Category Archives: Analysis

Deeper Analysis of a Potential Apartment Purchase

After using a property’s annual income and expense data, combined with the local cap rate to determine value, most offerings will be set aside as the unrealistic dreams of a deluded seller. Occasionally, however, a property will pass our first scan and deserve a second look. So what are the next steps to determine if we’ve really found a keeper?

The first step is to dig more deeply into the financial reports released by the seller. The critical thing to watch for here is to separate the actual figures from the pro forma numbers. Every seller, with the help of their broker, will attempt to paint the rosiest picture possible. You’ll do the same when it’s time for you to sell.

As an example, I’ll use information pulled from the most recent offer to cross my desk via Loopnet, a 28-unit C class apartment in Colorado Springs, offered at $1.3 million.

The Annual Property Operating Data (APOD) is a one-page summary of income and expenses. It calculates the Net Operating Income (NOI) as well as the cash flow before taxes. This particular APOD shows a cap rate of 8.79%, certainly within the current range of 8-9% expected for this class of apartment in this town in this year. It also lists the cash flow as $114,280 per year, or just over $9,500 per month. Assuming you paid the asking price of $1.3 million and put down 25%, or $325,000, the cash-on-cash return would be 114,280/325,000 or 35.2% So far, the numbers look promising.

But let’s look a little deeper. One of the easiest tricks to play is to merely leave some lines of the APOD blank. It’s easy to overlook something that is not even there. On this APOD there is a line for Management Services, but there is no number next to it. Even if you choose to manage it yourself, you should put a value on your time and effort. As it turns out, last year $8,300 went to this line item, which represents a 7.2% charge, reasonable in this market for this size property. Of course, underestimating your expenses, in this case by leaving one out, has the effect of increasing the NOI, which drives up the property value.

The other sin of omission occurs here by neglecting to include the annual debt service. Using the broker’s assumptions of 25% down and a 4.5% interest rate, the total mortgage payment is $60,800 per year. This is subtracted from the NOI to get the actual before-tax cash flow, which now drops to $53,480. This makes the actual cash-on-cash return 16.5%, definitely decent but less than half of what was shown on the APOD. Leaving out the management fee and the debt service has the effect of making this deal look much better than it actually is.

Now let’s look more closely at the income assumptions. The APOD has a note indicating that the current market rent for one-bedroom apartments is $495 per month. Since all the units in this apartment are one-beds, it’s easy to calculate the Potential Rental Income as $166,320 per year (495x28x12). However, in another part of the sales package labeled Income Summary, we find that less than $110,000 was actually collected in rent last year. Why the huge difference? Well, the current rent roll shows that 17 of the 28 units are paying $425 or less per month and only 2 are paying the full $495. What gives? Is the current owner asleep at the wheel, or is there something lacking in this property that prevents him from getting market rent? This is definitely something a potential buyer needs to explore in some depth. In fact, using actual numbers from last year, the cap rate at the asking price is only 4.7%!

Moving on from the financial analysis, we need to envision all the ways we can add value to the property. One of the easiest and most obvious ways is to improve the curb appeal. Potential renters won’t even slow down if the place looks like the owner fell asleep in the 70s and never woke up. A new top coat on the parking lot, well-trimmed and manicured landscaping and perhaps a new exterior paint job can make an apartment look like new almost overnight. Of course if the property has been a low-vacancy eyesore for a few years, changing the name and putting up new signage lets people know a new owner who actually cares for the property is now in charge.

Once you get a prospect inside, they will compare the perceived value to that of other apartments they’ve looked at. This is where your personal market research comes in. What amenities do other properties in your rental range have? Will you need new kitchen cabinets or will a paint job and new hardware be sufficient? Will you opt for new carpet or will you try the linoleum that looks like a hardwood floor? New lights in the kitchen and bathroom can add pizazz for very little cost.

Windows are a controversial topic among owners. If the residents are paying for utilities, it doesn’t directly help the owner to put in new ones, which is why you see so many older buildings with original windows in place. On the other hand, new double pane energy-efficient windows, along with uniform new blinds, can instantly improve the curb appeal. You can also tell prospects that their utility bills will be lower and their apartment quieter and more comfortable. It’s also one more thing the person who buys from you won’t have to pay to replace. In addition, there may be utility rebates available that lower your net cost if you choose to install them. Needless to say, all these expenses must be accurately estimated and still have all the numbers work. If a property has a lot of deferred maintenance, you must factor that into your offer or it’s not worth buying.

