About that Deal…

Apartment Building

 

I’m always cruising around, looking for good deals on properties.  In late 2008/early 2009, I had seen the above property listed on CraigsList for $80,000.  The interior was partially gutted.  The commercial space (on the ground floor) was originally a church, then was the post office, and most recently had been used as a strip club (keep in mind, this is in the heart of Amish country in Centre County).

I lost track of the building and purchased a few of my own UFUO’s.  Last year, the building came on the market again, this time at $215,000, with four apartments and unfinished commercial space (the mirrors and poles had been removed…I’m not lying).

$215,000 was way too much for me to afford.  With the commercial loans I am able to use to finance my properties, I need to put a minimum of 20% down (my current bank actually requires 25%).  This is $43,000 at 20%, or $53,750 at 25%.  I had $20,000 borrowed from friends.  I decided that the next time this property came on the market, I would try to purchase it.

Well, no one bought it.  The current owner decided to drop the price to about $190,000.  Still too salty for me.  I forgot about it and focused on my duplex.  The building still didn’t sell, so the owner dropped the price further, this time to about $150,000.  I felt it was just out of reach, but getting tantalizingly closer.

A little over a week ago, the owner dropped the price to $125,000.  This would be a long shot, but would probably be within reach for me.  The down payment would be $25,000 at 20% down.  I am in the process of refinancing a few properties, and had hoped the two properties would yield enough appreciation to give me the 20%.  Well, if you followed my post, you would know that I had a rough week and the first property came in SIGNIFICANTLY shy of any ‘good’ appreciation (post is here).

I decided that rather than get too down about the appraisal, I just need to exercise some creativity when I submitted my offer.  The same day my appraisal numbers came in, I read the blog post “Why I Often Pay More than a Property is Worth” by an author I really enjoy, Ben Leybovich of Just Ask Ben Why.

Many times, when two parties are negotiating a deal, an adversarial atmosphere begins to develop.  One party doesn’t want to pay full price for the house the other party is selling.  Sometimes these reasons are well thought out, other times not so much.  Ben’s post outlines many times when he decides to pay more than the asking price for the property.

Why?  Ben actually does a great job laying out the reasons to offer MORE than the asking price.  One of the reasons to ask more than the asking prices was if the owner could offer owner financing and take a lower down payment (the light bulb went on inside my head).

What if I could offer more than the seller is asking but ask the seller to carry the loan until I can get ‘regular’ financing?  To get the normal 20% down, I could ask investors to invest in the building, I could pay down the debt, if the building appreciated I would ‘own’ the 20%, or lastly and most likely: simply saving every last cent I own.

So, the day I learned I wouldn’t have the cash for a 20% or 25% down payment on a $125,000 property, I pulled up my spreadsheet and went to town working on my numbers.  I came up with an offer for the building of $135,000 with 5% down, the owner to hold the mortgage for 5 years at 5%.  With this offer, the down payment would be $6,750.  Between my appraisal and some stock I own, I can scrape together $6,750.

I wanted my offer to really stick out (beyond the financing).  I decided to send a cover letter along to the owner.  The property had been a mess when he purchased it.  He fixed it and the property now looks great.  Rather than try the (fairly) standard, “Well, the paint is a little off.  You used plywood for the kitchen islands rather than stone. Etc”, I would tell the owner that he did a really nice job with the property and that I really liked it.  In fact, I liked it so much that I felt it was worth more than he was asking.  See my letter here: Letter for Blog_Owner Financing.

On the way out to view the property, my Realtor and I discussed the offer and how to make it as strong as possible.  When we stepped inside the property, the improvements were so nice, my Realtor was actually quite surprised that a) I was interested and b) the numbers worked so well and no one else was interested.

As soon as I got back from the showing, I immediately emailed my Realtor the details of the offer.  I asked her to hold off on actually submitting the offer until I had rerun my numbers.

On Friday evening, I confirmed the numbers and asked my Realtor to prepare the offer.  Saturday, we reviewed the offer and made one final tweak, we asked the seller to carry the loan for two years at 5% rather than 5 years.

