All Forum Posts by: Mike Roy

Hi John Bapst. The challenge with investing in 2-4 unit properties is that you’re competing with owner-occupants who, rather than being interested in earning a positive return or even “living for free,” may just be happy with an effective rent that is less than or equal to market rent. Compounding the problem is that most of these owner-occupants are not professional investors and thus are not factoring in management, vacancy and repairs into their calculations. Given all this, it’s easy to see how these buyers can justify 3-4 caps that generate negative cash flow, especially in a town like Portland where inventory is tight. I really don’t think a lot of these buyers are calculating their purchase based on future appreciation or rent growth; rather I think many are trying to lock in an effective rent in a town that’s seen incredible rent growth over the past several years. At some point, the economy will turn down hard and cap rates will normalize. Some of us will have cash to take advantage and others will already be all in on 4 caps. Based on your observations, it sounds like you will be prepared for the coming opportunity.

I understand that a discount to pay early might be an illegal attempt to circumvent the late fee law, but I wonder if some of these other incentives to pay on time might be okay to include in leases?

Provided the preceding 12 months (or 11/12) were all paid no later than a certain date (i.e. 3rd):

* Offer a low max rent escalator (1-2%) for lease renewals

* Offer inexpensive but high perceived value items (i.e. big screen TV) for lease renewals

* Provide a Winter Fuel Credit in December if tenants pay for heating fuel  

* Offer a choice of unit upgrades that you may have been planning to do anyway (repaint, new appliance, ceiling fans, etc.)

Mike

That's awesome, and very generous!

Hi @Michael Swan - You're certainly correct that there are important distinctions between a 1-4 unit residential property and a 5+ unit commercial property, especially in terms of financing and ownership structure.

I think an important nuance though is that, while banks will look at comps when underwriting 2-4 unit properties, a lot of times these properties are being purchased by investors who, if they're doing it right, are looking at cash flow and the opportunity to increase it by reducing expenses and increasing rents - essentially the same value-add strategies you take to a 5+ building.  And while you may not be able to utilize a market cap rate to determine value added to a 1-4 unit building, I guarantee you that if you can increase cash flow, investors will pay more for it and appraisers will find the comps.

You mention being at the mercy of comps with 1-4 unit properties.  A counter could be that 5+ is at the mercy of cap rates, which can go up just as fast as they've gone down if interest rates revert to the historical mean.  

With respect to the newbies you reference, a 1-4 unit property could be a very good place to get their feet wet without having to take on interest rate risk.

Mike

Hi Kenny - I think about this a lot and have decided it's worth it to take the 30-year fixed.  I hedge with higher liability coverage and feel that as long as your coverage is equal to or greater than your net worth, you're probably going to be okay.  You can also go a step further with a commercial umbrella policy if your net worth calls for it.

I tend to be more worried that rates will spike, sending cap rates much higher and valuations much lower.  I perceive the future inability to refinance commercial debt as a greater risk in terms of loosing my buildings.

Some people will probably just tell you to buy in your own name and transfer to the LLC; that they've never heard of a note being called. I just wonder if that will change if rates go higher, giving banks an incentive to look for low interest notes to rein in. Not sure if that's how it would play out if rates go higher, but it seems to make sense that it could.

Finally, I think an investor's strategy will probably differ depending on where they are in their investing career. Early on, as we are, you're really trying to maximize cash flow and build a portfolio. However, if you've owned your buildings for decades and have much more equity in them, you can probably still cash flow well with a commercial note and take advantage of the LLC protection. So a big part of this will depend on how levered you are.

@Remone Randolph - As an investor, I personally would rather buy 4 units instead of 5 for the simple fact that I can finance with a conventional loan. If I'm going to go commercial, I want a much larger building for the economies of scale to make the less attractive financing terms, and inherent risk, worth it. I think you were right to buy a 4 unit, especially as a live-in. As far as adding value, my guess is that you are more likely to sell to an investor than not. Investors want NOI, so I would definitely focus on rents if there is immediate upside. That will obviously be good for you too while you own it. Increasing gross rent is never a bad thing. Improvements are nice too, but all investors really care about is that the building is clean, functional, safe and competitive within the market. The best improvements you can make will be those that increase income, such as adding rentable storage; or reduce operating expenses, such as separating utilities or making efficiency upgrades if you pay for heat/ac.