The bottom line for all this is how much can you raise the rents? Can you raise them enough to justify these expenditures? Can you buy it cheaply enough to allow these upgrades? You’ll definitely want an experienced member of your team to help you make these decisions when you’re first getting into this.

Finally, you need to look at the operating expenses to see if there are ways to reduce them. Running a more efficient, smarter operation can lower expenses. Do you need a full-time employee or can you outsource many of the operations? Can you charge back your residents for common area water, gas and electricity? Are they being charged for their share of trash pickup? Your market may put limits on how much of this you can do. You might also experiment with a lower rent plus these utility chargebacks versus a higher, all-inclusive rental figure to see which is more enticing to your prospects.

Once you’ve done your quick 5-minute evaluation of the numbers, most properties will be revealed as the duds they are. The ones that pass that first screening are ready for this more in-depth analysis. Once they pass this, it’s time to submit a Letter of Intent and let the negotiations begin. Have fun and good luck!

How to Evaluate an Apartment Property in 5 Minutes or Less

An active real estate investor may have multiple offers cross his or her desk in any given week. Since time is our most precious resource, we need to have a method to quickly eliminate those deals that have no chance to become part of our portfolio. Here’s how I do it.

The most critical number needed to rapidly evaluate a property’s potential is the Net Operating Income, or NOI. This is simply the difference between the gross annual income and the expenses paid to operate the property that year. Mortgage payments are not included in calculating the expense total, nor are capital expenses, those large one-time outlays, such as a new roof or heating system.

Getting accurate numbers from the seller can be problematic at times, but I generally take what’s offered at face value. If I decide to move forward, confirming the income and expense values is an important part of the due diligence process. However, we can learn a lot from the actual numbers they give us.

The NOI combines with the going local cap rate to determine the sale price. You can poll your local commercial real estate brokers to get their take on the going cap rate for each class of apartment. You can also monitor sales yourself and figure the range of cap rates that apply to recent sales (or offering prices) in your chosen category. In the examples that follow, we’ll assume that C class apartments in Colorado Springs are selling in the 8-9% cap rate range.

Sample Deal #1

  • 16 units, all 2-beds
  • Asking $759,000 or $47,400 per door
  • Income $98,634
  • Expenses $51,493 (52.2%)
  • NOI = $98,634 – $51,493 = $47,141
  • Cap Rate = 47,141/759,000 = .062 = 6.2%

This cap rate is obviously way below the market rate. Changing it to a more reasonable 8.4% creates a sale price of $559,000, or $200,000 below what the seller is asking.

Besides being overpriced, the property, built in 1962, still has the original windows and kitchens (including the stylish turquoise and pink metal cabinets). According to the property manager, it also needs both flat roofs replaced. The out of state owner is out of touch with the Colorado Springs market and is unlikely to sell anytime soon.

Sample Deal #2

  • 12 units, all 1-beds
  • Asking $464,900 or $38,700 per door
  • Income $60,240
  • Expenses $20,024
  • NOI = $60,240 – $20, 024 = $40,216
  • Cap Rate = 40,216/464,900 = .082 = 8.2%

The cap rate is reasonable, but the expense percentage is on the low side, especially considering the owner pays for all the water and trash. This probably indicates that the owner has not put much into the upkeep of the property. Again, original windows from 1967. Also, since fewer people are looking for a 1-bed apartment, it’s not as easy to raise the rent as much as with 2- or 3-bed units. We’ll pass on this one.

Sample Deal #3

  • 22 units 1 3-bed, 4 2-beds, 15 1-beds and 2 studios
  • Asking $1,075,000 or $48,900 per door
  • Income $119,760
  • Expenses $24,109 (20.13%)
  • NOI = $119,760 – $24,109 = $95,650
  • Cap Rate = 95,650/1.075,000 = .089 = 8.9%

The expense percentage is too low to be believed. If we double it to $48,000 and bring it to a more reasonable 40% expense ratio, the NOI drops to $71,760 and the cap rate moves to 6.7%, way too low for the market.

Changing the cap rate to a more reasonable 8% moves the price to $897,000 (71,760/.08).

Two other factors working against this one are the less than desirable location of South Nevada Avenue and the fact that the owner felt it needed to be enclosed by a high fence and security gate.

