The Complete Guide to Buying and Selling Apartment Buildings

Research conducted by Marcus & Millichap as reported in the 2004 NAI highlights important changes occurring in the top 40 regional markets.   These changes, which include forecasted employment growth, vacancy, construction, housing affordability, and rent growth have had a positive impact on some markets and a negative impact on others. Analysts report the following findings in the top 10 supply-constrained high-growth areas: Orange County, CA, topped this year’s index, rising four places on the back of top-five marks in every category except employment growth, (Location 282)

According to the NAI, Orange County, California is the number one spot in the nation for investing in apartments in 2004. The National Apartment Index is a comprehensive report that can be of great value to those investors seeking to deploy their capital in one or more of the nation’s top markets. (Location 297)

The focus of this book, in fact, centers on using a short-term, buy-and-sell approach, which I refer to as the value play. The value-play strategy is equivalent to flipping or rehabbing single-family houses, but on a larger scale. (Location 305)

An alternative approach, one that I prefer, is what I call the value play. This method involves buying a smaller multifamily property, such as an 8-unit or a 12-unit, that requires limited repairs, most of which should be cosmetic. In other words, it is the classic fixer-upper. Your mission, should you decide to accept it, is to initiate a series of improvements immediately after acquiring the apartment complex. This will include things like painting, landscaping, trimming the trees, making minor parking lot repairs, and just giving the site a good overall cleanup. This will enable you to increase the rents—which, in turn, adds value to the property—within the first few months of ownership. Assuming you are on an aggressive fast track to wealth accumulation, you will want to unlock that newly created value by the twelfth month of ownership, either by selling the property or by refinancing it. The validity of this methodology proves itself by permitting you to take your original equity, plus the additional equity created by adding value, and leveraging yourself up to the next level, which would be a property approximately twice the size of the one you just sold or refinanced.   This process will allow you to bridge the gap from single-family to multifamily property ownership at a greatly accelerated pace. Chapter 4 discusses the merits of the value play in much greater detail. (Location 433)

This money can be from a traditional source such as a bank, or it can be from a family member, a partner, or even the seller, who may carry back a note in the form of a second mortgage. Whatever the source, you want to use as little of your own money as possible, because this is what your returns are based on. (Location 446)

So, in a very simple example, if you pay all cash for a $100,000 building that generates $5,000 of income, your return on investment is 5 percent. You might as well leave your money in the bank and save yourself the time and energy that an apartment building will require. On the other hand, if you invest only $20,000 in the deal and borrow, or leverage, the remaining $80,000, assuming the same $5,000 of income, your return on investment now jumps to 25 percent. As previously stated, this is a very simplified example and does not take into account the debt service for the mortgage. (Location 450)

Three basic components must be considered when defining your objectives: your entry, postentry, and exit strategies. For example, to define your entry strategy you will need to start by determining what type of property you are looking for, the price range you are considering, and the holding period. Are you going to buy an apartment complex, fix it up, and turn around and sell it, or are you going to hold it for a number of years? Your postentry agenda should include things such as management changes, property improvements, and rental increases. Your exit strategy is probably the most important of the three components. (Location 494)

If you are a short-term investor and are going to “flip” the property, you want to be certain the market is conducive to your plan. In other words, is there sufficient demand, and are interest rates going up, going down, or stable? If you are going to hold the property for a number of years, these factors are not as crucial. (Location 500)

In large letters across the side, it has the word RISK. The caption reads, “Don’t be afraid to go out on a limb . . . that’s where the fruit is.” (Location 624)

Investor B implements the value-play methodology over the same 25-year period. She elects to buy and sell one property each year for 10 years, with the exception of the last property, Property 10, which she will keep through Year 25 (Location 636)

Before you even make an offer on a multifamily property, you will want to know the potential value that can be unlocked from it. Creating value in multifamily apartment buildings can be accomplished in any one of several ways. (Location 658)

The 10 Ways to Create Value 1. Increase rents. 2. Convert a master-metered property to a submetered property. 3. Add vending services including laundry, pay phones, and soft drinks. 4. Offer exclusive rights to cable TV service with revenue sharing. 5. Offer exclusive rights to satellite service with revenue sharing. 6. Provide access to building rooftops for cellular companies. 7. Consolidate two or more apartment complexes to achieve synergies. 8. Convert excess storage space into rentable living area. 9. Install water-saving devices in showers and bathrooms. 10. Protest assessed tax valuations to have them lowered. (Location 664)

There are many ways to enhance the income stream from an apartment complex. The most obvious of these is to raise rents. Generally, in order to justify a substantial rent increase in the minds of your tenants, you must give them something in return, such as improvements to the building. (Location 674)

Part of your initial analysis will include researching comparable properties in the area and their respective rates. This can be done by simply calling several of the apartments in the market you are considering and asking, for example, what the rates are for a one-bedroom, a two-bedroom, and so on. You will also want to know what your… (Location 677)

Most competent brokers who deal primarily with commercial or multifamily real estate (as opposed to single-family properties) will be able to help you with your market analysis by providing data such as the average rent per square foot. If the average rate in the area is, for example, $0.67 per square foot and the apartment you are considering is charging only $0.57 per square foot, you need to know why. The current owner, for any number of reasons, has not kept up with the market. A qualified and capable broker can also provide historical data regarding occupancy rates so you can determine whether an area has a stable, declining, or… (Location 681)

Many older buildings, however, have not. If the building has not been submetered, converting it from an all-bills-paid environment is an excellent way of enhancing income. Converting a property is not that difficult and can be done very cost effectively. Passing the cost of the electric bill directly on to the tenants will likely necessitate an offsetting decrease in rents by approximately 70 percent of the average electric bill on a per-unit basis. After making the tenants… (Location 689)

Consider an example. If the average electric bill per unit is $50, you will reduce the tenant’s rent by 70 percent of $50, or $35. This will result in an… (Location 694)

On a 50-unit building, this represents an annual improvement of $9,000. Using a capitalization rate of 10 percent, this is the… (Location 695)

You need to be aware that this conversion process will most likely create some tenant turnover, because some people simply prefer to have all bills paid with the rent. There are effective ways to minimize turnover, and most companies in the electrical submetering business can assist you with this process.   If you may be questioning the validity of the 30 percent savings, I can assure you from… (Location 697)

You may also be able to generate additional income by providing vending services. Most apartment buildings of 20 units or larger will offer some type of laundromat services. If the current owner or manager is servicing the equipment and collecting the money, it may be time for a change, especially if the machines are older. You can eliminate the headache of having to service this equipment by turning the entire process over to a professional company specializing in this business. (Location 706)

As soon as I had purchased the building, I arranged to contract the laundromat services out. The company providing the services replaced the old equipment with brand-new washers and dryers and completely redecorated the laundry facility at its own expense. I signed a seven-year contract with the company. It would receive one-half of all moneys collected in exchange for servicing the equipment. In addition, the company gave me an immediate up-front advance of $5,000 for allowing it the privilege of providing these services. Not a bad deal. I got a check for $5,000 and a brand-new laundry room complete with equipment within 30 days of closing, and the company got to take care of my laundry facility! (Location 715)

For example, just as a laundry service will pay you for the right to offer its services on your property, so will cable TV and satellite services. You can negotiate with the local cable and satellite companies to determine who will give you the best deal for the right to provide your tenants with television services. These companies may or may not be interested in providing your tenants with their services. Factors such as the number of apartment units you have, the proximity of existing services to your specific location, and the feasibility of installing the necessary equipment at the site will all impact their decisions. (Location 721)

You might also want to consider whether your apartment building is located in an area where the local cellular phone company might need a repeater tower. With the advent of cellular phones, phone companies are constantly seeking to rent space to place their equipment on building rooftops. The equipment need not always be visible, either. A minister was known to have received $1,200 per month for allowing the phone company to install a repeater tower inside the church steeple. (Location 726)

Finally, you might think about any excess storage space that can be converted into rentable living area, or other space that is currently not generating income. On the 25-unit building previously mentioned, the owner occupied one very large unit, which was not producing any rent. I had initially decided to convert the large unit into two smaller units, because the owner would be moving shortly after closing. Cost projections proved to be too high to justify the conversion, so I decided to rent the apartment as one large unit to be shared by two families. Since the seller of the apartment building accounted for rents on only 24 of the units, I had effectively created rents equivalent to those for an additional two units, for a total of 26, without any additional costs. (Location 730)

