There are several things you need to consider when approaching a multifamily deal, but before you begin you need to do your research on the local market. This means that you should know:
- Average rental prices,
- Price per door of the comps in the area of other multi family deals (size, age, neighbourhood, class of asset)
- Size of the job market,
- Local rental laws (eg rent control) and
- Projections for job growth in local services.
Once you’ve confirmed you’re buying in the right market, and you have identified a potential deal, ask the seller for:
- Their current rent roll; I always compare the rent roll with what I find on either rentometer.com, or do a google search for apartment rents in the area where the deal is located, (you will see if the rent roll is fake, or not).
- Current expenses;
- T-12 (the trailing 12 month Profit and Loss statement); probably the most import item to ask for;
- You can even ask for previous 2-year tax returns for the property. Some property owners will give this to you; most will not, but no harm in asking. This will show exactly what the owner has been reporting to the IRS;
- Rental agreements with the current tenants: Again another good litmus test to see if the owner has been managing the property effectively;
- Record of past rental costs: Normally a seller has a record of past rental costs and future predictions, however if this isn’t available I use realtywebhomesforsale.com. Ask a local mortgage broker about the information you are finding online; It is always good to quiz a local person (boots on the ground) about the area;
The main mistake investors make is trusting the information given by the seller; NEVER trust the numbers given to you by the seller/sellers broker:
Always make sure you analyze all rental and expense figures, and run them past your broker (a broker unrelated to the deal). If possible try to make a relationship with an insurance broker as well so you can get an accurate insurance quote before you make an offer.
After the insurance, taxes and expenses have been checked and cleared then it’s time to make an offer, at this point you have 10-15 days contingency to perform due diligence. Always complete a 4-point inspection report done by an external company
- Roof and
- Air/Heating (HVAC).
If any of the four come back with problems think twice about the purchase, or you can obtain a quote to replace/fix the problem and then re-negotiate with the seller.
Any changes you make when you first purchase are called “capital expenses” (CAPEX), however when you budget, don’t forget the other normal operating expenses (OPEX):
- Repairs & Maintenance: Budget 10% of the gross rent for maintenance and repairs (these are the on-going repairs you need to make to the property; these are not the capital improvements you will do when you first purchase the property). Rule of thumb Maintenance and Repairs shouldn’t be between 10-13% of gross income.
- Property Management: 6-10% for 4 units or less, 4-7% for over 4 units (Rule of thumb)
- Taxes and Insurance (Rule of thumb between 2-5% of gross income): This is when you need to have a good relationship with a local insurance broker to ask questions;
- Full Time Employees: If you are buying a large multi family deal i.e.: over 40 units, you may need a full time onsite employee. Typically rule of thumb is that you need one full time employee for every 50 units; (150 units = 3 full time employees). NOTE: If you have fulltime employees pay them a salary and make them pay rent like other tenants. DO NOT subsidies their rent as payment. This will avoid any issues if you have to fire them.
- Utilities: This can be a hard one to gauge; on small multifamily (under 4 units), and depending on the state you are investing in, you as the landlord may not have to pay for utilities (maybe water). On my large multi family properties I like to see between 8-12% of the gross income allocated to utilities. Again, this rule of thumb really does depend on the number of units in the property.
- Admin Expenses: This expense will only apply if you have full time employees; Approx. 3-5% is average.
Expenses (maintenance + insurance + management fees + taxes + payroll + admin) = Net Operating Income.
Net Operating Income – mortgage and debt services = Cash Flow
At the end of the day I want to see an expense ratio in the order of 40-50% of the GROSS rental income, on large multi family deals; anything over that is an indication of deferred maintenance.
Takeaway tip: Do your own analysis based on the information given to you by the seller, at the same time give the same information to your local property management company (they can’t be connected to the property) and have them do their own analysis of the PnL for the T12. Then compare notes.. you have another set of eyes on the deal which helps pick up on things you might have missed.
Example: LIVE DEAL
I am going to walk you through a live deal that came across my desk a few weeks back:
The information from the seller’s broker:
“NOI in place today is around $515,000, providing a value of $7,350,000 at a 7% cap rate.
Existing rent roll is well below market rents of $830 and $725 for the 108-2 x1’s and 12 – 1×1’s Currently 100% occupied. ”
Ok great: First, nothing is ever “100% occupied”
STEP 1: Jump on rentometer and check what they are saying about the “market” rents. I found out average rents in the area for 2bed apartments are $747/month (say $750), and $625 for 1 bed apartments. Straight off the bat my research shows me that the broker is already telling me lies.