Sample Deal #4

18 units 16 2-beds, 1 1-bed, 1 studio

Purchased for $800,000 or $44,400 per door

Income $124,577

Expenses $52,648 (42.3%)

NOI = $124,577 – $52,648 = $71,929

Cap Rate = 71,929/800,000 = .0899 = 8.99%

This one has a good unit mix, expenses just about where they should be and a cap rate that indicates we got a good price. In addition, within the last five years, both roofs were replaced, new windows, doors and kitchens were installed, and 16 decks had been rebuilt. Oh, and it was full.

As these examples have shown, once you know a full year’s income and expenses, you can use those numbers with your knowledge of the local cap rate to analyze a property in less than five minutes. Then you only spend real time on those worth pursuing.

 

 

Use a Cost Segregation Study to Improve Your Bottom Line

The IRS gives a tax break called depreciation to commercial property owners. According to the rules, an apartment building will be worthless after 27.5 years of ownership. That means a building depreciates about 1/27, or 3.64% per year. Therefore, each year the owner is allowed to deduct 3.64% of the building’s value from the property’s income before computing the tax liability.

Non-residential commercial property is depreciated over 39 years, so each year 2.56% of its value can be deducted as an expense.

It must be noted that land does not depreciate, at least according to the IRS. Many property owners use an 80/20 rule to value the building versus the land. In the case of an $800,000 purchase, the building(s) would be valued at 80% of that or $640,000. The land would therefore be worth $160,000. Starting at this point, an apartment owner could deduct $640,000 x 3.64%, or $23,296 each year. For an owner in the 28% tax bracket, that’s a real savings of $6,522.88 a year.

However, through a formal procedure known as a Cost Segregation Study (CSS), much greater savings can be realized. The IRS allows you to speed up depreciation on certain elements that make up the property. For instance, many land improvements such as parking lots, fences, sidewalks, sewer lines, etc. can be written off over a 15-year period. Items classified as personal property can be depreciated over a 5- or 7-year period. Examples include carpets, appliances, window coverings, countertops, cabinets and more.

From the perspective of saving on taxes, the savvy commercial property owner will label as much property in the 5-year category as possible. If $100,000 of personal property was so designated, for each of 5 years the owner could take $20,000 as depreciation expense, lowering his taxable income. If that much property had not been segregated out, it would have depreciated over 27.5 years, resulting in only $3,636 saved per year. Over the 5 year period, just this one category would save over $81,000 in taxable income.

Let me give you a real life example. We recently purchased an 18-unit apartment property for $800,000. As noted above, if we just took 80% of this as value of the buildings and depreciated it over 27.5 years, we could expense just over $23,000 a year.

Now let’s see what happens when we do a Cost Segregation Study. To be in compliance, you need to have a third party perform the CSS. We picked a local engineering firm that specializes in this process.

They went into one unit of each type: studio, one bedroom and two bedroom. They measured the carpet, the countertop space, the cabinets, floor molding, window covers, electrical outlet covers, lights, interior doors and shelves, etc. Outside they inventoried the exterior lights, parking lot, fencing, retaining walls, planters, handrails, sidewalks and more. They ended up with almost 100 items put into the 5-, 7- or 15-year categories.

Here are the totals in each category:

5-Year: $86,775

7-Year: $66,543

15-year: $66,369

27.5-year: $511,916

Taking the first number, you can take 1/5 of the $86,775 or $17,355 as an expense every year for the first 5 years you own the building. Similarly, you can take 1/7 of the $66,543 or $9,506 each year for 7 years and 1/15 of the $66,369 or $4,425 per year for 15 years. And you also get 1/27 of $522,916 or $18,615 per year for 27.5 years.

So in each of the first 5 years you can deduct $49,901 from the property’s income before figuring your taxes. If you have a loan and are deducting the interest payments, that’s also deductible, along with your usual operating expenses. Thanks to the great power of the CSS, it’s actually possible to have a property throw off great cash flow and still show a loss on your investors’ K-1s. So they can have an income stream as well as a deduction on their personal taxes.

When you sell the property, the total amount you claimed as depreciation will be taxed (currently) at 25%. Still, you’ve saved way more than that upfront, so it’s still a great thing to do. And if you take advantage of a 1031 exchange when you sell, you can push that tax even further into the future.

Be sure to have a good conversation with your accountant before you get into this. It can really save you a lot of money over the long haul, but it’s best to leave the details to the experts.