Management fees. Fees paid to a professional property management firm will generally range from about 3 percent of total revenues collected on the low end to 10 percent on the high end. If you are using or intend to use a management company, you should be able to procure competent and professional services for no more than 5 percent on 50 units or more. If you have a smaller apartment building, you may end up paying more. • Repairs and maintenance. The cost of building repairs will vary with the age and condition of the building. Allow 10 to 20 percent of budgeted revenues in your analysis. It may be that after an initial injection of capital for property improvements you can scale back your budget to the 10 percent range. (Location 742)

To justify a full-time manager, I recommend a minimum of 50 units. Since a competent manager should be able to manage up to 100 units, you can achieve greater efficiency through better economies of scale. For example, with a manager earning an annual salary of $25,000 operating 50 units, your cost per unit is $500. Using the same manager earning the same salary operating 100 units, however, your cost per unit drops to $250. (Location 750)

Most of the apartment buildings you will be considering, however, will have master-metered gas and water systems in place. Although they can be converted to individually metered systems, it is generally not cost-effective to do so. Individual metering of gas and water is much more costly than it is for electricity. With the installation of electric meters, the electrician generally just has to install the meters and run a few wires to them. With gas and water utilities, however, a good deal of piping and plumbing is required, which may result in the temporary disruption of services. Since this process is much more labor and time intensive, your resulting costs will be considerably higher. A fairly simple and low-cost way to help control water expenses is to implement a program whereby faucets, fittings, and toilets are inspected with every make-ready. Every time a tenant moves out, all faucets and toilets should be checked for leaks and promptly repaired as necessary. (Location 757)

Another simple cost-savings measure is to replace the flush mechanisms inside the toilet tanks. Many older toilets use 2 to 5 gallons per flush, while all new toilets are mandated by law not to exceed 1 gallon per flush. Rather than replacing the entire commode, simply replace the flush mechanism with one equipped with a water-saving feature. You can shave 20 to 30 percent off your water bill almost immediately by implementing this one simple strategy. (Location 766)

Real estate taxes. More than likely, you will have little control over the amount of taxes you pay on your property. There are tax advisors, however, who can be instrumental in getting the assessed value of your property lowered, which will result in a reduction of your annual tax payment. This is achieved by analyzing neighboring apartment buildings and comparing their respective tax rates with those on your building. If a significant difference exists, the advisors can represent you in arguing for a reduction in the assessed value of your building. These types of tax advisors will generally charge a fee based on a percentage of the cost savings to you. (Location 770)

Depending on the level of coverage your lender requires, you should be able to insure your property for about $100 per unit per year on average. (Location 782)

I prefer looking for properties that are more than 90 percent occupied and that just look a little rough from the outside due to poor management and neglect. Rents for this type of apartment building will generally be below market. Because the price of an income-producing property is derived from its net operating income (NOI), the property should be priced accordingly. Do not let a broker attempt to convince you that the property is worth anything more than a multiple of its existing NOI. (Location 788)

In your search for that diamond in the rough, I recommend concentrating your efforts on the type of building that appears to be in disrepair but, in reality, just needs a little tender loving care. This is the classic fixer-upper. The apartment building will probably need a fresh coat of paint, a thorough cleaning of the grounds, and some general sprucing up. Unless you are prepared to incur greater investments of your capital, avoid buying properties needing major repairs. This would include things like foundation problems, completely replacing the roof, and replacing the boiler or air-conditioning equipment. Doing a cost-benefit analysis will help you determine the maximum amount you can spend on capital improvements and still achieve an acceptable rate of return on your investment. (Location 801)

Proper financing on this type of purchase is a key factor. Most lenders financing multifamily apartments will place a single loan on the entire property and use all of it as collateral. Then when you are ready to sell, it is either all or none. In other words, you cannot sell off individual units or buildings because the entire purchase is being used to secure the loan or mortgage. (Location 843)

Following is a sample list of some points you will want to include in your business plan. These can all be organized in a very professional manner in a notebook that includes tabs. • Executive summary. Include a one- or two-page summary of your plan. • Mission statement. Include one or two paragraphs that succinctly state your purpose. • Background. Present information about yourself and your experience. • Financial statement. List your assets, liabilities, and net worth. • Site location. Include a list of benefits, maps, and proximity to shopping and schools. • Demographics. Present information about the people living in the area (income, education, etc.). • Competitor analysis. Determine who your competitors are and present average rents and sales comparisons. • Marketing strategy. Define your target market (tenants, buyers, etc.). • Financial analysis. Include historical and pro forma operating statements. • Improvements. Define capital improvements to be made to the property. • Purchase agreement. Include your sales contract with the seller. • Exhibits. Include photographs of the property, tax returns, sample floor plans, and the like. (Location 860)

As soon as I had the duplexes under contract, I performed the usual due diligence. This included an examination of the seller’s records of income collected and expenses such as taxes, utilities, and repairs. The next step was a thorough physical inspection of each unit, inside and out. After carefully examining the property, I was able to assess more precisely the amount of repairs needed to bring the apartments up to a level I thought was suitable. The drive-by of the property I did before entering into the contract proved to be representative of the interiors as well. Just as for the exterior, the needed interior repairs were largely cosmetic. There was the usual wear and tear—worn carpets, leaky faucets, and old paint, but nothing of major significance.   After I was satisfied with the due diligence, the next step was to order the required third-party reports. This particular lender required a survey, an appraisal, an inspection, and a Phase I environmental report. All reports came in satisfactory. An added bonus was the appraised value—$520,000, with the property in its “as-is” or existing condition. I was of course pleased with the report, because it served to validate my beliefs about the upside potential that existed in this deal. (Location 875)

Now let us take a look at the postentry process. During the period when I had the duplexes under contract, I procured several estimates from contractors on all of the work I wanted done. Before the deal ever closed, I had most of them lined up to begin working on the Monday following the closing. The tenants were notified that the property was under new management and that they would begin seeing some much-needed improvements. The flurry of activity actually created some excitement among them, and they were genuinely enthusiastic that someone was finally taking an interest in their community. (Location 889)

My intent was to clean it up and make it as aesthetically appealing as I could for the least amount of money possible. This is not to imply that I am cheap. As an investor, my goal was to maximize the utility of each and every dollar spent on the project. I took the time to get several bids from contractors on all work performed, and did not hesitate to spend as necessary within the budget I had established prior to the purchase.   Over the next 60 to 90 days, the contractors stayed busy cleaning up the property. The very first people sent to work were a professional landscaping crew. You would be amazed at what a difference simply mowing down the weeds can make. They did not stop there, though. They trimmed all of the hedges, edged along the sidewalks, and cleaned up the grounds. I also had the landscaping crew bring in several truckloads of fresh mulch to place around all the bushes and hedges. Upon signing an annual contract with them, they assumed responsibility for all mowing, hedging, and edging on a weekly basis and at a very reasonable rate. There were large, beautiful trees planted next to each of the driveways, but they were so overgrown that they, too, had become an eyesore. A tree-trimming service promptly alleviated that problem. Within a single day, the crew had all of the trees trimmed and most of the branches hauled away.   While the landscapers and tree trimmers were busy with their work, I had also engaged the services of a painting crew. The painters did an excellent job of painting the exteriors of all 11 buildings. Each building was given two coats of paint by brush or roller. They used a combination of four different color schemes so as to give each building its own unique look while still maintaining a standard of uniformity throughout the community. The painters had the most work to do, and, consequently, their job took the longest. (Location 894)

I knew before I ever bought the duplexes that my exit strategy would be either to sell or to refinance the property within 12 months of the time of purchase. To justify the additional value, I needed to increase the net operating income. In this particular case, expenses were already fairly minimal because the tenants were responsible for all of their utilities, including gas and water. As previously mentioned, an evaluation of rents at nearby properties had revealed market rents of $575 to $595, compared to the $425 to $440 I was collecting. As my tenants’ leases began expiring, I offered to renew them at $475 to $495. The stable tenant base the previous owner had enjoyed was suddenly not as stable. I had anticipated this, however, and when some tenants elected not to renew, I was able to rent the units out to others promptly. (Location 924)

Plan C was to get a new appraisal of the property that would reflect the newly created value, and subsequently refinance it. The only drawback to this approach was that most lenders require a seasoning period, usually a minimum of 12 months. I had owned the duplexes barely four months, so I was not having much success. (Location 957)