For this example lets use ($750 for 2 bed, $625 for 1 bed) – Remember that this is an existing building; maybe new buildings with amenities would fetch higher rents, but not in this case. Building was built in 1965.
STEP 2: Take the rent-roll provide and determine how many people moved in within:
- The past 0-3months
- Past 3-6 months
- Past 6-12 months
Show as a percentage of the entire building (ie: X/120 units), this will show you if the property manager is ‘filling’ apartments to show a lower vacancy. The higher the % is within the past 6 months, the more concerning it is (RED FLAG).
STEP 3: Lets go through the PnL: I am going to highlight things that jumped out at me (NOTE: I could write an entire blog on just analyzing the PnL for the trail 12 months). Looking back at the performance of the property; this is the most accurate way to analyze the deal:
1.GROSS Income: $926, 614 (see pic).
- In this deal they presented the “past due rents” and the “prepaid rents”; that is great, but look at how much the “past due rent” is (approx. $22k)… It is something to note.
- Vacancy: $53,920 which represents 5.5% – So it is not 100% occupied
2.Other Income: They have good additional income from laundry and security deposits. Ask the seller for proof of these incomes (you want to see documented evidence)
3.Administrative Expenses: Nothing crazy to report here, they have included the property management fee in this line item. Total Admin expenses 5.73% seems reasonable (PM 4% of gross which is fine)
4.Maintenance and Repairs: This is where I like to ‘get into the weeds’…..
- First thing I notice is that for some reason some expenses are not charged for 4-5 months of the year: Cleaning, Contracted Maintenance… This isn’t uncommon to see this but ask the seller why for 4 months they didn’t have cleaning… what are they cleaning? Apartments?
- Contracted Maintenance: This line item needs to be carefully considered… You need to ask yourself why in some months is the seller spending on average $2500/month? Is it because they are gearing up to sell it.. Ask the question… Also, you want to make sure your full time employees aren’t just calling a contractor every time something is wrong. You want to employee a good handyman/trick-of-all-trades that can fix HVAC, Plumbing electrical.. Granted there will be times that you will need 3rd party work done, but keep this in mind.
- The big line items that stand out are: pest control, plumbing, painting and paint supplies.. What happened that they need to spend $30,000 on pest control?… Giant mutant rats? It seems very high.. and in combination with the paint and plumbing in June 2015.. Clearly something happened. Ask the seller what happened. If they don’t have a good answer they are hiding something (RED FLAG).
- Overall, the maintenance and repairs are 16.85% of the gross rental income.. That is high!
5.Payroll: $141K (approx.): for 120 units you will probably have 2-3 full time employees (one in the office $38k, two maintenance $56K): this seems reasonable for the average wage.
6. Utilities: $165,978; approx. 17%.. this is high. I would want to start billing back the tenants to reduce expenses. Research the market to see if a bill-back program is acceptable in the area. I would want to reduce this line item to approx. 10%.
7.Taxes and Insurance: 4.35% seems reasonable, check with your local insurance broker.
8.TOTAL Expenses Ratio: 58.38%, which is very high! It screams that there is a lot of deferred maintenance going with this property, this I not a bad thing, as there are areas to reduce expenses.
9.The total NOI based on the T12 is $406,954! This is over $100k less than what the broker told me..
Based on a 7% CAP the building is only worth $5.813 mill not $7.35 mill
STEP 4: Do your own analysis: I would want to get the expenses down to around 45%… that is a 13.4% reduction… Is this achievable? Well probably not give the age of the building. You have to be realistic with yourself.
STEP 5: Make an offer for $5.7mill.. And then I would walk the property.
Ultimately I would walk away from this deal given:
- The high expense ratio.
- Cash on Cash return is 2.74% at $7.25 mill, this is really low..
- I don’t know the area but I know it is not worth $7.25 mill
- This property would require A LOT of hands on management to reposition it. If I lived in this town, yes, I would consider it, but as I am 1,500 miles away it is high risk to leave such a large reposition in the hands of other people.
- I have only just started to scratch the surface… I haven’t even seen the HVAC systems or roofing. Again, in DD you can inspect the property.
At the end of the day you need to ask yourself can I increase the cash on cash to 12% (which is my investing criteria)? This would require a reduction in expenses to 41% and I need to pick up the property for $5.8 mill.
What would you do? Leave a comment….