Why I Don’t Buy Houses for $30,000 or Apartments in D-Class Areas

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This has been an interesting week in the life of Ben Leybovich, both on the BP Forums and off. I posted several times on the Forums this week, most notably a thread entitled, “How to Lose Money on Multifamily!” There ensued a spirited discussion of why I pulled the plug on this deal and whether or not there was a deal to be had, but I missed the boat. Even my wonderful partners hung me out to dry a little bit…

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The Background

I spent some time this week evaluating a deal in an MSA (Metropolitan Statistical Area) about 8 – 9 hours from Lima by car. This MSA is quite attractive from an employment and demographics standpoint, and combined with the fact that the property was unlisted, this seemed like an interesting lead to follow.

I remember how this lead came in. I was in the car with my entire family on our way to Columbus, OH for one of Aaron’s appointments when the text came in from my friend, Serge Shukhat. It read something like this:

120+ units in xyz MSA. Talking to seller in 30. Will get back…

I was in the waiting room with my laptop on me when Serge and I connected over the phone an hour or so later to discuss details.

The subject is a troubled asset. In fact, right upfront the seller told us that only about 20% of the units were filled with paying tenants. He told us rents were low, but that with about $6,000 – $8,000 of CapEx, we’d be able to raise the rents to market and achieve normalized occupancy.

The Research

I started to do research. Sure enough, rents seemed to be low, but from what I could see online in terms of the square footage and amenity packages of the competition, I was not comfortable with the seller’s projections of stabilized rent levels — too aggressive. There was room to push, just not as much. I thought that having spent $10,000+/door we would move rents, and more importantly, at this point in the process I thought we could fill the units, and with the right kind of retention programs we could keep them full.

However, I found out that the asset has gone through several owners in the past several years. All of them tried to reposition the thing, and all of them failed.

This in and of itself means nothing. After all, Serge Shukhat, Brian Burke (oh yeah, the big dog came to play, too), and to some small extent Ben Leybovich represent the best and the brightest of what the real estate community has to offer in 2015…

Truly, between the three of us, we’ve got every possible angle covered. Think about this with me: Brian has the brains; I have the looks; and Serge… well, Serge got chutzpah!

Note to Brandon Turner: See? I’m making other friends. Pay attention, or one day you’ll look and the best thing that’s ever happened to you (me) will be gone!

Anyhow, the other guys failed, but we’ll succeed… right?!

Maybe. Here’s the thing I needed to understand:

Are people not choosing to live in this community because of the poor physical condition, or is there something more sinister going on? The building we can fix, but many other problems we cannot. Success or failure in this business is a function of understanding this.

Related: Newbies Take Note: Why You Shouldn’t Buy Houses for $30,000

Knowing that several people have tried and failed could either mean that they were country bumpkins of REI who simply didn’t have the appropriate skills to preposition such a project, or it could mean that this is not a good candidate for such reposition, period!

I needed to look at the demographics for the answer…

I researched the demographics of the town more closely. There were two zip codes in this particular town, and they basically divided the town in two halves. Here are some of the things I was able to glean:

  • Income levels in both zips are lower that the MSA by a considerable margin; however,
  • Income levels in the subject zip are really, really low!
  • Median home price in the subject zip is very low.
  • Population in the other zip has been growing steadily since 2000; however,
  • Population in the subject zip, while having stabilized between 2010 – 2015, has overall lost since 2010.
  • All but one of the comps are in the other zip.

So, as you can clearly see, this picture is less than sexy. People in this town are not particularly chomping at the bit to move into the subject zip code. In fact, it was beginning to look as though anyone who either needed to live in this town, or simply wanted to live there, were migrating out of the subject zip into the other.

The County Office

Something I do on every deal I underwrite is contact the municipal authorities to verify the processes and formulas they use to value property and assess property taxes. As I discussed in last week’s article, just because property taxes are what they are today does not mean that they will remain the same two years from now. And since property taxes are one of the largest drags on the NOI, I absolutely must be able to project with great degree of confidence what that bill will be at my exit.

The best way to do this is to understand the local custom as it relates to assessed taxes. And the best way to do that is by reaching out directly to the folks involved in the process.