Following is a recap of the numbers on this transaction (rounded estimates): This example demonstrates the potential of the value play. As you can see, it can be quite effective. In this particular instance, my out-of-pocket capital was approximately $100,000, or about 25 percent of the total cost basis. The return on investment (ROI) was roughly 326 percent ($326,000/ $100, 000) . The total increase in value of the property was almost 80 percent [($736,318 − $410,000)/$410,000]. So, you can see that the assumptions outlined in Tables 4.1 and 4.2 are reasonable. If we used the 20 percent assumption used in Tables 4.1 and 4.2, I would have needed to create only $82,000 in additional value. By employing some relatively basic techniques, I was able to achieve almost four times that amount. I do not mean to imply that you can create value of this magnitude in every case; however, I do want you to be aware that such opportunities exist and that the assumption of 20 percent is conservatively feasible. (Location 978)

This was a Class C building in a Class C neighborhood with strong demand. The thing I love about Class C properties (in the right market) is that their supply is finite. In other words, they don’t make Class C buildings anymore. All new-construction apartments are by definition Class A. When the supply of available units is fixed and the demand for these types of units continues to increase, it can mean only one thing. That’s right, you guessed it: continued upward pressure on rents. (Location 997)

Because I lived out of state, I could only go by what the broker told me over the phone, and also by a couple of photos he sent me. The photos looked good, and the broker assured me the properties were in fair condition, so I put the deal under contract. I had a 30-day feasibility period for due diligence and property inspections, so that gave me ample time to arrange a flight to Texas to view the properties. (Location 1003)

For every tenant that moved, I would incur a make-ready expense and also a loss of rents. (Location 1078)

My counteroffer was to leave the sales price exactly as it was, but to receive a credit for repairs of $125,000 at closing. This way I would not have to come up with the capital for the repairs out of pocket. If the sales price were adjusted downward by $125,000, I would have had to put up the 15 percent down payment and also come up with an additional $125,000 for the capital improvements. Since I was not at all interested in tying up my money in such a deal, I requested the credit at closing. That way I would have the money immediately available to begin making the improvements. As it turned out, the seller rejected my counteroffer, which was fine with me, and both of the agreements were terminated. (Location 1086)

You must first determine your niche in the marketplace by analyzing key factors regarding the type of property you are seeking. Once you have defined exactly what type of property you are looking for, you will be ready to embark on locating the property best suited to your needs. Establishing Your Niche Before you begin your search for an apartment complex, you must first define your niche in the marketplace. There are four crucial factors to consider: 1. The resources available to work with. 2. The size of the property. 3. The age of the property. 4. Your holding period. (Location 1109)

In general, loan-to-value (LTV) financing of 80 percent is readily obtainable. If you had $100,000 to invest and procured an 80 percent loan, you could buy a $500,000 apartment building. With that same $100,000, you could acquire a $750,000 complex with an 85 percent loan or a $1 million building with a 90 percent loan. (Location 1123)

You and you alone must determine what the best use of your time is. Where do you add the most value to the process? In the early stages of building wealth through real estate, the day-to-day, hands-on involvement will give you invaluable experience not available from any other source. As your level of expertise increases, however, it will be time to shift some of those responsibilities to others. Why burden yourself with trying to personally manage and oversee every detail of a 100-unit complex, for example, when you can pay someone $20,000 to $30,000 a year to assume those duties for you? (Location 1159)

Your role is to manage the managers by defining your objectives for the property. You provide the leadership, and then get out of the way and let them do their jobs. Do not micromanage. You will continue to maintain close contact and make yourself available for questions. In addition, you will scrutinize every detail of the financial reports every month to ensure that you are on track to meet your stated objectives. (Location 1167)

Class A apartments will typically be newer properties, less than 10 years old and in excellent condition. (Location 1177)

Class A apartments are often held by a group of investors that owns a portfolio of properties, possibly in a real estate investment trust (REIT). (Location 1185)

Advantages of Class A buildings include higher rents, lower maintenance costs, and numerous amenities such as swimming pools and weight rooms to attract tenants. Disadvantages include a much higher per-unit cost to you as the investor and, usually, a lower initial rate of return. Another disadvantage you must be aware of is that in the event of a downturn in the economy, this will be the first group to get hit, especially if the downturn is followed by a strong upward cycle. This is due to the fact that as interest rates decline, more and more product comes on line, and as rates start to go back up, there are still a number of projects in the pipeline yet to be completed. (Location 1186)

Class B apartments are slightly older than Class A buildings, usually between 10 and 20 years old, and are still in relatively good condition. (Location 1201)

These properties are often located in solid middle-income areas and are likely to be the most stable among the various property classes. (Location 1203)

B apartments are available to the patient investor who takes the necessary time to conduct a diligent search. They are not as readily available as Class C apartments, however. (Location 1208)

Class C apartments are those that range in age from 20 to 30 years and in price from $10,000 to $30,000 per unit, depending on the relative market values, rents, and property condition. Value-play opportunities are abundant in the Class C category for a variety of reasons. Many of these older units are still in fairly good condition, but may not offer some of the amenities that newer ones do. Cosmetic improvements can do wonders for Class C buildings, as can the addition of a few of the amenities that newer apartments offer. Modernizing the individual units with updated appliances and cabinets is an affordable way to add value. In addition, many of the Class C buildings were built before the notion of submetering became popular. As energy costs rose, investors in newly constructed units began more and more often to pass these costs on to the tenants. (Location 1211)

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Class C buildings are usually in fairly stable neighborhoods that are well established and have not suffered from deteriorating conditions in the surrounding area. As an investor, however, you must be careful in your selection of Class C apartments—some buildings may qualify as Class C units, but the immediately surrounding area may be suffering from declining values due to high crime, an influx of low-income families who may not have the resources to properly care for their homes, or any other number of contributing factors. Conversely, you might find a C property in a B neighborhood, which would likely present an excellent opportunity to add value by bringing that building up to the standard of the community in which it is located. (Location 1220)

Class D apartments are generally those in excess of 30 years of age; they range in value from $5,000 to $10,000 per unit, depending on the relative market values, rents, and property condition. Value-play opportunities do exist in this category. The caveat, however, is that they tend to be more capital intensive. Older buildings may require repair or replacement of heating and cooling equipment, boiler equipment for hot water, roofs, parking lot surfaces, and the like. Depending on the age of the building, it may even be time to replace the electrical wiring. This can be very costly. Furthermore, you will want to know whether the wiring is copper or aluminum. This may sound trivial, but believe me, it is not—for the simple reason that a number of lenders who specialize in financing multifamily properties will not even consider loaning money on an apartment with aluminum wiring. (Location 1236)

A thorough analysis of similar apartment buildings within a 1- to 3-mile radius of the building you are considering will give you an idea of the potential upside in the property you have targeted. (Location 1249)

Holding Period For value-play investors, the quicker the turnover, the better. Remember, you are attempting to maximize your wealth by going in, creating value, and getting out. Depending on the size of the property you are acquiring and the extent of work being done, your turnaround time may vary from three months to two or more years. (Location 1258)

Six Ways to Locate Properties 1. Real estate brokers. 2. Classified advertisements. 3. Industry-specific real estate publications. 4. Local and national Web sites. 5. Associations and real estate investment clubs. 6. Banks. (Location 1332)

Having two or three real estate brokers scouting properties for you is one of the most effective ways to quickly and efficiently identify potential multifamily property acquisitions. I must stress that it is crucial to your success to ensure the competence of the brokerage team you put together. I have worked with many brokers; their range of expertise and experience varies greatly. (Location 1338)

Then there are commercial real estate brokers who focus on a mix of income-producing properties. These will often include office buildings, retail strip centers, small businesses, hotels and motels, industrial sites, and, finally, apartment buildings. This group of brokers is certainly more qualified than the residential brokers, because they are used to valuing properties on an income basis rather than on comparable sales. (Location 1345)

Finally, there are those brokers who focus solely on multifamily properties and nothing else. These are the people you want on your team! These brokers are generally experts in the multifamily property industry who have migrated from single-family or commercial sales for one reason or another. (Location 1350)

It is important to note that a Multiple Listing Service (MLS) such as the one used for single-family houses does not exist for apartment buildings, but apartment brokers are plugged into a network of similar brokers, and they will be among the first to know when a building becomes available. This can vary, however, because brokers will sometimes attempt to keep a listing in-house and offer it to their own lists of buyers to avoid splitting the commission with another agent. (Location 1355)

