All Forum Posts by: Frank Gallinelli

At least 12 months -- the more financial history you can get, the better. In fact, you may be able to get those bills directly from the utility companies. For property taxes you should check with the tax assessor (to see if there might be an abatement in place that doesn't travel to a new owner). As for insurance, call your own agent to find out what it will cost you -- don't rely on the cost of insurance in place. In regard to due diligence in general, I did a videocast with @Kyle Zylor on that topic, which he posted here: http://realestate-java.com/2013/02/24/the-importance-of-due-diligence-with-frank-gallinelli/

You've got some excellent advice so far, which in summary is: a) be sure to account for potential vacancy and credit loss; and b) do your due diligence in regard to operating expenses -- in other words, make sure you've taken all of the possible expenses into account and have have done everything possible to confirm that the dollar amounts are realistic.

Let me add one more consideration: After you've done the above, you'll have your expected NOI. Find out from local brokers or appraisers what is the prevailing market cap rate for apartment buildings in your area and use that rate, along with the NOI, to see if the asking price makes sense.

@Ben_Leybovich No worries, to be sure. A little give-and-take on the details helps us all focus -- and it doesn't change the fact that we're very much on the same page here -- helping our fellow BPers make the best deals they can.

Look forward to your post -- I'm sure it will be great.

A qualified "however" to Ben's observations.

Theoretically, less money down will increase your cash-on-cash return. However, the lower down payment means you have higher debt service on your larger mortgage and generally also means that you'll get less favorable terms on that financing (iow, if you have little or no skin in the game, you are a high-risk borrower -- perhaps higher rate, more points, shorter term?). All of this translates into less cash flow. You might have a better cash-on-cash with a smaller down payment, but not necessarily.

Also, I must respectfully disagree that a more robust analysis is too academic (although, since I teach this stuff in grad school it would be fair to say that my take on this is, by definition, too academic). I feel that cash-on-cash return can be a useful metric for the first year of a property's operation but not beyond. It does not take into account the time value of money, the timing or amount of potential future cash flows, or -- most important -- the timing and proceeds from the ultimate sale of the property. IRR (and MIRR) give a more complete picture. I believe that an investor should take all of these elements into consideration before making a decision.

Just my two cents.

@ Anne S. No need to speculate as to why she is selling. Ask point blank. Then, if the answer doesn't ring true (like the politician who "wants to spend more time with his family"), or if it turns out clearly to be false, then you have your first red flag.

re: financials, start by asking for the usual suspects: The actual current rents, the basic lease terms (expirations, renewal options, if any), and the operating expenses. Inquire after the back-story as well: are the any current or recent delinquencies or eviction proceedings, what is the occupancy history, etc.

If those numbers suggest a promising cash flow, then move on to the next step, called "reconstructing the owner's statement." That's a polite way of saying, "Thank you, but I don't necessarily believe anything you told me." Ask to see the current leases as well as the property's tax return or at least a P&L. You can verify many of the operating expenses independently, e.g., property taxes, utilities, sewer/water, and should do so. Ask your own insurance agent for an estimate. Inspect the property for potential deferred maintenance or needed capital improvements (roof, heating system, etc.). Now re-run the numbers.

At the same time, do your due diligence on the market. No property exists in a vacuum. If this is commercial, or residential > 4 units, what is the market cap rate for such properties? What is the market-wide vacancy for such units? What financing is available and what are the lenders' underwriting terms (DCR, LTV, rate, term)?

Finally, take your numbers a build a pro forma that projects the overall performance going out at least five years. Is the expected IRR at least in the low teens?

If it doesn't look like it's going to work out, no worries. You'll find one that does.

@Bill Gulley Thanks for filling in the blanks on the LLC issue. I was unaware of the backdoor vulnerability. I've learned something today -- so now I can take the rest of the day off ;)

@Karen Margrave Since my company has analysis software (including partnership structuring) for developers as well as investors, we get to talk to these developers and see a fair number of the ways they try to put these deals together. Probably the only thing I can say with real confidence is that there is no "one size fits all" structure.

One approach that we do see very commonly is for the developer to charge the project a fee (or fees) for the work he or she does in running the project through to completion. Then the developer may test several possible splits of the final disposition to see is there is a stucture where the equity investors can get an adequate IRR and the developer can also get a reasonable "promote" over and above the fee income.

@Bill Gulley I'm interested in learning more about what you say here, that there is no advantage to separating your properties' LLCs, because I've always believed that it was indeed important to do this to prevent liability from one property spilling over to another. In fact, I think at least one state (is it Delaware?) tried to address this by creating something called a Series LLC which is a single umbrella with "cells" (effectively, sub-LLCs) that isolate each property from the others. If you have any references, links, whatever that could shed more light on this issue, I would be grateful to receive. Thanks.

@Zac P. Many of the partnerships I see, where the managing member contributes a minimal amount amount of capital, are structured something like this:

The non-managing members (i.e., the equity investors) receive the bulk of the cash flow year-to-year, perhaps as much as 90-95%. The split is different, however, when you sell the property, where the managing member gets a larger split, perhaps as much as 50% of the cash proceeds.

This sort of arrangement conveys an important message to the equity investors. It tells them that you are confident enough about the overall profitability of the project and about your ability to manage it that you're will to wait until it reaches a successful outcome before getting most of your share (although you'll probably take a management fee in the interim). You have to remember that these folks are putting a chunk of cash in your hands and relinquishing control; they're looking for tangible evidence that you believe you can deliver.

Something else that is very common to encourage investor participation is what's called a preferred return. Basically, that's a promise that the investor will receive X% on his or her investment each year out of the cash flow before any cash flow split with the managing partner kicks in. If there isn't enough cash to cover that preferred return, then the arrearage is carried forward and still owed, even up to the time of sale if necessary.

Finally, one bit of housekeeping since you mention LLCs and a plan to buy several properties: I would urge you to form a separate LLC for each property you purchase. A main reason for using the LLC is to isolate liability. If you purchase several properties under one LLC umbrella and one of those properties turns into a legal nightmare, it could jeopardize the others.

@Andrew Broadbent Seeing your comment, I realize I wasn't as clear as I should have been. Just about all non-residential properties, regardless of the number of units, are valued on income capitalization. It's for residential four units or less that it is typically not used.