One of the side benefits of doing this is that most of the time, the people on the other end are very friendly. Let me tell you, when the nice lady starts out by saying something like:

…how do I say this without getting in trouble…

You know there is an issue… or two… or three…

A couple of points:

  • You know how I mentioned in the beginning that this place is 80% vacant? Well, I bet you’re thinking this means that 80% of the units are empty with nobody living in them. Nope — there’s no water, sewer, or electricity to the units, but this, according to the nice lady, does not stop people from living in them. You ever heard of squatters…?!
  • The building is next door to subsidized housing, which I knew since I Google Earth-ed the asset and could clearly see a community next door that looked like subsidized housing (these all kinda look alike in the Midwest). This in and of itself is not necessarily an issue, especially since these looked rather not bad. However, when I heard the nice lady say, the city has done a lot of work in the past few years to clean that up, and it’s nothing like it was 5 years ago, I knew immediately that it would be a matter of another economic slowdown before the city dropped the “clean-up” effort like a ton of bricks.

Can it Be Stabilized?

This is a loaded question indeed. Or perhaps it’s a very simple question. Any building can be stabilized, but only if people’s perception of it can be transformed. And people’s perception is underpinned first by location, and only then by the structure.

Sure, we could fix the building; that’s only money. But can we fix this location?

My answer is: not a chance in hell would I even want to find out!

What Are the Options, Then?

If we are not going to spend a ton of money on rehab to make units attractive (because the projected rent revenue does not justify the expenditure), then what we are going to do is spend enough to make the units livable and call it done. In this case, however, several realities come forth:

  • We are NOT going to attract “stable and easy to manage” types of tenants. Which means that our CapEx, maintenance, make-ready, contract services, and vacancy are forever going to be sky high.
  • Also, we are going to need to under-price our units not just in the beginning, but FOREVER, in order to drive occupancy.
  • Management is forever going to be a pain in the butt — my butt, since I am 8 hours away!

The above means that since our top-line revenue is forever going to be compressed, and our operating costs are going to need to be well above the averages, the NOI is doomed. In fact, I see negative NOI as far as the eye can see, though both Brian and Serge disagree.

They say it can be done — an owner operator can do it; an owner-operator can turn the NOI positive on this project…

I disagree. I live closer to the action. I feel like I understand the dynamics better than my partners on this project. I also got an opinion from my PM company that manages thousands of units in this part of the country, and they concur with my findings.

I pulled the plug, and I stand by it. In my opinion, not even a skilled owner-operator can turn this thing around — it’s all about location!

Related: Newbies Take Note: You STILL Shouldn’t Buy Houses for $30,000

A project can be deemed financially obsolescent if it costs more to stabilize it than the exit value would be. This, I believe, is the case here.

Some Perspective

I am disappointed. Obviously, this had a lot of the hallmarks of a turn-around project. I have to admit as well that my perspective is colored by other elements which are present in my reality.

Screen Shot 2015-01-20 at 10.08.16 AM

 

 

 

 

 

 

 

 

 

This is my son Aaron and I in the hyperbaric chamber. You may know that we are recovering Aaron from autism. He is doing really well! He is now in school and doing great — yeah!!! And hyperbaric oxygen treatment is supposed to be the magic bullet that completely pushes him to the other side.

We started this thing this week. As the matter of fact, the message from Serge that I received in the car on the way to Columbus — we were on our way to get trained up with this machine. It’s now in our home, and Aaron and I spend 2 hours each day in it… 2 hours each day!

And then there’s school. And then there’s Kumon twice each week. An hour drive each way plus an hour there.

I guess you could say I am a little busy. I can do this primarily because I don’t buy units that require me to babysit tenants in perpetuity!

Can you extrapolate this please?!

Life is too freaking short, and there are more important things…

This week, Aaron was tested for his IQ by the director of the school, and can you guess what they found? The director pulled me aside and said:

According to the test, your son is a genius!

Excited is an understatement!

The first call I made was to Patrisha. You can imagine the emotions…

The second call I made was to my mom.

The third call was to Serge. I am 3 hours ahead, and I think I practically got him out of bed. I told him about Aaron, and then I said …this is why I pulled the plug on the project…

To which Serge said, you made the right decision!

Guys, when I tell you not to buy houses for $30,000, I do so because I don’t think it’s wise to conceive of real estate outside of the prism of everything else in life. My time and yours is by far the most precious asset we’ve got.

I don’t think that this particular project will ever make money. But even if Brian and Serge are right and it can turn out some cash flow, I just have no time to try and turn around D-Class buildings in a D-Class area. I do have time to turn around D-Class buildings in C+ areas or better, but this ain’t it!

