securing the operational side, etc. etc. The key is to listen to others and identify their needs.
Keep at it and let me know how things progress.
Thank you for more detailed info on class B-/C MF properties. It is not surprising to hear that overall tenants in B-/C neighborhoods create more problems than those in A-/B neighborhoods. I think there is a trade off between cash flow, ease of management and the stage of investment. As I am in my early stage, I would be ok to trade more hustles, and higher risks for higher cash flows to accelerate the process. My portfolio may change again once I achieve my current goal and will focus more on the passive aspect of MF investment.
Thank you for your advice on how to proceed from where I am now. Partnering with someone is definitely one option that I will consider. According to Michael Blank, partnering with some more experienced investors is a kind of leverage too, which I totally agree. I will also check into his training programs.
Yeah, I will definitely keep that in mind! I heard so many stories from RE podcasts about how these newer investors got their programs started by providing values to goals of those more experienced investors.
Thanks again and I will absolutely reach out to you if I encounter some issues in the deal making process and property management!