Most larger metropolitan newspapers carry an “Apartment” or “Multifamily” heading in the real estate section; this will often provide a handful of listings. Sometimes they may be found in the commercial property section. The information in these ads is usually fairly limited. They are designed to get you, the investor, to call the broker for more information. This can be an effective way to get to know apartment brokers. (Location 1363)

These publications can be a very good source for locating potential deals. You will also find many helpful real estate-related advertisers in these publications, such as apartment brokers, lenders, appraisers, environmental engineers, and surveyors. (Location 1370)

Most cities have a number of real estate investment-related associations and clubs. These clubs provide an excellent opportunity for you to network with others who share similar interests. Members often include investors like yourself, real estate brokers, tax and real estate attorneys, engineers, appraisers, and other real estate professionals. (Location 1384)

Smaller local or regional banks can also be a good resource for locating properties. (Location 1390)

Lenders are often quite flexible in the terms and conditions they are willing to offer, which may result in an opportunity for you to reach an agreement that is acceptable to both of you. The basis for the lender’s starting point will likely be determined by the hard costs the bank has sunk into the property. (Location 1395)

These topics are, however, covered in The Complete Guide to Real Estate Finance: How to Analyze Any Single-Family, Multifamily, or Commercial Property (Hoboken, NJ: Wiley, 2004), which is written with an emphasis on the concepts of financial analysis as they pertain to real estate and is intended to help fill this current void. (Location 1414)

Say, for example, you decide to sell your house. To help you determine what price you should list your house for, your broker will pull up all of the current listings in your neighborhood, as well as recent sales, and calculate a range of prices based on average sales per square foot. Then the broker will consider factors such as the overall condition and the various amenities of your home. Does it have a fireplace, or a swimming pool? Is it a two-car garage or a three-car garage? And so goes the process, adding and subtracting until a final value is determined. (Location 1487)

Five Essential Components of an Income Statement 1. Operating revenues. 2. Operating expenses. 3. Net operating income. 4. Debt service. 5. Reserve requirements. Operating revenues consist of all sources of revenue, such as gross scheduled income, vacancy loss, and other income. Gross scheduled income represents 100 percent of the potential income an apartment complex could produce if every single unit were occupied. In other words, if the vacancy rate were zero and all tenants paid 100 percent of their respective rent, the rental income for the property would be maximized. Vacancy loss represents the amount of income lost due to unleased units. Promotional discounts and concessions, as well as delinquencies, also fall under the vacancy loss category. Other income includes income from late fees, application fees, laundry rooms, vending machines, and any payments that may be collected for utilities. (Location 1597)

The third category of the income statement is net operating income. While generally just a single line item, this is the most important element of the income statement. Net operating income is derived as follows: Gross income − total operating expenses = net operating income Net operating income is the remaining income after all operating expenses have been disbursed. It is also the amount of income available to service any associated debt—that is, to make any loan payments. Finally, net operating income is the numerator in the quotient used to calculate the capitalization rate, which is discussed in greater detail later in this chapter under Five Key Ratios You Must Know. (Location 1623)

Finally, the reserve requirements portion of the income statement is used to cover any capital improvements to the apartment complex. Lenders will often figure into their calculations a budgeted amount deemed appropriate to make necessary capital improvements. The reserve requirement is estimated on an annual basis, and often is broken down into a per-unit figure, such as $250 per unit per year. Under this scenario, on a 100-unit apartment complex, you would have a total of $25,000 budgeted for improvements. (Location 1633)

The rent roll, or rent schedule, as it is sometimes known, provides information that is vital to you as a potential buyer. A good rent roll should provide most of the following data: • Unit number—the apartment number • Tenant’s name—the name of your tenant • Type of apartment—for example, two bedroom, two bath Table 7.3 White House Apertments Balance Statement, Fiscal Year End 2000 (as of December 31, 2000) • Scheduled rent—the amount of rent your tenant was supposed to pay • Collected rent—the amount of rent your tenant actually did pay • Other income—any other income collected from utilities, application fees, late fees, and the like • Date paid—the date or dates when rent payments were made • Comments section—notes such as “new move-in” or “gave 30-day notice” The seller should be able to provide you with rent schedules for no less than the previous three months. Ask for up to six months’ worth if they are available. By closely studying the rent rolls, you should be able to assess the stability of the property, the efficiency of collections, and, probably most important, the occupancy rate (inverse of the vacancy rate). (Location 1687)

First of all, stable property implies one where there is minimal or normal turnover. The turnover rate is calculated by dividing the number of units vacated over a given period of time by the total number of units: In a 100-unit complex, for example, normal turnover might range from 1 to 5 move-outs per month, with 5 being on the high side, but allowing for some seasonality (more move-outs in the summer months). Low turnover suggests that the tenants are happy and content with their overall living accommodations. (Location 1703)

If the rents are below market, you may be able to take advantage of one of the value-play techniques previously described. Here is a simple example. Say you have located a 50-unit apartment building that is charging on average $600 per month. Your research indicates the market will bear $640 per month. Using a capitalization rate of 10 percent, a bump in rental rates over a 12-month period of $40 per month would create $240,000 in additional value. Table 7.4 White House Apartments Rent Schedule,January 2001 (Location 1727)

Five Key Ratios You Must Know A ratio is a simple mathematical equation used to express a relationship between sets or groups of numbers. The use of ratios in analyzing multifamily properties is essential to properly and fully understanding their respective values. In addition, ratios provide a gauge or a general rule of thumb so that you can quickly determine how a given property is valued relative to the market. Five ratios are required in multifamily property analysis: • The capitalization rate • The cash return on investment • The total return on investment • The debt service coverage ratio • The gross rent multiplier Each of these elements plays an important role in helping you to determine whether the investment you are considering is worthy of your investment capital. (Location 1743)

Here is an example. We know that net operating income (NOI) is derived by subtracting total operating expenses from gross income. If you were to pay all cash for an apartment building, NOI represents the portion of income that is yours to keep (before taxes and capital improvements), or the yield on your investment. If you were considering purchasing an apartment building that yielded $50,000 annually and the seller had an asking price of $800,000, should you buy it? Plug in the numbers and find out: Net operating income = $50,000 Sales price = $800,000 In this example, you can see that the asking price of $800,000 provides a yield of only 6.25 percent. Assume that comparable properties in this particular market are selling for cap rates of 10 percent. Armed with that knowledge, we can easily determine a more reasonable value for the property by solving for sales price, as follows: So in this example, based on the limited information we have, we know the apartment is overpriced by $300,000. Understanding this simple yet powerful equation is fundamental to properly assessing value, allowing you to quickly determine whether the asking price of an apartment building is reasonable. (Location 1767)

The cash ROI is different from the NOI and the cap rate in that cash ROI is calculated after debt service, while the cap rate is calculated before debt service. Excluding tax implications, if you were to pay all cash for an apartment building, the cap rate and the cash ROI would be the same. Most investors, however, elect to utilize the other people’s money (OPM) principle, which means that the cash return becomes a function of the return on your invested capital; hence, the name cash on cash. So while the cap rate is an important ratio used in determining relative property values, the cash ROI is an important ratio used to determine your cash rate of return on invested capital. (Location 1783)

The total return on investment is similar to the cash ROI, with one important distinction—it accounts for that portion of return which is not cash, namely the principal reduction. In other words, it takes into account the portion of the loan that is reduced each year by payments that are applied to the remaining loan balance, or the principal portion of the loan payment. The total ROI is the ratio of the remaining cash after debt service plus principal payments to invested capital: (Location 1789)

Here is how it works. Sellers or brokers use “setup sheets,” which provide minimal information about a property being offered for sale, such as the asking price, number of units, location, gross revenues, and terms. After reviewing the setup sheet for a given property, you can contact the seller or broker directly to ask for a full offering package, which they will gladly furnish. As a general rule of thumb, total operating expenses will average between 40 and 60 percent of gross income, depending on a variety of factors. If you split the difference, you end up with 50 percent on average. Take the gross income as reported on the setup sheet and multiply it by 0.50 (or simply divide by 2). The result is a reasonable estimate of net operating income, which can then be divided into the asking price, giving you an estimate of the cap rate. You know that cap rates are usually between 8 and 12 percent, with 10 percent being the average. Compare your result to the 10 percent average. Are you high, or low, or somewhere in the ballpark? The One-Minute Assessment in Three Easy Steps 1. Divide gross income by 2; the result is an estimate of NOI. 2. Calculate the cap rate by dividing NOI by the asking price. 3. Determine whether the resulting cap rate is in line with the market. I frequently use this quick and dirty approach. If the offering price appears to be completely out of line, which it sometimes does, I move on to the next deal. Conversely, if it appears to be in line with my expectations, I may then decide to proceed with a more thorough analysis. (Location 1845)

