First Commercial Property (8 Unit Multi-Family). Good investment?

Question

Hello BP!

I'm interested in your comments regarding the price for this property considering the current rents. The property is located in Montgomery, AL. The contract price is $274,500. The asking price was $280,000. I have approximately 2 weeks to complete inspections, receive contractor estimates and secure funding before locking in this deal or walking away, if necessary. The property has 6 of 8 units occupied. The rents are below market. However, the property is plagued with deferred maintenance and outdated cosmetics. The building was constructed in 1947. The 2 vacant units require approximately $18,000 to rehab.

My research indicates average rents for 2 bed/1 baths in the area is $650/mo x 8units =$5,200/mo x 12 = $62,400. The data on the spreadsheet below reflects actual rents for 6 of 8 units. Should I include rents for the 2 vacant units to determine if the numbers work for the purchase price?

My strategy is to immediately rehab the 2 units and have them available for rent 2 weeks after closing. I anticipate the remaining units will require $5-8,000 in rehab costs. My plan is to upgrade each unit and increase rents as each tenant's lease ends. Last, the property will need a roof as some of the upstairs units have minor leaks. My estimate for a roof is $8,000. The remaining calculations are below. The first group of numbers include over $18,000 in capital expenses and 2 vacant units. The second group of numbers reflect the property receiving rents at market value. I'm looking forward to your responses BP!

(8 Plex) $274,500 Contract Price. $251,300 Tax Value

YEAR 1

Gross
  Scheduled Income ($3290/mo) 6 of 8 units rented.

$39,480

Laundry
  ($75.00 x 12=$900.00

$900

Vacancy
  Allowance (10%)

$3,948

Total
  Operating Income

$36,432

Property
  Taxes

$1,872

Insurance

$2,000

Homeowners
  Association

$0

Capital
  Expenses (Maj Repairs/Upgrades) 10%

$18,950

Maintenance
  Reserve (6%)

$2,369

Property
  Management (10%)

$3,948

Lawn
  Maintenance

$1,200

Water
  and Sewer

$4,320

Total
  Operating Expenses

$34,659

Net
  Operating Income (NOI)

$1,773

Mortgage
  Expense (PI) (1389.00/mo) 7yr

$16,668

ANNUAL
  CASH FLOW

($14,895)

MONTHLY
  CASH FLOW

($1,241)

3206
  Wellington Rd. (8 Plex) $274,500 Contract Price. $251,300 Tax Value

YEAR 2

Gross
  Scheduled Income ($5,200/mo) 8 of 8 units rented at $650/mo

$62,600

Vacancy
  Allowance (10%)

$6,260

Total
  Operating Income

$56,340

Property
  Taxes

$1,872

Insurance

$2,000

Homeowners
  Association

$0

Capital
  Expenses (Maj Repairs/Upgrades) 10%

$6,260

Maintenance
  Reserve (6%)

$3,756

Property
  Management (10%)

$6,260

Lawn
  Maintenance

$1,200

Water
  and Sewer

$4,320

Total
  Operating Expenses

$25,668

Net
  Operating Income (NOI)

$30,672

Mortgage
  Expense (PI) (1389.00/mo) 7yr

$16,668

ANNUAL
  CASH FLOW

$14,004

MONTHLY
  CASH FLOW

$1,167

Ben Wilkins · Answer

@Juan Turner - I'll agree with @Diogo Ferreira in that you should do your analysis assuming the worst-case scenario. That said, it also makes sense to look at the future cash flow by assuming all eight units are occupied.

With a 10% vacancy, you're running your numbers fairly conservatively (and exactly where you should!), so on paper with the numbers you provided, this looks like a good deal.

Of course, it will come down to what the GC's estimate is for renovations and whether you have the capital to pay for repairs (unless if you wrap repairs into your purchase loan).

Diogo Marques · Answer

Hi Juan.

What i usually do in any business, is to give more confidence to the worst case scenario for an extended period until i am proven wrong, because there is only a way up. That way you will find out creative ways of not going under.