@Sunny Burns when you start to experience the true cost of turnovers, I think you'll find that your vacancy and repair costs will be much higher.  For North Arlington, you're budgeting $1,500/year for maintenance, or $30,000 over twenty years.  If you analyze every likely repair and capex item you'll experience in 20 years, plus add in a few you don't expect, you'll quickly see that $30,000 isn't going to cut it - especially in pricey Jersey.  The other $1,500 per year for vacancy represents less than 3%.  That's less than 11 days per year for the building, less than 4 days per year for each unit.  

We usually underwrite at 10% for repairs, 10% vacancy and another 10% for property management.  Even then I sometimes feel these are optimistic numbers.  So if I were analyzing these two properties, I'd see it as running a negative cash flow on average over the long term.   

Part of the problem is the high taxes in New Jersey.  The annual tax on North Arlington is about 27% of annual gross rent!  In our investment radius, taxes are closer to 10% of gross rent.  There are definitely better cash flow markets than North Jersey!   

The $100k gross goal is cool, but I would respectfully suggest that you focus on NOI and the things you can do to manipulate NOI to increase asset value. That is how you win the multifamily game.

Best of luck!

Agreed @Mickie Hanson.  I think the only thing you can do is shop private insurance and assume the cost doubles or triples in the near future.  That's why I'd like to get to a point where income exceeds expenses by about 50% before taking the plunge, so that I can absorb short-term cost of living spikes, particularly in healthcare, that hit me faster than they impact rent prices.  

Hi BP - I thought I'd share a strategy I have to maximize my reach on Craigslist and potentially pull renters that were considering other nearby locations.  This works especially well for my rentals in rural areas.  When I create a title, I try to list several surrounding communities that have higher population and are a short driving distance away.  For example, I have rentals in Wiscasset, ME (pop. 4,000) that are a 10 minute drive to Bath (pop. 8,000) and 15 minutes to Brunswick (pop. 20,000) and Topsham (8,000).  

My title reads something like "Wiscasset 3 BD - Short Commute to Bath, Brunswick, Topsham!"

Now, my ad shows up in the search results for these three nearby towns, the towns that most people in the area are searching for anyway.  Since my rental is priced very attractively compared to listings in these towns, some people may now decide that the short commute is worth the lower rent in Wiscasset.

This is a pretty basic trick, but hopefully one that some of you haven't thought of and can now employ. 

Please share other tips and tricks you are using to maximize the effectiveness of your Craigslist ads!

In my investing radius, I look for 15% or more after subtracting 10% for management, 10% for repairs and capex and 10% for vacancy.  My rationale is that, while there are few alternatives in which to invest that can generate returns even close to 15%, residential real estate done well is a significant commitment of time, and I want to be compensated for that.  Anyone who tells you real estate investing is passive either hasn't done it or isn't paying enough attention to what they own.  

I calculate cash on cash based upon all initial costs to acquire a building, as well as to perform initial repairs/upgrades.  For example, we just closed on a 9 unit and will spend $30,000 to separate the heating systems, and I include this amount in my cost basis.  I also consider any upside on rents and pay more attention to cash on cash after rent increases rather than what it looks like on Day 1.  If you are only looking at present day rents, you may screen out a good opportunity based on a low present cap rate.

A "good" cash on cash should be considered in the context of the alternative investment options available to a particular investor, the perceived risks associated with those investments, the current inflation rate and prevailing interest rates.  A "good" cash on cash will also be different in every market.  If a particular market generally delivers a 10% cash on cash and you find a deal that can deliver 15%, all else equal, you've probably found a property that is underpriced and worth pursuing, even if you generally achieve 20% cash on cash in other markets.