After analyzing dozens of financial statements for apartment buildings, you will begin to get a feel for every line item on the income statement. You will know, for example, that on average repairs and maintenance will run between 10 and 15 percent, property taxes will run about 5 percent, insurance will run about 2 percent, and management fees will run about 5 percent. These averages will obviously vary from area to area, but if you are focusing on properties in a particular city or county, you will have a good idea of what costs should be on average. By comparing the expenses as reported on the income statement with your expectations, anything outside of the norm will begin to jump out at you. If repairs and maintenance are reported at 4 percent, for example, you will want to investigate further. Something is out of line, and there is a good chance that not all of the repairs and maintenance items are being reported. Although unlikely, it could be an indication that management is operating the property extremely efficiently and that there is relatively low turnover.   Another benchmark you can use to determine relative income and expenses is to break everything down on a per-unit basis. You know, for example, that on average total operating expenses per unit run about $3,200 in your market. If you examine an income statement for a particular property that reports total operating expenses at $3,800 per unit, you will want to know why. This may be an indication of poor management and high turnover. If this proves to be the case, experience has taught you that with the right management team in place, you can significantly reduce costs and turnover and thereby create value. (Location 1861)

Another good source is the Institute of Real Estate Management (IREM) . Each year it publishes a comprehensive book entitled Income and Expense Analysis: Conventional Apartments (Chicago: IREM/National Realtors Association), which provides data on more than 3,700 apartment buildings in over 150 different major metropolitan areas. The book also includes the following features: • Detailed analysis of financial operations • Subdivisions by property age, size, and rental range • Analysis of direction of vacancy rates and operating ratios • Various other historical trend reports The book retails for about $300, but if you become a member of IREM, you can buy it for half of that. Check out the IREM Web site at www.irem.org (note: .org, not .com). IREM provides a lot of other valuable resources, as well. (Location 1878)

Before ever going to look at a property, I first review the related financial statements. If the deal makes sense after running it through my model on the first pass, it may be worth looking at further. In this case, the output from my model indicated that the returns were acceptable, but that there was also room for improvement. I decided it was worth taking a look at to see if perhaps there was a way that I could add or create value. It also had been awhile since I had found any deals even close to being worth looking at, so with this in mind, I arranged to meet with the broker to see the property. (Location 1905)

Since Improvements and Closing Costs are included in the Total Purchase Price, this must be taken into consideration when entering the amount of equity. Sometimes some of the closing costs can be rolled into the financing, and sometimes the seller will pay some of them. Inasmuch as every closing transaction is different, the model provides the user with the flexibility to estimate total cash outlay in this section. Whether some of the closing costs are rolled into the loan or paid for by the seller is irrelevant. The total amount of cash required by the investor, including closing costs or improvements, is input into this cell. (Location 1922)

Operating Expenses include all of the day-to-day costs incurred to operate the property with the exception of interest, which is accounted for later. Operating Expenses include such items as repairs and maintenance, management fees, taxes, insurance, utilities, landscaping, and any other day-to-day operating expenses. This section would not, however, include long-term capital improvements such as replacing an entire roof or expanding the parking lot. (Location 1953)

Total Operating Expenses for a multifamily property typically range anywhere from about 40 percent of Gross Income to as much as 60 percent of Gross Income. If expenses run any higher than that, the property will most likely have a difficult time cash-flowing properly. One primary factor that significantly affects operating expenses is whether the property is submetered. For example, in some older apartment buildings a master meter was installed at the time of construction. In this type of situation, the apartments are often rented out as “all-bills-paid” and the landlord or owner assumes the responsibility for paying all utilities. (Location 1958)

The next section of the model is Net Operating Income. Recall that the value for NOI is crucial as it is the numerator in the cap rate calculation. The annual NOI in this example is $113,590, which gives us a cap rate of 9.71 percent (Location 1965)

Depreciation is then factored in for tax purposes; however, I prefer to evaluate income-producing properties on a before-tax basis since this is the way a lender will evaluate it. The tax rate was therefore set to zero, which means the value determined for depreciation is irrelevant in this example. (Location 1969)

Below that is Principal Reduction, which is the amount applied to pay down the loan in Year 1. When the Principal Reduction of $13,541 is factored in, the Total Return on this property is $36,990. (Location 1975)

Most lenders require a minimum DSCR of 1.00 to 1.20. I personally prefer to see the DSCR above 1.20 as a minimum standard so as to ensure that the property has adequate cash flow to cover any debt-related obligations. (Location 1979)

This section of the model allows the user to evaluate what the potential resale value of a property is based on cap rates specific to its area. In this example, the value of $1,350,000 in Year 1 has a corresponding cap rate of 8.41 percent. (Location 1983)

I made an offer for $1,100,000 with the standard 30-day feasibility period and ½ percent of the purchase price as earnest money matched with another ½ percent after the 30-day period when the earnest money goes hard, or becomes nonrefundable, and an additional 60 days to close. These terms are not at all out of the ordinary and in fact would be considered reasonable and customary in that market. The value-play opportunity for this property was to convert the units into condominiums and sell them individually. Conversion costs were estimated to be approximately $7,500 per unit, which would result in a total cost of $30,000 per unit. It was then estimated that the newly converted condominiums would resell for an average $50,000 each, resulting in a gross profit margin of $20,000, or $1,040,000 in aggregate. (Location 1985)

Pam, for whom I had arranged financing on a smaller 12-unit property. After doing some market research to determine the average rental rate for comparable properties, Pam concluded that the apartments she was buying were being rented for considerably less than the market average. The price she was acquiring the apartments for reflected the existing income only, and not any upside potential. This should be true for any property you are considering, as well. Remember, you should be willing to pay only for what the property is worth as it is currently operating and not for any future upside potential the broker or seller may promise you exists. Pam knew going into the deal that she would be adjusting rents to market rates as soon as the tenants’ respective leases expired. She also knew and accepted that there would probably be some tenant turnover as a result. Adjusting her rents to market rates would immediately add value to her apartments, as value is derived from a multiple of net operating income (NOI), as previously discussed. (Location 2038)

Scenario I: Five-Year Pro Forma Income Statement. (from Berges Investment Group, Copyright © 1998) (Location 2099)

Now take a look at Exhibit 8.2, Scenario 2. Note that the cost and revenue assumptions, as well as the financing assumptions, remain exactly the same as in the analysis in Exhibit 8.1. The only assumptions that have changed are the variables used for the estimated growth rate projections. Take a few minutes to study the table. (Location 2112)

By keying in our basic assumptions, we can very easily change a few variables, which can help us to readily identify any upside potential. Additional information regarding the availability of the model used in the case studies is available on the Web at www.thevalueplay.com. (Location 2130)

Remember, you must define your objectives from the outset. Entry, postentry, and exit strategies must all be clearly established. If you are a value-play buyer, your investment philosophy will by definition be to assume a short-term approach. Every potential acquisition candidate you analyze should meet your established criteria for a value-play opportunity. You cannot afford to implement the buy-and-hold technique if you truly intend to maximize the return on your investment capital. (Location 2241)

The 25-unit had also been constructed with a master meter, but had not yet been retrofitted with submeters. Both were solid Class C properties in a Class B− to C+ community. After personally calling 14 competing apartment complexes within a 1- to 3-mile radius, I discovered that most of the comps in the surrounding area enjoyed high occupancy. A limited supply with strong demand—just the way I like it. (Location 2259)

I know this has been stated before, but it is worth repeating: You should be willing to pay a price based only on how the property is operating today, not based on how the broker or seller tells you it can potentially operate. If you do not remember anything else in this book, please remember at least this one principle. By doing so, you will prevent yourself from paying more than a property is really worth. Examine the actual operating statements and use them to negotiate to your advantage. (Location 2273)

I was able to negotiate with the owners of both properties to have them carry back a second mortgage for 10 percent of the purchase price. The lender offered what is known as 75/10/15 financing, meaning they loaned 75 percent, the seller carried a note for 10 percent, and my required down payment was 15 percent of the purchase price, which did not include capital improvements. (Location 2292)