In a recent podcast with John Azar that runs 5,000 unit he told me the worst mistake he made was not to account for Maintenance Capex expenditures when purchasing a deal. You have to workout this number and the impact it will bring you because you will have to pay. Then is to know when are you going to become positive cash flow on the deal. If it is a bad property to begin with, don't do it, as D-Type properties will drain your cash and you won't build any equity on them. It is the mermaid and the sailor tale. You must me able to collect rent from the tenants on a hands-off consistent basis, because in the the end they will pay for everything.

Good luck.

Kevin S. Campbell · Answer

I am not sure about the vacant units, but you can get a fair rent rate at rentometer.com, just punch in the address and it will give you rates for your unit.

Lisa Sanders · Answer

I'm sure you'll catch it, if you haven't already, but just in case..

"$650 x 8 x 12 = $62,400 x .9 (occupancy) = $56,160 gross income."

Note: ".9" is stated as occupancy, which is 10% vacancy.

Jen Rogers · Answer

I just wanted to thank you Juan for sharing your opportunity and everyone who gave their input. It was really helpful for me to read through the whole thread and follow the logic, strategy and numbers. I am researching multi-units right now and they seem to have a much better return than SFR which I had been focused on. This conversation was really helpful. Thanks!

Juan Turner · Answer

@Chris Grenzig - Right on target. This is the approach I would like to take, however I did not have a clear picture how to evaluate the deal considering my intent to provide up front capital for repairs/upgrades on 2 units and curb appeal.

I plan to negotiate additional value after receipt of all inspection reports. Documented capital expense requirements will be my basis. Do you apply a similar strategy?

I haven't found past sales comps. I will address with my commercial agent.

"$650 x 8 x 12 = $62,400 x .9 (occupancy) = $56,160 gross income." Is .9 your standard for vacancies? I used 10%. Should I adjust for more accurate estimates until I gain history?

The banks I'm working with offer 20-25% down payment opportunities. I selected the 20% option, 5 Year/ 25 Year Amoritization. I haven't talked to anyone with knowledge of the prevailing Cap Rate in the area. Do you know of a source other than Commercial Real Estate Brokers and lenders? I think you used 10, 8 and 6 percent as examples and based on past experience?

Last, I have the upfront capital to cover the 2 vacant units, curb appeal and possible a roof replacement requirement. I will build the additional capital through my W-2 job or pulling equity from a smaller property we own free and clear.

The current owner does not have the best records. A comprehensive Pro Forma does not exist. We're gaining more clarity regarding some expenses as we work through the inspection period. I anticipate minor increases to my current expense projections.

I'm very thankful for your post and look forward to communicating with you again.

Chris Grenzig · Answer

@Juan Turner so I wasn't clear if you plan on using cash flow to renovate or if you plan on bringing extra capital upon closing to do all the renovations even if it's as tenants leave. I'm going to assume up front because that's just how we do most of our deals.

First of quick rule of thumb if you take monthly total rent times 100 can give you a rough estimate on the price. 3290 x 100 = $329,000. However if you have to raise an additional $84,000 in CapEx ($18,000 per down unit and $8,000 for each additional unit, I always assume the worst) that gives you an all in cost of $358,500 or $44,812.50 per door. Not sure if you have any past sales comps to compare, but I would look to see what they sold for on a per door basis to try and get an idea how this compares.

I like quick and dirty math.

$650 x 8 x 12 = $62,400 x .9 (occupancy) = $56,160 gross income.

$17,000  roughly in expenses (minus your CapEx because I'm including that as upfront capital and using you're numbers)

$39,160 in NOI.

If you're mortgage numbers are right than it's $16,668 in Debt Service a year

$39,160 - $16,668 = $22,492

Now let's figure out rough equity needed

Figure 30% of purchase (70% LTV): $274,500 x 0.3 = $82,350

$82,350 + $84,000 (CapEx) = $166,350 in equity needed

Cash on Cash Return: $22,492 / $166,350 = 13.52% a year

Rough Sale Price:

$39,160 / .10 (10% Cap Rate) = $391,600

$39,160 / .08 = $489,500

$39,160 / .06  = $652.666.66

So what do I take away from all this. It looks like a pretty sweet deal. My reservation is do you have the equity to be able to do it this way? Is the mortgage amount correct and will you possibly have to raise additional capital to cover any payments while renovating and pushing rents for the first 1-2 years? How correct are you're expenses and how much could it affect you're NOI? All that being aid it looks like you have a decent amount of wiggle room in you're returns and could potentially be a very nice deal.