I scrapped my piggy bank (literally rolled quarters) so that I had enough for the good faith money.  We submitted the offer at about 3pm on Saturday.  On Saturday evening, I updated my rent rolls and my personal financial statement.  I sent these updated numbers to my Realtor in case the seller requested additional information about my financial situation.

Then we heard nothing.  And nothing on Sunday.  And nothing on Monday either, until about three in the afternoon.  My Realtor called to make sure the seller’s agent had received the offer and to see if the seller needed any additional information.  Apparently, the seller’s agent was out showing the property to someone else.

At first I was a little miffed that the seller was showing the property to someone else, but because of my offer, I understand the desire to want more ‘traditional’ financing.  However, by the end of the day, the seller’s agent told my Realtor that the seller had submitted my proposed mortgage to his attorney.  I think means that my offer is at least being taken seriously.

We’ll see how this all goes and I’ll keep updating the progress.

UFUO #2: Fail?

[Sorry for the premature email blast earlier today…hit the wrong button!]

To say that yesterday was a disappointment is quite an understatement.  I knew I had two huge ‘at bats’.  I hoped to at least get a single from one of these two.  In addition to these two at bats, a third ‘at bat’ came my way.  In all three cases I struck out.  Sort of made me want to go out and scream “WTF!?!?”    Trying to keep my head up and make the best of disappointing situations.

At Bat #1: I met with a potential investor to discuss a multifamily investment.  I was hoping the investor would be open to the idea of working together on this project.  The property is 80% rented and currently makes a profit.  Fixing and renting the last unit would only add to the cash flow.  Once the conversation turned to financing on the project, the entire discussion got frosty.  I was fortunate enough to have worked up an ‘alternative’ financing package that we were able to talk through, which eventually lead to a thaw of our conversation.  We left on good terms, will meet again in the future, but man, I really whiffed this one.

At Bat #2: I met with the boss today to discuss moving my Day Job in a different direction, but within the company.  Essentially, my proposed plan is to purchase run down houses, fixing them and holding onto them for rentals (sound familiar?).  I was hoping for some buy-in to start this process this year, including the purchase of at least one property.  While I wasn’t entirely shot down, the initial reaction was “let’s discuss it this year and maybe consider moving this direction in 2015 or 2016”.  While not a total loss, it wasn’t the reaction I was looking for.  I’m searching for creative ways to make this shift a reality this year.

At Bat #3.  I knew this ‘at bat’ was coming at some point, but didn’t anticipate it happening on Thursday.  I’m in the process of refinancing UFUO#2.  Gross receipts (monthly) are $1,170, which is a FAT paycheck.  Obviously, loans, insurance, taxes, etc all eat into that and the profit is significantly less, but it still leaves a tidy sum at the end of the month.  As part of the refinancing process, I pulled all my receipts to see how much I actually spent improving the property.  Net receipts were about $15,000, excluding my time.  Given the improvements to the property, I wanted to at least cover the cash expenditure on the property.  Well, the appraiser determined the property was only worth $10,000 more than when I purchased the property.  At 75% LTV, I’m only able to access about $7,500 of the improvements.  Not only is this a frustration, it significantly slows my ability to continue investing this year, which compounds my frustration on a bunch of levels.

While I could be really down about yesterday, I instead chose to do my best imitation of Brian from Monty Python’s “Life of Brian” (If you need a refresher, check here).  I returned home, consumed an adult beverage and pulled out the spread sheets to review.  I also started to question some of my personal investment theses.  Do I really need to continually purchase extreme fixer-uppers?  (Answer: No).  Should I focus on single family fix-to-rent projects?  (Answer: Probably not in the markets I am currently able to afford.)  Should I look for capital appreciation in these B-/C+ neighborhoods?  (Answer: Probably not, look for excellent cash flow).

APOD_1

What did I learn from the spread sheets?  Well, for the markets I am currently able to afford, a duplex, triplex and even a 4-plex costs marginally more than a single family home.  Sure, you have to deal with exponentially more resident issues (MY NEIGHBOR JUST BURNED SOME POPCORN…CAN YOU FIX IT FOR ME?  yes, I really got this phone call this week).  However, even after dealing with the resident issues, duplexes, triplexes and 4-plexes usually offer significantly more cash on an annual basis.  In addition, with smart purchases, one or two units will carry the whole building, meaning that additional units simply add to the bottom line.