This project is the syndication-level equivalent of a $30,000 project in most markets in the US. You wanna fight that fight…?!

OK, I’m done.

And now I need to find a quite place and do some thinking. I need to cut myself down to size — cause we sure as hell can’t have 2 geniuses in one household… 🙂

What do you think? Do you agree with my assessment? What would have done in this situation?

Leave me a comment, and let’s talk!

About Author

Ben Leybovich

Ben Leybovich has been investing in multifamily residential real estate since 2006. His area of expertise is creative finance. Ben works extensively with private as well as institutional financing. Ben is a licensed Realtor with YOCUM Realty in Lima, Ohio. He is also the author of Cash Flow Freedom University and creator of a cash flow analysis software CFFU Cash Flow Analyzer.

53 Comments

    • Ben Leybovich

      Thanks, Jonathan! I know this was the right call., Perhaps other folks will have been able to pull the plug after only a few minutes of looking at this, but I am not the sharpest knife in the drawer, as they say.

      In the end, I feel completely content with my call.

      Thanks indeed!

  1. Hello Ben,

    This was a great read for me specifically. I’ve been looking of it on BP forum but I can’t seem to piece together what is a likely definition of A class neighbourhoods vs B, C and D…

    Any help would be greatly appreciated.

    Cheers,

    Jamie

  2. Julia Rowling

    Hey Ben – I definitely get what you are saying about buying low-end properties not working for you. I respect and admire your dedication to your family and the very reasonable and appropriate REI choices you’ve made in light of these commitments. But what I keep coming back to, the more I read on BP, is how there is almost never a single choice that would be “right” for everyone. You discourage others from investing in lower-end properties because it isn’t worth YOUR time to get involved in such projects. However, that doesn’t mean these endeavors can’t be profitable to others, particularly those (like myself) who have plenty of time on their hands to handle the hassles….

  3. Michael G.

    Phenomenal post!

    Nothing more important that health and family!

    This post was smartly written with a good insight on the mechanics of the deal. The highlights for me included a) uncovering the fact that several owners have tried and failed to turn this property ( Success leaves clues…and so does FAILURE) b) picking up on the language of the tax assesors office and her opinion. c) Your demographic study and analysis – Blatantly displayed why this deal had a big NO on it.

    In a nutshell this could have turned into a total nightmare had you gone against your instincts.

    I’m excited to hear that you son’s situation has improved so significantly! I mean at the end of the day we all want our children to be healthy and safe.

    Great post Ben. Full disclosure – I havent always agreed with your postings but this one was spot on.

  4. Matt R.

    What a handsome and smart son! Yeah, I agree with your take. It does not matter if it is one pig or a bunch of piglets it is all the same. If locals can’t turn it around it does not look great for the next investor especially long distance.

  5. Maurice J.

    Ben,

    This is the best article I have read! Not just the numbers but the importance of family and life. This is why I feel REI is the best investment possible, it gives you the stability to enjoy life with your family and kids. Thanks for the post.

  6. Sharon Tzib

    The level of sophistication in your due diligence is inspiring and informative – this ain’t for amateurs, that’s for sure! No one can tell you if you made the right decision or not – that’s between you and your family. Thanks for sharing this story – really enjoyed reading it.

    • Ben Leybovich

      Well, it’s between my family, and my partners both of whom also put time into this deal. In the end, though, I think my decision was right for all involved – the downside was too great, Sharon…

      And yes, this level of sophistication and thought is how REI rolls at higher level. It’s chess – got to think ahead, and not 1 or 2 moves…

      Thanks so much indeed, Sharon! And thank you for your help with the other thing…

      Ben

  7. Kyle Mack

    I agree with this philosophy Ben. I was in a similar boat about 4 months ago, although only on a 4 plex…in the end, I had to pull the plug because as you say, I really don’t want to “babysit tenants in perpetuity.”

    But like you say, I will explore an opportunity with a D building in a C+ neighborhood, I think its important to establish a criteria where you can more easily distinguish between the two. What do you think?

    • Ben Leybovich

      Kyle – exactly. It matters not what the condition of the building is. Assuming there is no un-remediable functional obsolescence, at the right purchase price we can fix anything. The location, demographics, statistics – we can’t fix…and it works the same for a 4-plex as it does for 100+!

      ‘Thanks indeed for your comment!

