8 units - Monthly cash LOSS of $6,000 - where did I go wrong?

[Adam Sherritt]

Hey guys, 

So I've heard this rumor that the goal in real estate is to actually make money.  With that being said I am very confused as to how this deal would make sense to anyone. 

Now I am still cutting my teeth when it comes to analyzing multifamily deals, but I figured I would show you guys my numbers with the hopes you can tell me where/if I went wrong.

Asking Price: $2,100,000 (has offer of $2,000,000)

Number of units: 8 

EGR (Effective Gross Revenue): $7,160 / mo.

Operating Expenses: $2,952 / mo. (not verified, this # was pulled from appraisal which used a "market derived expenses" technique to generate expenses.  I have asked seller for actual expense sheet.)

Now, if you run the 50% rule with these initial numbers (and assume a 20% down with 3.6% financing) you get an NOI of $3,580 ($7,160/2) and a mortgage payment (P&I + insurance + prop. tax) of $9,614 for a total of -$6,034 in cash flow. Not exactly the $800 ( 8 x $100) in cash flow that we are looking for.

Now, the appraiser forecasted EGR at $9,705 (36% increase.)  Ok, not bad, maybe that helps the bottom line...

Yea, not even close...In order to cashflow $800 (8x100) for this deal the rents would have to be set at $2,503/unit.  That is a 106% increase from "potential" and 180% higher than current!!!  

So my question for you guys is how does any investor make sense of this deal at $2.1m? Even with free money you'd only have a 2.05% ROI. At that point U.S. Treasuries are a better deal at 2.75%.

[David Faulkner]

Agree with Bob, throw away the 50% rule and come up with a real grass roots estimate of the expenses. Think about it, a $260k unit in CA leaves the lights on all day; a $52k unit of the exact same size and layout leaves the lights on all day; you telling me that the electricity bill is going to be 5x higher for the unit in CA? That's what the 50% rule implies.

Another thing to consider is value add. For an apartment in CA with a 5 cap, raise the rents by $100/mo/unit, and you just added (8*$100*12/.05) $192,000 in forced appreciation. Do the same thing in Ohio with a 10 cap and you just added (8*100*12/.1) $96,000.

Finally, appreciation. Most of coastal SoCal has a longterm (going back 40 or so years) average appreciation rates of 6%-8% of both prices and rents (please independantly confirm this for your market, but this is what my research tells me). 6% * 5-to-1 leverage is 30% return on price appreciation alone, and that does not count cash flow after rent increases. Of course, yes it is true that cash flow dy 1 will not likely be stellar, which is why it is important to make sure that financially you can hold through the ups and downs to make it to the long term.

After all these factors, this still may be a bad investment, and frankly it sounds to me like this particular property may be, but above gives a few hints on why investing in SoCal, even with low or even negative initial cash flow that the midwest might balk at, can be an excellent investment. Not trying to pick on Ohio or other markets like them; local, skilled investors in those markets still make good money, it is just a different strategy for high initial cash flow and low appreciation markets. Investing in low initial cash flow and high appreciation markets like coastal SoCal is not for everyone, but those who do it right make a lot of money ...