Why I Don't Buy Houses for $30,000 or D-Class Apartments

I recently spent some time evaluating a deal in an MSA (Metropolitan Statistical Area) about 8-9 hours from Lima by car. This MSA is quite attractive from an employment and demographics standpoint, and combined with the fact that the property was unlisted, this seemed like an interesting lead to follow.

I remember how this lead came in. I was in the car with my entire family on our way to Columbus, OH for one of Aaron’s appointments when the text came in from my friend, Serge Shukhat. It read something like this:

120+ units in xyz MSA. Talking to seller in 30. Will get back…

I was in the waiting room with my laptop on me when Serge and I connected over the phone an hour or so later to discuss details.

The subject is a troubled asset. In fact, right upfront the seller told us that only about 20% of the units were filled with paying tenants. He told us rents were low, but that with about $6,000-$8,000 of CapEx, we’d be able to raise the rents to market and achieve normalized occupancy.

The Research

I started to do research. Sure enough, rents seemed to be low, but from what I could see online in terms of the square footage and amenity packages of the competition, I was not comfortable with the seller’s projections of stabilized rent levels—too aggressive. There was room to push, just not as much. I thought that having spent $10,000+/door we would move rents, and more importantly, at this point in the process I thought we could fill the units, and with the right kind of retention programs we could keep them full.

However, I found out that the asset has gone through several owners in the past several years. All of them tried to reposition the thing, and all of them failed.

This in and of itself means nothing. After all, Serge Shukhat, Brian Burke (oh yeah, the big dog came to play, too), and to some small extent Ben Leybovich represent the best and the brightest of what the real estate community has to offer in 2015.

Truly, between the three of us, we’ve got every possible angle covered. Think about this with me: Brian has the brains; I have the looks; and Serge… well, Serge got chutzpah!

Anyhow, the other guys failed, but we’ll succeed, right?!

Maybe. Here’s the thing I needed to understand:

Are people not choosing to live in this community because of the poor physical condition, or is there something more sinister going on? The building we can fix, but many other problems we cannot. Success or failure in this business is a function of understanding this.

Knowing that several people have tried and failed could either mean that they were country bumpkins of REI who simply didn’t have the appropriate skills to preposition such a project, or it could mean that this is not a good candidate for such reposition, period!

I needed to look at the demographics for the answer.

I researched the demographics of the town more closely. There were two zip codes in this particular town, and they basically divided the town in two halves. Here are some of the things I was able to glean:

Income levels in both zips are lower that the MSA by a considerable margin; however,
Income levels in the subject zip are really, really low!
Median home price in the subject zip is very low.
Population in the other zip has been growing steadily since 2000; however,
Population in the subject zip, while having stabilized between 2010 – 2015, has overall lost since 2010.
All but one of the comps are in the other zip.

So, as you can clearly see, this picture is less than sexy. People in this town are not particularly chomping at the bit to move into the subject zip code. In fact, it was beginning to look as though anyone who either needed to live in this town, or simply wanted to live there, were migrating out of the subject zip into the other.

The County Office

Something I do on every deal I underwrite is contact the municipal authorities to verify the processes and formulas they use to value property and assess property taxes. As I discussed in last week’s article, just because property taxes are what they are today does not mean that they will remain the same two years from now. And since property taxes are one of the largest drags on the NOI, I absolutely must be able to project with great degree of confidence what that bill will be at my exit.

The best way to do this is to understand the local custom as it relates to assessed taxes. And the best way to do that is by reaching out directly to the folks involved in the process.

One of the side benefits of doing this is that most of the time, the people on the other end are very friendly. Let me tell you, when the nice lady starts out by saying something like:

“How do I say this without getting in trouble?”

You know there is an issue… or two… or three.

A couple of points:

You know how I mentioned in the beginning that this place is 80% vacant? Well, I bet you’re thinking this means that 80% of the units are empty with nobody living in them. Nope—there’s no water, sewer, or electricity to the units, but this, according to the nice lady, does not stop people from living in them. You ever heard of squatters?!
The building is next door to subsidized housing, which I knew since I Google Earth-ed the asset and could clearly see a community next door that looked like subsidized housing (these all kinda look alike in the Midwest). This in and of itself is not necessarily an issue, especially since these looked rather not bad. However, when I heard the nice lady say, “The city has done a lot of work in the past few years to clean that up, and it’s nothing like it was 5 years ago,” I knew immediately that it would be a matter of another economic slowdown before the city dropped the “clean-up” effort like a ton of bricks.