While continuing to look on the bright side of life, my Realtor and I toured the apartment building today.  The building is in AWESOME shape; the price is perfect; the property cash-flows (at it’s current 80% occupancy); the property is in a market I want to move into; and, after our tour, I learned that the rents the seller’s agent had advertised were LESS than the actual rents (which I verified through signed leases), meaning there is even more money dropping to the bottom line than originally advertised.  This single property would satisfy all of my 2014 investment goals.  Using my cash flow projections, I would then enter 2015 with a huge (for me) war chest ready to begin purchasing additional rental properties.  My Realtor jokingly said “I don’t know Liam…this property may be in too nice of shape for you to buy!”

My biggest hurdle for this apartment building is the down payment.  I have some ideas and will be submitting an offer, probably Saturday, with my ‘creative’ package.  We’ll see if the current owner is interested in ‘creative’ offers.  More details to come as this project progresses.

In addition to seeing the awesome apartment building, I had a major epiphany regarding investments with my Day Job.  One of the problems with my Day Job is that the company has nothing to capitalize (use as collateral on a loan), so when we pull loans, the banks put a lien on owner’s houses.  If the company were to collapse, some owners could possibly lose their homes…not a pretty prospect.  My idea is to enter into a partnership with the houses-on-the-line-owners and myself.  We would look for fixer-upper single family homes and do the old fix-and-rent.  Then, rather than refinance the property, we would use the equity in the property to reduce the houses-on-the-line-owner’s exposure by ‘swapping’ the rental property’s equity for the owner’s equity.  Obviously, it’s a two way street.  The partners get access to the equity; in my proposal, I would get access to all the cash flow (depreciation would be split).  I’ve pitched the idea.  We’ll see how it is received.  (However, after seeing the apartment building today and the associated building’s numbers, I actually question this partnership pitch, but I should probably have a few lines in the water).

A Lesson from the Past (#2)

As much as young whipper snappers like to think they are smarter, faster, better prepared, have it all figured out, etc, etc etc, history really does repeat itself.  The older you get, the less you feel like a young whipper snapper and that’s probably for the best.  Every time I think I have something unique figured out, I stumble across wisdom like this:

“…Others are less kind.  They say America’s economy is falling apart.  Big labor has lost its ability to protect the rank and file.  Japan and Korea are changing the way we think and work, and the British-style Fleet Street hype has taken over TV and most of the press.  Huge numbers of college students struggle to read and write.  They graduate without having learned to think or decide.  Product quality is an impossible dream in many industries, and the focus on current earnings per share plagues even the most farsighted planners.  All that’s left, it seems, is to work hard and make money.”

If I had left in the original first sentence to this quote, which reads “Some say America is changing from a smokestack to a service economy,” the quote would have shown it’s age.  With a few minor tweaks that quote is apt for life today.  Reread the quote but substitute “China” for “Japan and Korea”, and while I actually had to look up what “British-style Fleet Street” means, my local NPR station does play a variety of BBC type broadcasts throughout the day.

Just as history repeats itself, I’ve got a whipper snapper at home.

Whipper Snapper feet

 

PS.  The above quote is from “Cashing in on the American Dream”, written by Paul Terhorst.  Copyright: 1988

Using an APOD

An Annual Property Operating Data sheet (APOD) is a very important tool to use before you buy a rental property, while you own the property and even when you sell the property.  At its most basic, an APOD is simply a worksheet to calculate your potential profit or loss.  With minor tweaks to a basic APOD, you can have a powerful tool available at your fingertips.

As the name suggests, an APOD details the annual costs required to own the rental property.  Some APODs factor in lost rent due to vacancy, costs for repairs, costs for improvements, utilities, etc.  Typically, when I ask my real estate agent for an APOD, I receive either hand written chicken scratch from the current owner, or a worksheet that seems to show the house in quite a rosy light.  When I receive these “Income and Expense” statements, I usually ignore their bottom line and plug and chug in my spreadsheet.