      • Al Rivera

        Exactly. Unless someone has the unlimited funds to purchase an entire, dilapidated neighborhood, it’s not worth it. Too many factors to consider when you have bad neighbors. In Houston, there are tons of $400K+ townhomes built next door or one block away from slums. Who would buy a townhome like that? People from out of town that don’t do their research.

  8. Brian Burke

    Great article, Ben. I feel like I just re-lived last week! For the record, I agree that NOT doing this deal is the right decision. I don’t need headaches either, and taking on excess risk is simply unnecessary. I still maintain that this deal, if done right, would be NOI positive but that alone doesn’t justify doing a deal. Return on investment is what counts and that return should be high enough to warrant the risk of doing the deal instead of investing in money market accounts. The return on this deal relative to the investment made would be too low and the pain in the butt factor too high.

    That said, it serves a purpose to disagree with you…it makes you think, it makes you justify your opinion, it makes you gather data to prove us wrong. Only the uninitiated would want to team up on a deal with a couple of “yes men” who simply agree with everything you say. Disaster could be right around the corner and go totally unnoticed until it’s too late. If three people, each with a different perspective, all agree that a deal is a good one, I think it has a higher chance of being a good one than any “yes man” deal. More than likely, that is the composition of the team from whom we are purchasing.

    • Ben Leybovich

      Brian – I, unlike you, cannot qualify exactly “why” it gives me so much pleasure to disagree with you, but I’ll be damned if it’s not fun:)

      Positive NOI “if done right” means nothing. The set of skills and the perspective required to do this “right” is prerogative of highly sophisticated investors – none of who, much as ourselves, will touch this. Thus, this thing is doomed and heading for demolition, with the only 2 questions being – how many people loose how much money trying…

      Brian, Serge and I disagree on a daily basis (several times most days), so that ain’t no big thing. Disagreeing with you, however, is a special event in my life, worthy of a celebration. I just feel so strongly that at a close analysis, this deal has no redeeming qualities… no matter how much lipstick you put on it 🙂

      I tend to defer to you on most things – you know this. I am very cognizant that while I know a lot, I just don’t know what I don’t know. But…

      No yes men around me – ever. That’s how we create disasters – in business, as well as personal lives. Some day you’ll meet Patrisha and understand…

      I appreciate your friendship and perspective more than you know.

  9. Good stuff Ben, I think your perspective in analyzing this deal will be very helpful to many. We talked about this one at length and in the end we did in fact agree that this wasn’t the right syndication. I’d like to elaborate briefly on where it is I disagree with you:

    1. This IS a deal I would have purchased if it was in my location. I absolutely disagree that there was no chance of NOI nor that a savvy operator could have made money on this deal. Furthermore, I could argue that the NOI was not as relevant as you make it out to be and in general this type of project will never have stable NOI.

    2. You forgot to mention that through all of your analysis, you never went and looked at the property. I can figure out if a property is worthy in 20 minutes on the ground compared to weeks of online analysis. Thus I just don’t see how you could have done comprehensive underwriting by guesses of capex and third party opinions.

    3. All of your “third party” conversations (tax assessor, property manager, failure of prior owners), etc generally means very little to me. These are typically the deals I look for. On my most successful project, every owner since 1971 had failed. The tax assessor, water company and current tenants all told me hellish stories. This is all what scared off guys like you and let me buy it for pennies on the dollar. By time I repositioned and the new buyer made those due diligence calls, believe me they were all singing the praises of the complex. And no, I never achieved the NOI I hoped for but my Pro Forma did:))

    4. Finally (please no offense to you or Brian on this one) but I have to wonder if the underwriting model we are using is past its prime. I understand and very much agree with the model as it is based on the fundamentals of the project. I can’t argue with anything that goes into it. My only thought would be to underwrite the exit price on Pro Forma and not the conservative NOI that you think we can achieve. Over the last 24 months I do not see many projects that sell based on actuals. We all agree that we would not buy this way but this is how everything is selling. Maybe my lack of experience in this asset class is showing but if we had underwrote the exit value based on proforma with 2-4 months of actuals that were close, our underwriting would have looked very different. Not necessarily advocating doing it this way but thinking it may be more appropriate today as compared to 5 years ago. I don’t see how real NOI drives so much when we all know that the real NOI will NEVER be the driver of actual exit value. If it was the driver then there would be NO value of C and D class buildings as I am convinced there is very little real and sustainable NOI in these projects. What I’m saying is that I don’t think that matters as much as you do.