Can it Be Stabilized?

This is a loaded question indeed. Or perhaps it’s a very simple question. Any building can be stabilized, but only if people’s perception of it can be transformed. And people’s perception is underpinned first by location, and only then by the structure.

Sure, we could fix the building; that’s only money. But can we fix this location?

My answer is: not a chance in hell would I even want to find out!

What Are the Options, Then?

If we are not going to spend a ton of money on rehab to make units attractive (because the projected rent revenue does not justify the expenditure), then what we are going to do is spend enough to make the units livable and call it done. In this case, however, several realities come forth:

We are NOT going to attract “stable and easy to manage” types of tenants. Which means that our CapEx, maintenance, make-ready, contract services, and vacancy are forever going to be sky high.
Also, we are going to need to under-price our units not just in the beginning, but FOREVER, in order to drive occupancy.
Management is forever going to be a pain in the butt—my butt, since I am 8 hours away!

The above means that since our top-line revenue is forever going to be compressed, and our operating costs are going to need to be well above the averages, the NOI is doomed. In fact, I see negative NOI as far as the eye can see, though both Brian and Serge disagree.

They say it can be done—an owner operator can do it; an owner-operator can turn the NOI positive on this project…

I disagree. I live closer to the action. I feel like I understand the dynamics better than my partners on this project. I also got an opinion from my PM company that manages thousands of units in this part of the country, and they concur with my findings.

I pulled the plug, and I stand by it. In my opinion, not even a skilled owner-operator can turn this thing around—it’s all about location!

A project can be deemed financially obsolescent if it costs more to stabilize it than the exit value would be. This, I believe, is the case here.

Some Perspective

I am disappointed. Obviously, this had a lot of the hallmarks of a turn-around project. I have to admit as well that my perspective is colored by other elements which are present in my reality.

This is my son Aaron and I in the hyperbaric chamber. You may know that we are recovering Aaron from autism. He is doing really well! He is now in school and doing great — yeah!!! And hyperbaric oxygen treatment is supposed to be the magic bullet that completely pushes him to the other side.

We started this thing this week. As the matter of fact, the message from Serge that I received in the car on the way to Columbus — we were on our way to get trained up with this machine. It’s now in our home, and Aaron and I spend 2 hours each day in it… 2 hours each day!

And then there’s school. And then there’s Kumon twice each week. An hour drive each way plus an hour there.

I guess you could say I am a little busy. I can do this primarily because I don’t buy units that require me to babysit tenants in perpetuity!

Can you extrapolate this please?!

Life is too freaking short, and there are more important things…

This week, Aaron was tested for his IQ by the director of the school, and can you guess what they found? The director pulled me aside and said:

According to the test, your son is a genius!

Excited is an understatement.

The first call I made was to Patrisha. You can imagine the emotions…

The second call I made was to my mom.

The third call was to Serge. I am 3 hours ahead, and I think I practically got him out of bed. I told him about Aaron, and then I said, “This is why I pulled the plug on the project.”

To which Serge said, you made the right decision!

Guys, when I tell you not to buy houses for $30,000, I do so because I don’t think it’s wise to conceive of real estate outside of the prism of everything else in life. My time and yours is by far the most precious asset we’ve got.

I don’t think that this particular project will ever make money. But even if Brian and Serge are right and it can turn out some cash flow, I just have no time to try and turn around D-Class buildings in a D-Class area. I do have time to turn around D-Class buildings in C+ areas or better, but this ain’t it!

This project is the syndication-level equivalent of a $30,000 project in most markets in the US. You wanna fight that fight?!

OK, I’m done.

And now I need to find a quite place and do some thinking. I need to cut myself down to size—cause we sure as hell can’t have two geniuses in one household. 🙂

[Editor’s Note: We are republishing this article to benefit our newer members.]

What do you think? Do you agree with my assessment? What would have done in this situation?

Leave me a comment, and let’s talk!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.