What to look for when buying a multifamily?

Question

I am interested in buying a 5 units multifamily property. What should I look for before I make an offer besides doing an inspection? How to verify that the tenants that are living there now have always paid on time? Should I only buy if the seller has a lease contract with all the tenants? If I am buying the property, do I have the right to run a credit report on the tenants, or ask for one, as part of the deal to make sure these are good tenants?

Ron Flatt · Answer

First off, I am not an attorney, but I will tell you my method.

I ask for rent rolls- many of the mom/pops may not have this available, they think .....

many of these smaller units are on a month to month, I ask for copies of the leases.

I also ask for maintenance records for the  last 2 years,

I do not believe you can run a credit report on the tenants without their permission.

I do want estoppel signed by both tenants and seller before closing-  This will give you the amounts of deposit on file and if they have prepaid rent or if they are behind on rent.  (Note if a renter is behind, the seller is not going to get this, but if they have prepaid rent, it will be settled back to me at closing.)

If they do not have leases, they get one of my leases the day I close.  I give them 30 days to vacate or sign the lease, with the terms of my lease.

If they have a lease, I have read it.  I will notify renter that I will honor the  current lease, but at the end of the term it will be renewed by my lease.  If it is going to be a pet free property, they have until their lease is up to find a home for their pet or to find a place to move.

I do not go up immediately on rents, but if property is way below market I let them know it will go up in 90 days to whatever I believe the tenant and market can stand.  (I do not want a mass exodus at once.)

Basically, I grandfather them in under their lease or they can sign my lease, without a credit check.  I do have them fill out the application, so I have it on file, for future reference if needed.

Hope this helps.

Doyle Brown Jr. · Answer

@Ronaldo Carvalho  I agree with @Brent Coombs that you need to know the cap rate in your area so that you can purchase above market.

Thou cap rates are important, you need find out what you want your return on investment to be. I generally use the 2% rule to determine a quick quant purchase price. This will give you a better idea of what your cash flow (profits) could look like if you were to purchase a property at that given price considering the associated expenses with servicing the debt and operating the property. Here's my general start to assess a deal.

1. Calculate what the Gross Operating Income is per month

2. Divide that number by 2%

3. The result is a purchase price that would yield a 24% annual cap rate.

3. Find out all cost associated with operating the property: debt coverage, management fees if your not going to self manage, taxes, maintenance, management, capital repairs funds,....etc.

4. Create a mock operating financial statement. :Income = gross months rent - 10% vacancy rate; Expenses = #3

5. Assess the numbers

6. Determine a offer price and if the property is a good deal.

There's so many other things to consider beside the cap rate but this will start you on the activity of assessing deals. Hope this helps! Message me if I can be of assistance!

DGBJR

Timothy Murphy III · Answer

@Ronaldo Carvalho

You can ask the listing agent for leases, rent rolls, etc. prior to submitting an offer, or you can write an offer contingent upon receipt and review of such documentation. I'd want to know the tenants are current on paying on time, because the benefit of having the unit already tenanted is actually a burden if the tenant is not performing. You'll have to honor the existing leases through the expiration of their term (as long as the tenant hasn't breached for non-payment, etc) but can raise rents, terminate leases, etc. at the expiration of the term.

I don't see much point in running background / eviction / credit / criminal checks on tenants that are already in the property. Whether the existing tenants would pass your qualifications or not doesn't really matter, they're already in possession of the units.

John Casmon · Answer

@Ronaldo CarvalhoIs it a 4 or 5 unit? This is a critical factor. 4 units are residential, 5 units are commercial. You need to understand what the property is legally zoned for and if it's zoned for 4 and being marketed as 5, that means there is a non-conforming unit. This will be problematic for your lender and insurance company. Ignore the county appraised value, it only matters for taxes. The valuation of the property will be determined by comps if residential or cash flow if commercial, so again this is a critical factor. You need to understand the NOI and cap rate to determine the value. Not what the seller is asking and definitely not the county's assessed value.Do you have an agent that's experienced with investors and multifamily properties? If you're not experienced, you need to get people on your team who can shorten the learning curve.

John Casmon · Answer

@Ronaldo Carvalho You want to start by getting the actual financials, not the pro forma. Ask for the trailing 12 months or T12. This will give you collected income and paid expenses. They may also supply their Schedule E, which is the income they report to the government. Many seller's are likely to under report income and over report expenses to minimize their tax obligations, use this info to your advantage.  Ask for all leases and note that many lenders will not give you credit for expired leases, even if they are now month to month. Financing for a 5+ unit is much different, so ensure you understand the lender requirements.