As you will recall, the three basic components that must be considered when defining your objectives are your entry, postentry, and exit strategies. My entry strategy on this property was to identify as many opportunities as possible to create value, adjust the variables in my model, and then determine whether the project would provide a reasonable return on my invested capital. (Location 2305)

Immediately after I acquired the property, I began implementing my postentry strategy by making the required capital improvements identified during the analysis phase, enhancing the revenue stream according to the projections outlined in Table 8.4, and finally by applying the cost-savings measures necessary to operate the property more efficiently. The capital improvements shown in Table 8.5 were all accomplished within the first six months. I did experience higher than expected turnover at Franklin II as a result of the submetering process. All but 5 of the original 25 tenants moved within six months. Franklin I, however, continued to remain very stable during this period and was profitable enough to offset losses incurred from the higher turnover. The new tenants moving into Franklin II understood that they would be responsible for their own utilities, so by the eighth to ninth month, both Franklin I and II were stabilized. It was time to begin preparing my exit strategy.   With all capital improvements, revenue enhancements, and cost-savings measures now fully completed, it was time to implement my exit strategy. I knew that by the time I made the property available for sale and put it on the market, I would be well beyond my desired 12-month holding period, the minimum required for taking advantage of the lower long-term capital gains tax rate of 20 percent. Franklin I and II, by the way, is the same apartment complex discussed in the previous chapter—the one the broker recommended selling at a price of $1.8 million, claiming I would be lucky to get $1.65 million for it. As you may recall, my own analysis—which suggested an exit price of $2 million to $2.1 million—was ultimately corroborated by two other brokerage firms and an appraiser, and the property eventually sold for a price of $1,995,000. (Location 2314)

Take a minute to refer back to the Estimated Exit Price YR 1 line in Exhibit 8.7. My original estimate of $1,950,000 proved to be quite accurate and slightly on the conservative side. You can see firsthand from this example the value of having a powerful and dynamic model, such as the one I developed, to help you with your analysis. By simply adjusting the variables to reflect realistic projections based on your research and analysis, within minutes you can determine the latent potential of any multifamily property before you buy it. (Location 2342)

Chapter 7 describes the financial analysis principles used to value income-producing assets in considerable detail, and Chapter 8 discusses the practical application of those principles, so by now you should have a fairly good understanding of the valuation process used to analyze multifamily properties. Once you have identified a value-play opportunity and have determined through your research and analysis the maximum amount you are willing to pay for a property, the next logical step is to negotiate for the best possible price and terms. Upon reaching an agreement that is acceptable to both parties, you are then ready to implement your due diligence process. This chapter explores the five cardinal rules of artfully and skillfully negotiating the best deal possible, and then examines a step-by-step approach to performing the required due diligence. (Location 2356)

Five Cardinal Rules of Successful Negotiation 1. Engage a competent broker to act as your intermediary. 2. Justify your offering price armed with the seller’s operating statements. 3. Know why the seller is selling. 4. Safeguard yourself with a 30-day “free look.” 5. Know when to walk away from a deal. (Location 2367)

By the time you are ready to make an offer, you should have reviewed the seller’s financial statements in great detail. At a minimum, you should have reviewed a recent income statement for the trailing 12 months and the last 3 months’ worth of rent rolls. If you have not yet examined these crucial operating statements, you are not ready to make an offer. (Location 2402)

If a seller is asking, for example, $1 million for the apartments, and your analysis indicates a value of only $800,000, you should use that information to your advantage by explaining to the broker exactly why the subject property is worth that amount and no more. Walk the broker through your analysis, and help the broker understand why you believe the value is only $800,000, so the broker, in turn, can use your rationale to explain it to the seller. Because cap rates vary within a range and are somewhat subjective, I recommend starting below your target price of $800,000. If in this example, the net operating income (NOI) is $80,000 and the market comps suggest a cap rate of 10.00 percent, then If your target price is $800,000 and that is the first offer you make, guess what? You are not going to get the deal for $800,000. You must be prepared to start lower so that you end up achieving your true objective. As you walk the broker through your analysis, simply state that you believe the property falls into the 10 to 11 cap-rate range, and that at a cap rate of 10.5, the property is worth only $761,905; therefore, you want to start the bidding at $760,000. (Location 2407)

If the broker is the seller’s agent, the broker is going to tell you every reason he or she can think of as to why the apartments are worth the $1 million the seller is asking. You politely but firmly explain to the broker that if the property were truly worth the full asking price, then it should be generating a minimum of $100,000 of net operating income today—not tomorrow, not a year from now, but today. If all of the potential the broker claims to be in the property truly exists, then why has the current owner not achieved that level of performance… (Location 2420)

As a prospective buyer, it is important for you to know why the seller is disposing of the property. Knowing the underlying reasons for the sale can potentially give you the upper hand at the negotiating table. Is the seller burned out and just trying to get rid of the apartments (and the headaches of operating them), or is the seller just testing the waters to determine what price the market will bear? In other words, you want to know whether your seller is motivated, and if so, to what degree. The more motivated the seller, the more likely the seller is to be flexible on both price and terms. Reasons for selling typically fall into one or more of the following six categories: Six Reasons Sellers Sell Their Property 1. Need proceeds from sale for another investment opportunity. 2. Burned out due to poor management. 3. Changes in economic conditions. 4. Tax considerations. 5. Life-changing event. 6. Retirement. One of the most compelling reasons for a seller to divest property is that the seller is a value player like yourself and is ready to take the gain on sale and move on to the next deal. The degree of motivation will vary depending on factors such as how much value was created and the timing for entry into the next investment. If, for example, the seller created $600,000 in value on a $3-million apartment complex over a 12-month period, the seller may in fact be willing to accept $2.85 million for the deal, thinking that a bird in the hand is worth two in the bush. In other words, instead of holding out for the full $600,000 in profits—which could take as long as another six months to a year—the seller can go ahead and accept the lower price, lock in a gain of $450,000, and be ready to move on to the next deal. You may be inclined to think that $150,000 is a lot to leave on the table, and, granted, it is, but a value player has a different mindset. The value player is thinking about the next deal and the $500,000 he or she will make on it.   Poor management is another primary reason sellers look to dispose of their apartments. The degree of motivation will correlate directly with the seller’s degree of distress. This is where subtle clues can be detected by direct communication with the seller. A meeting with both the broker and the seller at the property site… (Location 2427)

Rule 4: Safeguard Yourself with a 30-Day “Free Look” One key point you should include in your negotiating technique is to protect yourself by providing an open-ended out for any reason whatsoever within the first 30 days of signing the contract. This initial period, also known as a “free look” or feasibility period, gives you the right to walk away from the deal for any reason at all, or for no reason at all. Once you are under contract, the 30-day period is the time for you to complete all phases of your due diligence. Any number of factors could arise that might cause you to change your mind. You might find excessive deferred maintenance, or discover after looking through the records that the turnover ratio is higher than you initially thought, or you might just simply not like the flowers planted outside the building. Whatever the reason, be sure to safeguard yourself with a free-look period. The seller may not always give you a full 30 days, but you should have a minimum of 15 days to perform your due diligence. (Location 2488)

If you cannot convince the seller and broker of the validity of your offering price (see Rule 2), then it is time for you to move on to the next opportunity. An exception you may consider, however, is when the seller is willing to offer you some compensating incentive, such as more favorable terms. For example, if the seller offers to carry back a second mortgage for 10 percent of the purchase price, enabling you to get in with less money down, then you will want to reconsider the deal. Simply change the variables in the model you use for your analysis from 20 percent down to 10 percent down, adjust the offering price to what the seller is requiring, and examine the effect on your return on investment (ROI). On a $1-million apartment complex, your cash investment is reduced from $200,000 to only $100,000. This one change in your model is likely to have a significant effect on your returns. As a value player, to create enough value to double your money in this example, you need to create only an additional $100,000 of value, or 10 percent of the deal value. Assuming a cap rate of 10 percent, we know that NOI is $100,000. To create an additional $100,000 of value, NOI must be increased to $110,000. This could be done with a 5 percent increase in rents and a 5 percent decrease in expenses, or any combination thereof. (Location 2497)

I made an offer of $1.1 million with the standard 30-day feasibility period and 0.5 percent of the purchase price as earnest money, matched with another 0.5 percent after the 30-day period when the earnest money goes hard, or becomes nonrefundable, and an additional 60 days to close. These terms are not at all out of the ordinary, and in fact would be considered reasonable and customary. (Location 2509)

