Mike’s Apartment Blog

Another opportunity local to my area has shown itself. It’s funny how these opportunities blossom, only to shrivel up and die more often then not.

No doubt, the game has changed. What makes opportunities tough to get done is the constant rule changes. When rules like loan qualifying, short sale approval, and seller expectations keep changing, even the most steadfast buyer cannot make it happen.

I hear a lot of folks stating “cash is king”. It’s a fun buzzword and people like to say it a lot about real estate investment. They believe great deals can be purchased for all cash. I have not found this to be true.

All investment decisions are based on ROI and, more importantly, IRR. The big draw to real estate is the availability of leverage which allows you to multiply your ROI. In absence of this, ROI suffers, often times leaving you with an average investment you could beat by investing in other markets.

Until leverage becomes readily available, real estate will continue to be ostracized by the investment community.

Does this mean time to get out? Heck no! Being the investor who can see when financing comes back will position you to make incredible returns when the pent up demand for commercial real estate returns.

This post is two parts: 1 part advice, 1 part politics.

If you don’t know what Section 8 is, Wikipedia gives a good little explanation and history here.

Advice

A lot of folks look at Section 8 as a gauranteed way to ensure rents.  Section 8 rents can often be higher than market and get paid directly by the government rather than the tenant.  This takes away the hassle of trying to chase down tenants for rent.  All this is nice, but there is a yin to every yang.

When people are not personally paying for something, there is a certain respect that is lacked.  This is just human nature.  Ever get a free t-shirt from a concert or a convention?  Do you take it home, hang it up, make sure it is drycleaned ony, and wear it carefully?  No.  You probably wad it up, throw it in your bag, wear it while painting or working on your car.  The point is, you didn’t “pay” for it and so you don’t respect it.

Translate this human nature into apartment leasing.  Though you have tenant paying on time at an above market rate, get ready to make repairs.  Expect the unit to get torn up.  And move outs… those will be even more costly as most everything will need to be replaced.

There are two things you can do to compensate for this and get the best of both worlds.  First, vet out the tenant like crazy: find out how long they have been on Sec 8, talk to them about their situation, ask them the same penetrating questions multiple times to see if they are apt to lying, and get previous landlord input.  Second, make the unit indestructible: tile or vinyl instead of carpet or hardwood, high gloss paint that can be easily wiped down, heavy front doors with strong frames, and caulk every nook and cranny in the entire place.  Some thing you should just expect to replace like appliances and countertops, so be sure to find a low cost supplier for these things.

“Politics”

Let me initiate this by explaining that I am an economic libertarian.  I believe in minimal government involvement in all things: religion, crime, health care, regulations, and most importantly – business.  As a general rule, I stay out of politics.  But when it impacts my investing strategies, it is important to comprehend.

Government continues to get involved in free enterprise, often knocking it off course.  The idea is to aid those who are considered low income, give them the chances that might not normally be afforded to them.  Like most ideas, the essence of it is great – helping people – but the execution is and will always be flawed.

Government assistance is based off taxes, the amount the government collects is in direct relation to how much they can give out.  The flaw occurs when they increase taxes to create a new program.  The intention is to take money from those with lots of it and give it to those with less.  However, most folks who make lot of money are smart enough to work within tax laws and structure their businesses to avoid having to pay those higher taxes and the burden falls to the next level of income class.  Furthermore, these programs that are designed to give assistance to low income are sought out by the high income folks who then build a way to get that money back (like building indestructible apartments) - in turn getting richer.

This is the case with Section 8.  This is the case with food stamps.  This is the case with welfare.

The only question is which side are you going to be on?

Nitro Real Estate Services sent me a note earlier this week.  We have been thinking about making some minor improvements to a C-class building we have in downtown Kansas City.  We took this building over about 2 years ago and since then have been making slow but continuous improvements for the residents.  Every time something needs to be repaired or replaced, we redo it better to add curb appeal and value to the building.