    • Ben Leybovich

      Serge – your points are well-taken as always. A few things, if I may:

      1. Whether somehow some positive NOI is beside the point. Whether I am wrong or right is beside the point. All of us agree – it’s not syndicatable. Why not? Risk – too much risk and too little upside…

      Of course, I am speaking in fundamental terms, which transitions us to the next point:

      2. You are right – the cycle is no longer about fundamentals. We are in a bubble; there’s a euphoria present in the marketplace. Since the exit is all about anticipating the buyer’s attitude, perhaps it’s no longer possible to buy on fundamentals.

      However, the suggestion that the model is past its prime is incorrect – the intent of this model is to ensure No Loss. Perhaps that means I can’t buy using this model in this cycle. But, with other people’s money on the line, my first objective is not to get a deal, and it’s even not to make money – my first objective must be not to loose. I just cannot throw fundamentals out the window, even though everyone seemingly has done exactly that…

      Could this project be bought, slapped some lipstick on, and sold on a carefully constructed pro forma to someone who either can’t or won’t dig into the numbers too much? Possibly. Am I willing to risk ending up with this pig on my hands and the cycle shifting back to fundamentals – absolutely not. Fundamentals are not there…

      Thanks, Serge!

  10. Brandon Sturgill

    Hey Ben, thanks for your candor in the post…should I be scared that the only potential deal you have looked at in several months is an 8hr drive away?…have you made your mind up that syndication is the right direction?…isn’t there still value in smaller commercial multifamily?…

    • Ben Leybovich

      Hey, Brandon!

      Yes – I’ve looked at 3 in the past couple of months. The distance is not an issue with these big project, since management is 3rd party. Yes – there’s still a lot of value in small multi; looking at 12 unit right now. Syndication is always the right direction if the deal is right 🙂

      Give me a call – I’ll tell you about the 12 unit. May not be right for me, but might be right for you!

  11. Great decision not to buy. I did not value my time enough in the past, but have learned from my mistakes. I have 4 kids and they are my top priority. It is great that you have your values in the right place.

    As an aside, what is the best way to sell a small multi-family (17 units)? It is a great property and I had planned to keep it forever, but it seems dumb not to investigate selling if we are in a bubble and I can get more money for it than I think. With single families, I just list with my local real estate agent, but I am not sure I would get the exposure to out-of-town buyers or out -of-state buyers this way. How do you find multi-family investments? (That may give me a clue of where to list mine.)

    • Ben Leybovich

      Thanks for reading, Michelle!

      I’d go to local REIA meets and advertise there. If you don’t have a mortgage, you can sell on contract of some sort and get much more than the thing is worth. Of course, the way people underwrite today, You can just list and still likely get more than the thing is reasonably worth:)

      Thanks so much!

  12. Hi Ben,

    I live in Ohio, and as soon as you mentioned the property was located in Lima I knew there wasn’t a chance in hell that that deal would work. I’m glad your partner performed his die diligence to include contacting the city or you would have expended alot of money and time trying to fix the unfixable.

    • Ben Leybovich

      Haha Garland – I live in Lima, and own many units that work ..lol

      This property was, if you read a bit more closely, * hours away in a VERY attractive MSA!
      And it wasn’t my peartner performing due-diligence – it was me. I spoke to the city.

      Thanks for reading, although I am a bit puzzled at which article you read, exactly…hahaha

      I needed a laugh today – thank you indeed:)

  13. Bill Neves

    If you’re not comfortable with a deal you gotta pass. Good analysis.

    And great job with your son. That’s awesome.

    My wife has done some hyperbaric chamber sessions. We have a friend in Vancouver, WA who has a clinic with 2 chambers. They’re booked pretty solid. Lots of benefits.

    • Ben Leybovich

      Lots of benefits is right, Bill! I am noticing that my joints are feeling stronger – been struggling for a few years. We have just started – excited at what the back end is going to look like…

      Thanks so much for reading, Bill!

  14. Al Rivera

    Personally, I would have passed on this property as well because it sounds like a slum lord’s dream. There are spotty areas in Houston and I know where they are since they haven’t changed since I moved here (30+ years.)

    I don’t want Class D tenants or properties because the headaches and extra expense of purchasing a gun and Kevlar jacket does not sound appealing to me.

  15. Paul Malcolm

    I classify the D’s as war zones and I immediately got the picture of the classification when someone said elsewhere, I wouldn’t send my wife there to collect the rent. If you have to bring a gun—-stay away!

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