I have often found that one of the best ways to learn is to look at a concrete case study. Hopefully, a step-by-step retelling of how we recently purchased a 32-unit apartment complex will help illustrate some key lessons in real estate investment, particularly when it comes to purchasing apartments.
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Finding the Property
This was actually a rather lucky break on our part. Surprisingly, we found the property on Loopnet. Usually this means the property has been passed over or at least that it was just listed and is currently accepting offers.
In this case, the property had just fallen out of contract from another buyer the day it was supposed to close and had just been put back on by the owner himself. My brother caught the property and the $24,843 price per unit seemed ridiculous. Even properties in the worst parts of town sell for that if they are performing.
This property, on the other hand, is in a good, albeit relatively rural, area. According to CLRSearch, the crime rate is about the national average and the per capita income is $39,442, well above the national average of $29,126. The occupancy was listed at 90 percent, although the average rent was low (only about $450/month), and the owner was also responsible for most of the utilities.
So we called the seller to take a look.
The first thing that was obvious was the property had very good curb appeal, but the parking lot was in complete disrepair. I must have driven over 10 potholes before getting to the building (or perhaps the parking lot could be referred to as one giant pothole).
In all likelihood, this was one of the major reasons for the low rents. Who wants to drive over that madness day in and day out? And it’s an absolutely terrible first impression for potential tenants to get.
We have found that properties with units that rent for much under $450/month are hard to make cash flow because the expenses only have so much downward flexibility. In this case, though, the units were rather small, making maintenance, turnover and utility costs less demanding. Furthermore, a market survey I did afterwards confirmed to me that the rents could be raised at least $50/month, especially with a new parking lot.
Anyway, while we were at the property, our goal was to do two things: 1) learn as much as we could about the property and the tenant base and 2) build rapport with the seller. The latter was rather easy in this case, as the seller was quite the talker. Indeed, anytime we got in the same room with him, we were there for at least two hours.
We looked at a couple of units, as well as the basements, HVAC and grounds of the property. You don’t need to do extremely thorough due diligence up front. If you’re looking at lots of properties, it just isn’t practical. Instead, we tried to figure out what the major issues were, get an estimate for the necessary repairs and figure out what we would want to look at further if we got the property under contract.
The main items we found were the parking lot, the units being dated and patched together (the seller used different paint and carpet in each unit), the foundation wall was leaning a bit in two of the three buildings, the grading needed improvement and the buildings required more hot water heaters.
After I came up with a repair estimate, I took the seller’s operating statement and then tried to create a pro forma from it. (Pro tip: Never rely on a seller provided pro forma; always use real numbers when you can and fill in the rest with your own estimates if need be.) From there, I calculated what it would take to get a 10 cap rate and set that as my strike price.
I wrote an article about this negotiation if you’re more interested in that aspect. But there are a few key points to discuss here. First, I had done my homework up front. I knew what it was that I was willing to settle for (although, as I note in the above linked article, I should have also picked a goal price instead of just settling for my strike price). In this case, the seller was asking $795,000 and our strike price was $725,000.
The second point is that we asked the seller to come to our office. It’s a bit awkward to present an offer this way, but it’s a huge benefit. He had other interest in the property, and we wanted to separate ourselves from the pack. Being face to face allows you to tailor both your offer and how you present to what the seller really wants. In this case, he really wanted out of the property, as it had sucked the life out of him and his wife for the last couple of years, and the previous sale that had fallen through had really irked him. He wanted confirmation that we could close, and being face to face helped us assure him we could.
In addition, meeting face to face makes the whole process much less of a “yes or no” type affair. There’s a tendency on both sides to find a solution when you’re in the same room. The one risk here is that you find that “solution” by caving on your price. No matter what, always stick to your strike price.
After we talked for 45 minutes or so, I framed how we came to our offer before blurting it out by explaining how I was valuing the property and what we needed to hit. I opened with an offer of $675,000. He then responded that that was “way too low.”
The tendency with these sorts of responses is to be defensive or apologetic. Try not to be. It’s just business. In this case, I did pretty well and just replied, “Well, at what price would you be willing to sign a contract today?” I then paused. Let him respond, even if it takes 10 seconds. Don’t start negotiating with yourself.
He came back at $740,000, and we eventually settled on $725,000. I should note that I think I could have done better, but oh well — I hit my number.
Due diligence is boring, and many investors slack on it. DON’T! (Yes, all caps is necessary when it comes to due diligence.)
- Walked each unit to determine the condition and deferred maintenance. (Always walk every single unit.)
- Got a roof inspection.
- Had our HVAC technician check out the boiler system.
- Had our electrician check out the panels.
- Got a bid on the parking lot.
- Scoped the sewer line.
- Got a structural engineering report on the two buildings with foundation problems.
- Got multiple quotes on insurance and flood insurance (it was in a flood plane).
- Analyzed each lease and asked for proof of deposits for the last month to verify the rent had come in. We also verified the taxes and utility expenses.
- Had a property inspector inspect a few items we weren’t sure about.
- Reanalyzed my initial numbers to make sure everything was in line.
All of this cost less than $1,000, as well as some time. But we found that one of the sewer lines had a break in it, and the flood insurance would be more expensive than the seller had paid, along with a few other issues. We also verified that our planned repairs to the foundation were sufficient and the HVAC and electrical were satisfactory. Furthermore, particularly because of the flood insurance issue, we were actually able to negotiate an additional $10,000 discount.
In the end, we closed the property (after a sizable hiccup when our lender pulled out at the last second for apparently no reason, but fortunately, we had a backup). So far, we are about halfway through our upgrades, and the property is performing quite well in the early going.
In this case, we decided to purchase the property with our own money. But if you have a similar deal on your plate without the money to purchase it, bringing in partners and doing a syndication is a great way to go about it. Indeed, we strongly considering going that route on this one.
In the end, this appears to be a great acquisition for us. These deals are out there, even on Loopnet (occasionally). But make sure to be conservative in your analysis and thorough in your due diligence. A large deal that goes sideways can suck the life out of you. Next week, I’ll write about how that happened to us.
Have any questions about the process we used to purchase this apartment building?
Be sure to leave a comment below!