I developed an APOD that is conservative, meaning the APOD exaggerates the downside risk, effectively taking a worst-case-scenario snapshot of the property.  I developed this because I want to ensure that I will make money when I purchase a rental property.  I don’t have cash to burn owning a property that doesn’t throw off cash at the end of the month.  To be conservative, I slice almost 30% off of the gross rent each month (detailed below).

Here is a snapshot of my APOD:

APOD_1

We’ll start working through each column:

The first column is rather easy, it’s simply current information about the building.  I always include the address for the building.  I do this for a few reasons.  First, it is simply a record of a property I reviewed.  Secondly, I now have one additional point of data for calculating my local rents.  Lastly, keeping the address allows me to follow up on the house or building if it goes off the market.

After the address, is the current information on the asking price, current rent, taxes and insurance.  All of these figures are then used to determine potential profit from the rental.  The ‘Month to Close’ allows you to remember when you purchased the building to calculate your first partial year’s gross income.  I prefer to have each rent recorded rather than only a gross rent for the building.  This allows me to determine if certain units are under market rent.  Again, I can also compare the rent of the new building to my rentals to determine if I am over or under charging.

Note: If this is a UFUO (Unique Fixer Upper Opportunity), then input your calculated rents (see: Calculating Your Rent).  Remember, if you purchase a UFUO, your first year’s numbers will generally look horrible because you are incurring costs while you are fixing the place (Watch for the post: Repair vs. Improvement).

The taxes and insurance are usually available on the MLS listing.  If not, ask your real estate agent for this information.  Note: It is good to verify the tax information by calling the municipality.

You do not need to include the information about the building’s size, zoning, heating system, etc.  I do just to remember how the building is set up.  I am usually leery of private wells and septic systems (many other people have no problems with them…it’s one less cost for me to consider).  I also try to keep away from oil heating systems, unless it is possible to upgrade to gas or high efficiency electric.

In the ‘Loan Information’ section, you should input your Purchase Price, Term for the loan, and the rate.  Typically banks will require 25% down for a non-owner occupied investment property.  Seldom will a bank lend if you have less than the 25%…but sometimes they do.  The second property I purchased, I was able to negotiate for only 15% down, which helped my cash flow significantly.

Let’s move to the Operating Expenses:

This column is relatively self-explanatory.    Under the “Administrative” heading are your ‘overhead’ items.  If you are smart and willing to put in a little work, there should be very few costs while you only own a few buildings.

I do not have a property manager yet, but if I did, all of her/his payroll information would be located under the “Property Management” heading.  You could include yourself as an ‘employee’ under the property management heading.  Monthly, you would be able to take the cash allocated under that heading.  I don’t do this because I am trying to expand my business, so I am reinvesting all of my profits.  This rate is also 10% of gross rent (part of the 30% off the top I mentioned earlier)

Under “Maintenance”, the ‘unexpected maintenance’ is a self-calculating cell.  I arbitrarily chose a value of 10% of the property gross cash flow (the second 10% off the top).  I assume this is what is going to randomly break and will have to be repaired (This is also part of my downside risk assessment).  Once my repair reserves are adequate to cover most random expenses (roof repairs, boiler repairs, etc), I will pare back the repair reserves and add that to my profits.

The “Services” heading lists typical services that may have to be paid.  I normally pay for trash because it is a fixed monthly cost.  If you have other services or utilities, you would want to include a brief description.

For “Utilities”, I included the typical utilities for our area.  I never include phone or cable in my rent, but maybe you want to do so.  There are two free spaces for other utilities at the bottom of that page.

HA!  Now we are at the fun part.  The Income/Payments column is a LOT of fun to look through.  Our first stop is the Income.  This is where we see the gross rent for the property.  Some properties may have coin-op laundry, vending machines, etc.  The monthly income from those other sources would be included as Other Income.

When my bank evaluates a loan, they assume a 5% vacancy rate.  In order to be conservative, I assume a 10% rate (the third 10% off the top).  If you manage your property properly, this vacancy rate may be as low as 0% (which is additional profit).

The ‘Net Annual Income’ is the total potential income less the vacancy.