Hope that helps in some way and best of luck!

Doyle Brown Jr. · Answer

Hey Juan. As a rule of thumb I never buy negative cash flowing properties. Why should you pay for another operators deferred capex? You shouldn't. At a minimum, that's a basis to better negotiate your purchase price. Don't buy in pro forma or presumed appreciation, buy in actuals! Leverage the value add in your negotiations

You have a multitude of munition to negotiate a discount purchase price that accounts for underperforming operations and deferred maintenance. Assess thoroughly

Routinely, I analyze deals using the 2% percent rule. For every incremental $180k of the purchase price I recess the 2% by .0018 percentage points. Again this is just my baseline assessment that takes 1 minute. If the numbers fall within a certain tolerance I take it the step further and run a full scale financial assessment.

Ben Wilkins · Answer

@Juan Turner - you have a pretty good understanding and breakdown of your numbers, so you're off to a good start. The Full Analysis tool on the site is pretty close to what you're looking for, except that I didn't break apart landscaping expenses (which I can do, plus some other expenses.

Thanks for your input on the website and tools! If it makes you feel any better, I've attached the outputs from the Full Analysis calculator based on the numbers that you gave in this post - this still looks like a good investment property. I assumed all 8 units were rented at $650/mo, and can share the other inputs if you or anyone else is interested in seeing them. Since I account for income tax, the monthly cash flow is a little lower based on my calculations than what you had. I also had to guess a little bit on your financing situation.

As far as percentages, I generally default at 8% vacancy when doing a first analysis of a property. I'll either look at historical data for the area or will ask the tenants / owner of a building to determine if I need to estimate higher. After a year, I will adjust the percentage in order to stay a few percentage points higher in order to be conservative.

Juan Turner · Answer

@ Ben Wilkins - Thank you. I reviewed your profile and website. Thank you for sharing several great tools. I'm interested in a tool that builds on the numbers I used above and Cap Rates, COC, ROI and ROE.

What percentage do you recommend for estimating vacancies and would you adjust the percentage after a year of historical data?

(8 Plex) $274,500 Contract Price. $251,300 Tax Value	YEAR 1
Gross Scheduled Income ($3290/mo) 6 of 8 units rented.	$39,480
Laundry ($75.00 x 12=$900.00	$900
Vacancy Allowance (10%)	$3,948
Total Operating Income	$36,432

Property Taxes	$1,872
Insurance	$2,000
Homeowners Association	$0
Capital Expenses (Maj Repairs/Upgrades) 10%	$18,950
Maintenance Reserve (6%)	$2,369
Property Management (10%)	$3,948
Lawn Maintenance	$1,200
Water and Sewer	$4,320
Total Operating Expenses	$34,659

Net Operating Income (NOI)	$1,773
Mortgage Expense (PI) (1389.00/mo) 7yr	$16,668
ANNUAL CASH FLOW	($14,895)
MONTHLY CASH FLOW	($1,241)

3206 Wellington Rd. (8 Plex) $274,500 Contract Price. $251,300 Tax Value	YEAR 2
Gross Scheduled Income ($5,200/mo) 8 of 8 units rented at $650/mo	$62,600
Vacancy Allowance (10%)	$6,260
Total Operating Income	$56,340

Property Taxes	$1,872
Insurance	$2,000
Homeowners Association	$0
Capital Expenses (Maj Repairs/Upgrades) 10%	$6,260
Maintenance Reserve (6%)	$3,756
Property Management (10%)	$6,260
Lawn Maintenance	$1,200
Water and Sewer	$4,320
Total Operating Expenses	$25,668

Net Operating Income (NOI)	$30,672
Mortgage Expense (PI) (1389.00/mo) 7yr	$16,668
ANNUAL CASH FLOW	$14,004
MONTHLY CASH FLOW	$1,167

First Commercial Property (8 Unit Multi-Family). Good investment?

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