<photos on their way>

This weekend, we added a retaining wall and a new front door.  What a difference it made!  It improved the building, added curb appeal, and created a sense of pride with the current residents.  Good people tend to want to be part of a positive movement.  The goal is to keep everyone moving forward

It’s no secret the housing market has been hammered.  Prices are down and inventory are up – the worst its been in decades.  Add to it the lending standard and apprehension banks have in giving anyone a loan, sales have come to a grinding halt.  Foreclosures and bank owned properties dot neighborhoods all over the USA, and few areas have been unaffected.

But what about commercial real estate.  Apartment buildings in particular?  Depends on the area, but most areas are starting to feel the pinch.  Check out this articlefrom Bloomberg.

Basically, the worst is yet to come – at least for banks.  A rash of unprepared buyers, lofty proformas, and lax underwriting led to many building being over leveraged.  These over-leveraged buildings now present a huge issue for banks, for as the asset value comes down, owners walk away.  Defaults to the tune of 5.5% of all mortgages are anticipated in 2010.

So what does this mean for investors? 

Well, if you own buildings you are probably already feeling the pressure.  Increased vacancy and decreased collections are apparent due to job loss, while increased energy costs can pinch cash flow.  Many loans are expecting to go variable or hit their balloon payment terms within the next couple years and those owners will be unable to sell their property or refinance their loans.  Banks will be staring at an inordinate amount of REOs.  They will have to change their standards just like they are doing with home loans.

If you are a buyer, this in an incredible opportunity.  There will be many properties stuck at the banks looking for owners.  Whether it is discounted price, killer terms, or extra leverage opportunities, it will be time to capitalize.

I am in the unique situation that I will be in both camps.  I intend on negotiating with any of our current buildings to take advantage of any leniency the banks offer while attempting to pick up additional assets in the downturn.  No doubt, it will be a interesting time to be an apartment investor!

Capital improvements.

In the value add investment strategy, capital improvements often drive value into the building.  Therefore, it behooves you to make them ASAP. 

Let me explain.  Imagine you bought a 19-unit building with a laundry in one of the units.  Through your due diligence, you have determined residents would like to have their own laundry machine and would be willing to pay $25/month extra to have washer/dryer hookups in their unit.  You decide to add the W/D hookups and turn the laundry room into a serviceable unit.  Doing it sooner rather than later benefits you for two reasons:

1. You get to start collecting the increased money sooner.
2. You start building a pattern of increased income – you need a two year documented increase to take full advantage of the capital increase for sale/refinance purposes.

Remember, in a value play you want to reduce the timeline for purchase and resale/refi.  Making your changes earlier rather than later will aid you in speeding up the turnover process.  Time = Money!

by biblicone on Flickr

A business plan for investing?  You betcha!

Newsflash – investing IS a business.  It has customers, suppliers, and provides a service/product.  Even trading stocks on the NYSE, you buy shares from people who are selling (vendors), sell to people who are buying (customers), and are trading shares in companies (product).  The more time you take to understand all these things, the greater your chance of success is.

It’s not about the actual plan that is written down on paper, that is just the end product.  All the data that goes in there about competition, marketplace, customer desires, and suppliers mindsets are the valuable things.  It helps prepare you and educate you before you drop even one dollar into the market.  This preparation greatly increases your chance of success.

A business plan also helps keep you focused.  When you start to get off track, or find yourself looking at other potential avenues, refer to your business plan.  Is it part of the plan?  No?  Stick to the plan!  If it has been working well so far, stick to it.  If you still think its worth taking the risk to go after another avenue, fine, write it into your business plan first.  This will ensure you have done all the proper research prior to taking on additional risk.

I write business plans, not only for my various businesses, but also for every apartment we purchase (yes, apartments are businesses too).  It greatly increases your chance for success.

Today was Memorial Day, a U.S. holiday in which we remember those who died in service of the military.  This is commonly done through large cookouts where friends, family and neighbors get together to socialize and hang out.

Why do I bring this up and how does it fit in with apartment investing?  I love cookouts and having them at apartment buildings.  People alway appreciate free food and you would be surprised how many people show up.  Funny thing is they are a great way to get to know your residents.  Find out how long folks are staying in the area, when they plan on moving, if they will need a bigger place soon, a smaller place.  Residents also tend to bring their friends and family – an excellent way to get referrals for your vacant units.