Next step is to subtract the loan payment.  I break out both a 15% down and 25% down, just to give you an idea of what is possible (normal commercial loans are 25% down, but sometimes banks will give you 85% LTV).  For most loans, especially if you are purchasing through a corporation of some sort, focus on the 25% number.

Taxes and insurance are the annual taxes and insurance (probably more expensive than you thought!).

The IRS allows you to assume that your asset (rental property) will be worth nothing after 27.5 years of ownership.  This is called ‘depreciation’.  The IRS allows you to deduct 3.636% of the initial value of the building, not the land, which you purchased.  This accounting happens at tax time.  Depreciation is considered a ‘loss’ to your business, reducing your taxes at the end of the year.  It’s not quite cash flow to your bottom line, but significantly helps to reduce the profit on your taxes.  Just remember that depreciation gets ADDED to an eventual sale of the building (the tax man giveth and taketh).

Now, let’s step to the last column, “Cash Flow”.

In the Cash Flow column, we account for all the income and payments to determine what our profit or loss is for the property.  Again, I have split out the 15% and 25% down payments.  The ‘Annual Income’ is the vacancy adjusted income.  The loan, taxes and insurance are rather firm numbers.  It’s tough to get the bank or the township to reduce your loan or tax payments.

Operating expenses may be a flexible payment.  One of the easier ways to reduce the operating expenses is to evaluate the energy consumption of the property.  The addition of energy conservation, renewable energy installations or energy efficient equipment, may significantly reduce the operating expenses.

The number everyone is interested to see is the ‘Monthly Cash Flow’.  This is your potential profit.  I have found that some investors insist on purchasing properties with monthly profits north of $500.  I have found that I am happy with properties yielding $100 – $300 per month (per unit).  I have friends ask me why I bother purchasing those properties when I could go on vacation or fix my own house (or buy the flat screen, new couch, new car, new…head over to Mr. Money Mustache for his take on this ‘new’ junk).  My typical response is “Do you want to give me $100 per month for the next 10 years?”  They usually say “no.”  Well, these properties ARE giving me that $100 per month, generally without complaint!

When I am going to make an offer on a property, I note a few items on the APOD.  First, I check to make sure the monthly cash flow is greater than $100 per unit.  This $100 is totally arbitrary; you could have said it had to be “1 beelllion doolars.”  Because the APOD automatically calculates these ratios, I adjust my purchase price (which is my offer) to get to the $100/unit threshold.  This offer is then my ‘highest and best’ offer.  Unless the building is in terrible condition, or otherwise warrants a lower price, I usually simply offer my ‘highest and best’ offer and let the chips fall where they may.

The next section calculates the required closing costs.  This helps me pull the necessary money together for any of these deals.  With the example above, you can see the significant difference between the 15% and 25% down payments.

Assuming the property passes the $100 minimum threshold, I then look to the ratios section.  Looking at the “Ratios” section, we’ll see the effect a larger down payment has on our money’s velocity, because we are unable to leverage our cash as much as if we had only used the 15%.

I want to make sure that my cash-on-cash return is greater than 15%.  This means that you will have all your cash back after 6 2/3 years.  It also means that for each $1 I invest, in 365 days, I will have $1.15.  This is also double the average return of the stock market for the past 80 or so years.  Now, the initial cash-on-cash rate may be low because the current owner is renting the building at lower than market rates.  If this is the case, evaluate the building first with the current rents, and then with your new proposed rents.  See how it stacks up.  To get your building to the new rents, there will probably be some friction with existing tenants and you will probably have to find some new tenants.  You don’t want to pay to own a rental property.

For my local market, a good rule of thumb for the actual value of a property is to assume five times net income.  This is only a rough guide, but does help me during negotiations or when I refinance.

The APOD is THE tool I use when I am evaluating a potential property.  Don’t force the APOD to show positive results.  If the property is not beneficial, you don’t want to buy it.  Period.  No one has enough money to throw at a poor property.  Think Tom Hanks in the Money Pit!

I have a few tweaks to make to my APOD.  Once I have those made, the APOD will be available to purchase on this website.  Stay tuned!