Your preliminary analysis brought you to the negotiation phase and you have successfully reached an agreement. Now it is time to thoroughly research and analyze virtually every aspect of the property in question through the process known as due diligence. The due diligence process should include an exhaustive review of the apartment’s physical condition and a review of the seller’s records and documentation. It should also take into consideration various zoning and environmental ordinances, as well as any outstanding legal issues. Finally, preliminary market studies should now be supported with solid documentation. Physical Inspection As a value player, your inspection of the physical condition of the property should include an examination of every unit, in addition to the general premises. You want to note items that could materially impact your decision to move forward with the purchase. There will always be minor repairs, messy apartments that need painting, and the like. These types of conditions are largely cosmetic and have no material impact. Your focus should be on the larger issues that will require a major injection of capital, such as the replacement of a roof, or foundation problems, or a parking lot that needs resurfacing. Air-conditioning and heating equipment should also be closely inspected. Note as a percentage how many of the air-conditioning units look like the original equipment, and how many of them have been replaced within the last five years or so. Take a look at Exhibit 9.1, a physical inspection checklist for the exterior. This will provide a good guideline as you conduct your own inspections.   Now take a look at Exhibit 9.2, a physical inspection checklist for the interior. You should use a checklist similar to this one in inspecting every unit. One final note on the physical inspection—you may want to hire a professional who will do an independent exhaustive inspection. If an engineering report is required by your lender, however, this report should be more than sufficient to tell you everything you need to know regarding the condition of the property, so hiring a professional inspector would only be redundant. I highly recommend you do your own inspection even if you decide to pay a professional. Your own eyes and ears act as receptors and can tell you things about a property no inspector could ever tell you. (Location 2517)

Records and Documentation Your due diligence should also include a thorough review of financial statements and their supporting documentation, lease agreements, maintenance contracts, zoning ordinances, environmental issues, and any pending litigation. The preliminary market research you conducted prior to entering into an agreement should now be supported with solid documentation. Most apartment owners will have much of this information available to you on-site. You should be able to meet with the apartment manager and owner and have ready access to all of the lease agreements, tax statements, utility records, tenant deposits, collection information, and the like. Now take a few minutes to review the due diligence checklist presented in Exhibit 9.3. (Location 2595)

As a value player, your focus is short term. This means you have to be very careful about the type of financing you put in place. You cannot afford to make the mistake of procuring a long-term loan, which may tie up the property for 10 years and potentially lock out prospective buyers for as many years. You must take care to examine all aspects of the loan arrangements you are considering. This includes knowing the effect each component of the financing instrument has on your entry, postentry, and exit strategy. For example, you should know the implications of the type of financing, the term, the interest rate, points paid at closing, requisite third-party reports, assumability of the loan, recourse provisions, lockout periods, and, finally, prepayment penalties that may be imposed. (Location 2662)

One advantage of utilizing local banks is that they can often offer a greater degree of flexibility. For example, they may provide money for capital improvements, or tailor your loan to best fit your needs, such as by providing a release clause for a condominium conversion project. Smaller banks are also likely to be much more familiar with the local area and would therefore have a greater degree of confidence in the specific market than a larger regional or national lender would. Personal relationships with your local banker are more easily established, as well. You can go into the bank, introduce yourself, and sit down and talk directly with the lender. This gives you the opportunity to sell yourself and your project. Once a relationship has been established and the banker gets to know you and is comfortable with you, future loan requests will be much easier and likely require less documentation, possibly as little as updating your personal financial statement. (Location 2675)

Most conventional bank loans are full-recourse loans, while most conduit loans are nonrecourse loans. Specialty programs designed for smaller-sized loans are typically full recourse, but there are some lenders who offer varying degrees of nonrecourse loans under this type of program. (Location 2733)

As a value-play investor, your focus is on the short term; therefore, you must take the necessary precautions to ensure that the type of financing you secure coincides with your exit strategy. Longer-term loans, such as 5, 7, or 10 years, may not be appropriate for a value-play opportunity for reasons related to prepayment and transferability of the loan. The shorter-term loans offered, such as 1 and 3 years, work to your advantage by providing you with the flexibility needed to facilitate your exit strategy. Don’t lock yourself into a loan that will create problems for you if you intend to sell the property in one to two years. Let the individual you sell to, who will most likely be someone who has adapted a buy-and-hold methodology, obtain the long-term loan. (Location 2737)

Even then, I recommend building flexibility into the loan by using the longer amortization period. If you want to pay the loan off over a shorter period of time, you have the option of paying a little extra each month, but you are not required to do so. (Location 2755)

Among the biggest expenses related to funding your project are the loan fees assessed. These include origination fees and mortgage broker fees. Lenders’ origination fees are usually equivalent to 1 point, or 1 percent, of the total amount of the loan. On a $1-million loan, the fee would be $10,000. Mortgage brokers typically charge between 1 and 2 percent of the loan amount, depending on the size of the loan. On a smaller loan, say $500,000, mortgage brokers may charge as much as 2 percent, while on larger loans, fees of 1 percent are common. When combined, these fees can add up. For example, on a $1-million loan, a 1 percent origination fee plus a 1 percent mortgage brokerage fee totals $20,000. While these fees are sometimes negotiable, you still need to be prepared for these added expenses when undertaking (Location 2763)

You should be aware that environmental inspections may encompass far more than you might expect. Believe it or not, while the actual property being inspected may be completely free from any underground contaminants or physical problems such as asbestos, a convenience store with a gas station across the street may derail your deal. Some lenders, especially conduit lenders, are very particular about anything that may pose some unforeseen threat or create a potential liability, such as seepage from an underground fuel storage tank located at a neighboring property.   Finally, third-party report fee expenses can range anywhere from $2,500 to $25,000, depending on the size of the apartment building you are buying and the particular lender requirements. (Location 2780)

Before obtaining a loan, I strongly recommend that you be aware of any lockout provisions in your loan agreement. Using the previous example, if you bought a property for $1 million and placed a conduit loan with a lockout provision on it, you would have no choice but to sell to a new buyer as described under Scenario 1. This would limit your ability to divest the property and take your gain, because even though the loan had an assumption feature, the new buyer would be forced to come up with an additional $160,000. (Location 2814)

If your intentions are to acquire an apartment building, create value, and turn around and sell it within 12 to 18 months, you will need to take the prepayment penalty structure of the loan into consideration. It is best to minimize your exposure by procuring a loan with a shorter term, such as a one-year or three-year term. (Location 2829)

Owner Financing Sellers of multifamily properties will often consider debt and equity arrangements with prospective buyers. A common form of debt financing is for the seller to carry back a second lien for 5 to 10 percent of the total sales price. Here is how it works: in a 75/10/15 program, which is allowed by many lenders, 75 percent of the purchase price comes in the form of debt from the lender, who holds a first-lien position secured by the property; 10 percent of the purchase price comes in the form of debt from the seller, who holds a second-lien position that may be secured by the property or any other collateral; and the remaining 15 percent of the purchase price is provided by the buyer, in the form of equity. Sellers are often amenable to carrying back small portions of the total sales price because they do not always need 100 percent of the cash provided by an outright sale. Moreover, if the seller believes that the buyer has a solid interest and is willing to accept the offering price, the seller becomes motivated to work with the buyer to facilitate the transaction. Under the 75/10/15 program on a transaction valued at $2.5 million, a lender would furnish debt financing of $1,875,000, the seller would take a second lien for $250,000, and the buyer would be required to provide the remaining balance of $375,000. This is truly a win-win-win situation for all three parties. The lender has a fairly secure loan with only a 75 percent loan-to-value ratio, rather than the more common 80 percent; the seller has divested the property but retains a small interest in it; and the buyer is able to achieve a greater degree of leverage and therefore earn a higher rate of return on the invested capital. (Location 2836)

Another form of owner financing is known as a wraparound mortgage. Under this arrangement, the seller retains title and continues to make mortgage payments to the lender, while the new owner makes mortgage payments directly to the seller. Wraparound mortgages are more common on smaller multifamily properties such as duplexes and fourplexes than on their larger counterparts. Be careful of any due-on-sale clauses in the deed of trust, which may expressly prohibit this type of financing arrangement. Lenders typically are not too fond of the transfer of ownership interests without their knowledge. (Location 2854)