Andrew Johnson · Answer

@Ronaldo Carvalho My thoughts...

1.) Ideally there's a 3rd party property manager that's involved.  They should be able to run you a report of all of the collected rents and expenses over the past 12 months.  At least the PM should be "pseudo-neutral" and can give you some insight.

2.) There should be leases for all the tenants.  If there aren't leases you can always ask that the units be delivered to you vacant.  If a property owner is self-managing and doesn't use leases then I don't know that I'd trust any financials (at all) that they would give you.

3.) You can ask for a rent-roll but with the caveat of 1.) and 2.) above.  If you have self-managing owner with no leases in place I don't know how much weight I'd put one whatever rent-roll they have to provide.

4.) You can ask for and should get copies of all of the leases after an accepted off.  Before then you can ask for financials, rent rolls, etc. but I've never received copies of leases (often with sensitive information) while not under contract.  Since you're buying a commercial (5+ unit) property there's a good chance your lender will want to review the leases as well.

5.) I don't think I'd ever ask to run a credit report, they either pay the rent or they don't.  And no tenant with horrible credit is going to say "sure, you have my permission to run my credit again."  Are you going to back out of the deal because one tenant has bad credit?  Probably not, especially if there are a month-to-month lease.  I understand why you'd want to do it, the risks of not doing it, but there's a level of practicality you have to think through.

*** One thing you haven't brought up that you will want to do is to check the dates on the leases.  Unless it's a college town and you're leasing to students I'd be suspect if all of the leases were signed a similar times.  I don't know how much of a problem "tenant stuffing" is but many people want to market a "full property" to make the financials look good.  What you don't want is for the previous owner to have filled the property with lousy tenants 3 days before putting the property on that market.  I don't think it's "common" but it also does happen.  So I'd look at the leases, when they were signed, and see how that looks compared to when the property was listed.

Ron Flatt · Answer

Here in Texas we have to honor leases that are signed, but you can change at the end of lease.  I agree credit checks on these existing tenants is a waste time and money.

Class C is my bread and butter.  With time you can bring them into a C+.  Raise rents and the better tenants will stay.  I am having luck making completely rehabbed units as smoke free.

Jeremy Hua is correct that you trust no one.  The signed estoppels will make sure someone does not claim they had a $1000 deposit up or that they paid 3 months in advance, both seller and tenant signs these.

If the numbers work, jump and get started.  If they don't, do not talk yourself into the deal.  It is all about the numbers, Know what you can lease for, and be prepared to raise the rents to that.  I make minor improvements as I go, sometimes just taking care of deferred maintenance items.  When tenants see improvements they do not balk at rent increases.

Note on Class C-  I still want working people if at all possible, tenants that are at home all day everyday has too much floor time.  It is hard on your unit and it seems they are home everyday but the day you need to serve notice on them.

Ham Merritt · Answer

@Ronaldo Carvalho Do you plan to finance the purchase? If you do, conventional financing will not be an option for this purchase as anything over 4 units is considered commercial property. You would need to obtain a commercial loan in order to finance the transaction. If you are using cash or a hard money lender, then no worries there. Good luck!

Brent Coombs · Answer

@Ronaldo Carvalho, as with any commercial property, you should know what the market CAP RATE* is for the area.

Once you know that, you'll have a better knowledge of what ball park its value should fall in. THEN, try to squeeze a bargain, so that you'd be getting a HIGHER Cap Rate than market. Care to share those numbers? All the best...

* [This terminology needs to be understood by ANYONE considering commercial property.]

Jeremy Hua · Answer

In Ohio, you have to honor the lease the tenant signed, regardless of ownership changes, as the lease is with the property. Paying to run credit checks on existing tenants is a waste of time and money.

Based on my experience, believe no one. Not your agent, inspector, seller, or the tenants. I'd look at the job market for the area, are they decent jobs, or are they all consumer/low income businesses, such as check cashing, quickie marts, etc. If it's a C property, you'll have a heck of a time finding tenants that don't smoke, and have a credit score of 550+.

My hunch is that if you proceed, you'll end up cleaning house, tenant wise, if it's a C property.

What to look for when buying a multifamily?

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