If you have been following the news and the state of the U.S. government these past couple decades, you know our social security system is on a collision course with bankruptcy.  How did this happen?  Pretty simple… our social security system is like an insurance company.  It gets paid premiums today which it will pay back to you later in life.  The problem is it’s run like most government operations where it spends more than it takes in.

The stress this puts on the social security system is increasing.  Unless something changes, very soon the stress will become too great and it will collapse.  Once this happens, those currently relying on social security will become destitute and those who are expecting social security as a means to retire will be out of luck.

The only answer is to take charge of your own retirement.  Decide when you want to retire and how much you will need to be comfortable and start executing that plan.  We are experiencing one of the largest transfers of wealth in the history of the United States, don’t get caught on the wrong side of that transfer!

A lot of folks ask what the benefit of pooled investments are.  First, you need to understand what a pooled investment is.  A pooled investment is when people pool their resources.  Resources are more than just money – expertise, time, materials are all just as valuable.

A typical pooled investment for Cabal Investments is structured like a joint venture.  One side brings in the investment, expertise, and the plan while the other half bring the resources.  In short, one group bring the money and the other group does all the work.  Then you split any profits.

Here are important things many fail to consider before putting resources into any pooled investment:

1. Do you trust the people you are investing with?  If you don’t trust that the team you are investing with will take care of your funds like they would take care of their own, steer clear.  I cannot stress how important it is to avoid anyone you distrust.  Don’t let greed and a beautiful presentation sway your decision if you dont have trust.
2. How focused is the company you are investing with?  I have seen companies who started out as house flippers turn into gold mine investing.  I have seen internet merchandising folks turn into hedge funds.  All these folks lack focus.  They are going with whatever is hot at the time.  I agree that you need to be aware of the trends, but if you keep changing your focus you can never perfect it.
3. What is the compensation structure for the management team?  You want to make sure that most of the compensation is tied to success of the project.  Ie. management gets paid when the investors get paid.  Obviously a little compensation should be allowed up front to keep the lights on, but make sure that the success of the project is what drives the management team’s side of the deal.

The value play strategy is focused on improving the administrative performance of an apartment.  Increasing rents, lowering expenses, lowering vacancies, and improving tenant base are some basic pieces of this strategy.  These things all increase the bottom line or net operating income (NOI).

Since apartment buildings are valued based off a multiple of their NOI, increasing NOI increases the value of the building.  Here is a quick example:

by Jon Newman on Flickr

Marigold Apartments has an NOI of $100k/year.  Upon your due diligence, you realize that the rents are $25/month lower than market.  You decide to purchase the building for $1M.  Once you have purchased it, you spend the next year raising the rents to market level.  Expenses stay the same but since rent increases, you are able to increase NOI to $125k/year.

This increase in NOI leads to an appreciation of the building.  Since you bought it for $1M and it netted $100k/year, you use the same ratio to understand the new value.  You increased the amount of NOI by 25% (from $100k to $125k), which means the value of the building increases by the same.  The new value of Marigold Apartments is $1.25M.  You have made $250k in one year!

Obviously I am leaving a lot of the details out (how to increase rents without losing tenants, costs of advertising, etc.), but you get the gist of it.  On the surface, the deal looks good.  A 25% return is incredible by most standards.  However, we haven’t even added in leverage.

Assume you can purchase Marigold Apartments for 20% down and a loan for the remaining 80%.  This means you only use $200k of your own cash to do the deal.  Assume the return is the same as you conduct the same process to increase the value of the opportunity.  Clearing $250k on the value of the building with only $200k down is $250k/$200k = 125% return in one year, astronomical in fact nearly unbelieveable to most people.

If it’s this simple, why isn’t everyone rich?  Well, first off the only thing that is simple is the math.  Actually doing the things required to increase NOI is quite difficult.  Tenants do not like their rent raised, suppliers to not like to be negotiated, vacancy issues may abound due to crime and most criminals do not like to be told to stop.  You have to have a strong stomach, gritty determination, and be very good at dealing with people.

As you follow this blog, I will go into issues I encounter on a daily basis and how I deal with them.  One thing in common with all investors is that we make mistakes, what sets one apart is how we deal with and bounce back from those mistakes.