Equity Financing Although not as common as lenders who provide financing in the form of loans, or debt, a number of institutional investors exist who are willing to part with their capital in the form of equity. In other words, instead of loaning money to buyers, equity investors form a partnership agreement with them. This allows smaller multifamily property buyers to leverage themselves into larger properties. The investors funding the equity portion of the financing usually require a minimum return on their investment and will expect to share in any gain on sale, as well. It should be noted, however, that most of these types of investors are looking to employ large pools of capital, so the minimum purchase price of an apartment building is often $5 million or more. (Location 2858)

Partnerships Using the resources of a partner can be an excellent form of secondary financing. The type of partner referred to in this subsection is a friend, family member, or business acquaintance, not the large institutional investor described in the Equity Financing subsection.   Partnerships can be structured in any number of ways. For instance, capital injections by partners can take the form of debt or equity; partners can play an active or passive role; and terms for the repayment provisions can be defined in various creative ways. If your partner agrees to invest in your project using equity, then your partner will share the risk with you. If you lose, your partner loses, but if you win, your partner also wins and shares in the profits. Conversely, if you do not want to give up any of your profits, you would have your partner participate on the debt side by making a loan to you. In this case, the loan can be secured by the property or any other collateral you may have, or it may be an unsecured loan.   You may decide to have your partner actively participate by exploiting whatever skill sets the partner may have. If your partner is mechanically inclined, for example, you may consider having the partner perform some of the maintenance. Conversely, you may choose to have your partner… (Location 2865)

Unless you have been through the financing process for apartments at least a couple of times, I recommend working with a mortgage broker.   Just as real estate brokers play an important role in matching up buyers and sellers, mortgage brokers play an important role in matching up buyers and lenders. Mortgage brokers usually have many contacts in the industry. They know which lender is best suited for the type of financing you are seeking, and they know who is offering the best deal. Experienced brokers have wellestablished direct relationships with the lenders and usually do a high volume of business with two or three of them. Because the brokers already have professional or personal relationships with their contacts, they can often persuade a lender that your deal is worth the risk of taking on a loan that might otherwise be considered borderline.   While you can generally expect to pay 1 point to the broker for his or her services, the fee can be well worth it if you are working with a professional broker who has solid relationships with several lenders. The broker’s service can sometimes make the difference as to whether the financing for your deal goes through. Furthermore, brokers know how to qualify your particular property before ever sending it to a lender, because they know what each lender will and will not accept. For example, if the apartment complex you are buying has aluminum wiring, you absolutely will not be able to get financing from some lenders, as they consider this type of wiring to be a fire hazard. While aluminum wiring may sound like a trivial and even insignificant factor, it represents an unacceptable level of risk for some lenders, and your loan will be flatly rejected.   A good mortgage broker can usually tell you if he or she can place your loan after spending just ten to fifteen minutes with you on the phone. The broker knows what questions to ask to qualify your property and which lender is likely to be the most interested in financing it. (Location 2888)

Several days before the closing, you should take the necessary precaution of performing one final physical inspection of the apartment building. Doing so could potentially save you thousands of dollars. (Location 3066)

A property management firm must be capable of operating your property effectively and efficiently. The firm’s representatives may promise a great deal over the phone when you are conducting your search. I recommend that the initial telephone conversation be followed up by a face-to-face interview at the management company’s office. This way you can sit down with them, look them directly in the eye, and discuss the issues that are most important to you in executing your postentry strategy. (Location 3138)

Your primary function is to stay focused on your role as a strategic manager, whether you decide to take a hands-on approach by actively participating in the daily management or not. Long before you got to this point, you mapped out a plan that included your entry, postentry, and exit strategies. You must keep those concepts in the forefront of your mind at all times; otherwise, you will find yourself off course. Use your well-thought-out plan as a compass to guide you in accomplishing your objectives. (Location 3196)

You have worked hard over the past 12 to 24 months implementing your entry and postentry strategies. You started by searching for and locating a property that met your specific needs. You then acquired the property using various closing and management techniques that enabled you to make the most efficient use of your available resources. You have since utilized the necessary tools to find ways to create value by enhancing revenues and reducing expenses. It is now time to capture as much of the newly created value from the property as possible in order to more fully employ the capital created by maximizing its leverage into a greater investment opportunity in another apartment building. Your exit strategy may include selling the property outright, refinancing it, bringing in an equity partner, exchanging the property for a similar one, or any combination of these. Four Effective Exit Strategies 1. Outright sale. 2. Refinancing. 3. Equity partnership. 4. Exchange of properties. (Location 3269)

Most lenders require a minimum of 12 months of seasoning before they will consider refinancing your property, while other lenders require anywhere from 18 to 36 months. Lenders require this seasoning period to ensure that you, as the investor, have committed adequate time, energy, and resources to the property. Many lenders do not understand the process of creating value, so you may have to educate them. They sometimes erroneously believe that the only way a property can increase in value is through a series of natural rental increases that occur over an extended period of time due to general price appreciation.   Lenders may grow suspicious if your property has had a significant increase in value over a short period of time. They will want to know when you bought the property and how much you paid for it. If the apartment building you bought 12 months ago for $2 million is now worth $2.6 million, they will want to know why, and rightfully so. You must be prepared to sell the lender on the process you used to create value. If the property was being poorly managed and rents were below market and expenses were unusually high, explain to the lender what you did to turn the property around. Be confident in your presentation, and describe in detail how you injected needed funds for various capital improvements, then initiated a series of rent increases while simultaneously reducing expenses. (Location 3303)

You just need a basic understanding of the mechanics of this analysis to apply these methods to the process of creating value. It should not be too difficult to identify an apartment building that is under market rents by a factor of only 6 percent, nor to identify one that is a little heavy on the expense side. Putting the right management team in place can make all the difference in the world. As the owner, an understanding of the valuation process is crucial to placing you on the fast track to wealth accumulation. (Location 3345)

Now that you know what the appraiser will be looking for, consider what the lender will be looking for. Although the criteria for refinancing apartment buildings among lenders vary widely, three factors most of them will focus on are (1) the seasoning period, (2) the loan-to-value (LTV) ratio, and (3) the debt service coverage ratio (DSCR). (Location 3351)

The second factor lenders focus on is the LTV ratio. From my experience as a mortgage broker, I know that the majority of lenders will usually provide only 75 percent financing for the new loan. While these same lenders will offer 80 percent and even 85 percent financing for acquisitions, they are often reluctant to allow you to pull cash out of your property. The feeling among lenders is that if you pull your equity out in the form of cash, you will no longer have a vested interest in the property. (Location 3360)

When searching for a lender to refinance a property, I have found that it is best to spend 10 to 15 minutes on the phone with them to determine what their requirements are. This way, you know before ever submitting any of the requisite loan documentation whether your loan has a chance of being approved. Good loan officers are well aware of this interviewing process and want to maximize the value of their time by prequalifying your loan. (Location 3377)

Another layer of protection investors have at their disposal is the use of corporations. If you did not originally form a separate legal entity such as a limited liability corporation, S corporation, or C corporation, you can do so when you refinance. The lender may place some constraints on the formation of the new entity, but in most cases, you can put the apartments in the name of the corporation. (Location 3432)

Introducing an equity partner is a way of circumventing the due-on-sale clause. Under this type of arrangement, no property rights are transferred. As the legal owner of the apartment building, you have the right to bring in a partner at any time under whatever conditions you agree to. No sale of the property takes place. Legal documents that outline the terms and conditions of the new partnership are drawn up. In this example, you have agreed to take $520,000 of cash in exchange for the income generated by the investment, minus the difference between what a new mortgage would be and the existing mortgage. (Location 3479)

By being willing to accept $100,000 less for your property, you will certainly create an investment opportunity that will be highly attractive to prospective buyers. Much like yourself, investors are seeking to maximize the return on their invested capital. If they can acquire an apartment building with only 16.80 percent down rather than the normal 20.00 percent, they will do so, because this provides a greater yield on their invested dollars. Remember the five key ratios every investor should know that are discussed in Chapter 7? This concept applies to the cash return on investment. Investors want the greatest return on their invested capital. If you can provide an opportunity for them to achieve that when divesting your property, you will greatly increase its marketability. (Location 3562)

The central focus of this book is on arming you with the specific tools necessary to identify potential acquisition candidates, to acquire and manage those properties once you have identified them, to implement sound techniques for creating value, and, finally, to capture all of that value, or as much of it as possible, through various exit strategies. (Location 3585)