How Your Down Payment Affects Your Bottom Line Return

When apartment investors evaluate a potential new property, they have many points to consider. If their preliminary analysis looks promising, they’ll eventually start figuring how to finance the project.

At this point they will check with various lenders to discover their current loan parameters. What loan-to-value (LTV) percentage will they honor? What debt service coverage ratio do they look for? What interest rate do they offer, and for what length of time before the balloon? For how many years will they amortize the loan?

In addition to the debt side of the equation, the sponsor must look to his or her investors for equity to cover the down payment, loan and acquisition fees, and reserves for known or anticipated capital expenses. They will poll their potential investors to discover how much they might contribute, as well as their tolerance for risk. They might also ask if any of them need to do a 1031 exchange, or need help setting up a self-directed IRA.

Once all this is done, they calculate how much equity to raise to complete the purchase. Most often, a sponsor hopes to raise just enough capital to meet the target LTV their favored lender is looking for. Currently, most lenders require a minimum of 25-35% down. So for a million dollar purchase, an investor group might look at raising a minimum of $250,000 to $350,000 for the down payment. However, not all groups want to get in for the minimum amount down. For their own reasons, they may prefer to put half down, or even pay all cash. How do these decisions affect the bottom line return after the holding period and subsequent sale?

In order to determine the answer, we’ll compare the internal rate of return (IRR) for three different scenarios. The IRR reflects the total return on investment, taking into account annual cash flows and final profit at the sale. All the following numbers reflect pre-tax dollars.

Assumptions

  • Purchase price (all-inclusive) = $1,000,000
  • Buy at 8% cap rate ($80,000 net operating income first year)
  • Vacancy rate = 7%
  • Rent income escalators = 3% per year
  • Expenses = 50% of gross operating income
  • Expense escalators = 3% per year
  • Expense of sale = 7%
  • Loan interest rate = 6%
  • Amortization period = 25 years
  • Loan term = 7 years
  • Sell at end of year 5
  • Sell at 8 % cap rate

If you’d like to see how the following numbers were derived, the spreadsheets are included below.

Down Payment

Year 1 cash flow Year 5 cash flow Sale @ 8 cap Sales Proceeds

IRR

$1,000,000 (all cash)

$84,600 $95,218 $1,225,932 $1,140,117

11.17%

$500,000 (50% LTV)

$45,942 $56,560 $1,225,932 $690,457

15.66%

$250,000 (75% LTV) $65,271 $75,899 $1,225,932 $915,287

24.16%

Upon close inspection, you will see that compared to putting 25% down, buying with all cash will give you better cash flow, but an overall smaller return. Putting in an intermediate amount gives intermediate results.

So why doesn’t everyone go for the maximum return? In these variations, putting in the smallest amount gives the biggest bang for the buck because you’re leveraging your money with the loan. It must be easier to raise $250,000 than a million dollars, so why do some folks buy for all cash?

One reason might be the ability to get a discount for an all cash purchase, where the seller doesn’t have to wait to see if your loan will go through in time, if at all.

It might also have to do with the mindset of the investors in the group putting up their cash. Younger investors with many years to go before retirement usually have a steady and growing income from their job and are often looking to work for a big payday down the road. Their risk tolerance may be relatively high since they have a long time to make up for any errors they make now.

People approaching retirement or already retired may place a higher value on a more robust cash flow today to supplement their fixed income. They may also be worried about that balloon payment a few years down the road when the loan term expires. They simply don’t have as high a tolerance for risk as they did in their younger years.

Many of the deals we see today are the result of projects not being valuable enough in the current market  to refinance the loan to pay off that debt coming due. So, paying with cash means there is no loan, so there is no balloon. As with all investments, the greater the return, the greater the risk. Therefore, successful sponsors will match the equity required with the risk-tolerance of their investors.

All Cash

50% Down

25% Down

 

 

 

 

Multifamily Property Evaluation in Colorado Springs

In this video, we walk through a financial analysis of an apartment building for sale in Colorado Springs. After a brief introduction of the property, we list the assumptions we’ll be making about the possible purchase. These include the proposed LTV of the loan, the amount estimated for reserves and closing costs, the projected annual increases in income and expenses, and the expected vacancy rate.

Next we look very briefly at the spreadsheets that crunch the numbers for us, focusing more on their purpose than their details. Lastly we compare the bottom-line results when we project purchasing the property for two different prices.

If you want to view this in full screen, click the icon in the lower right corner that has four arrows.