Apartment Analysis and Buying Process Questions

[Rivers Plowden]

I have been analyzing apartment deals and doing a lot of reading/listening/studying and have an assortment of questions that I hope some seasoned MF investors can help answer. Sorry if this is a little long, but I'm really looking for some specific techniques and strategies if you have them for the following.

1. As cap rates get compressed and interest rates continue to rise, are you trying to target a certain spread? Is there a number to look for here or a number where you are just saying, "this isn't going to work?" Or is it more of just whether the cash flow meets target ROI?

2. When underwriting/analyzing a property... what do you use for expenses and vacancy? Specifically, what are some things that can be gleaned from a T-12 to help with your numbers. I don't like general rules of thumb all the time such as just using 50% for expenses and 95% vacancy. Yes, I understand that each of those are not at all conservative and are dependent on different factors and that's what I'm trying to get at. I'm a numbers guy and I like to get as specific as I can.

3. What other things are red flags from the T-12 or rent roll? What can I look for? What are some opportunities to add value or decrease expenses?

4. How do you plan capital reserves and working capital? What do most lenders require for reserves? How do you plan to fund reserves after purchase? Is it so much $ per door per year depending on property condition? What other ways can you plan this?

5. How do you know when you can afford third party property management? I keep hearing people say they want a property large enough to support this, but what are you looking for? Obviously, you put it in the underwriting, but how should I be planning this and what should I be looking for?

6. If you can support third party management, what other payroll can be expected? What do PMs NOT provide? Will you have to have your own office manager, maintenance, etc? What is a typical number for these positions?

7. What does the buying process look like? I'm familiar with making offers and closing on residential properties. However, I keep only getting pieces here and there of the MF process. LOI, acceptance, due diligence.... when does earnest/hard money go down? Are there any contingencies on getting this back if something comes up as in a residential deal (inspection, environmental, non-compliance, etc.)? I'm assuming earnest money goes towards the down payment.

8. Finally, any tips on getting a broker to take you seriously?  I have spoken with some, but having not closed an MF deal, I don't get much respect and that seems to being the going norm. However, I have developed specific criteria, and will be sending that out. But, what else have you done to gain brokers' respect and attention prior to closing a deal?

I appreciate any answers and especially, everyone's time. I could have sent this to just one person, but I know there are so many on here with lots of different approaches to these subjects. 

Thanks, 

Rivers

[Sam Grooms]

Some good questions, Rivers. 

1. No. Underwrite to your return objectives, not to cap rates and spreads. Also, what type of MF investor do you plan to be? In today's market, you almost certainly have to be a value-add investor if you want to cash flow. If that's the case, what matters more is how much upside there is, not so much what your going in cap rate is. What if current rents are $100 under market, and if I do a light remodel, I can get another $100 of rent increases. I might be willing to accept a lower cap rate on T12. It's more important to know your repositioned cap rate (as well as the spread between market rates and your repositioned rate). But again, the ultimately deciding factor is your return objective, in my case, a 14% IRR on a 10 YR hold (10 year hold is the worst case scenario for me). I use IRR because I plan to exit the property after reposition, not hold on to it.

2. I use submarket specific averages. 50% for Operating Expenses is OK when having a discussion with something, but not when underwriting. I underwrite most major expense categories to the average. Payroll will be based on number of units. Property tax is based on your jurisdiction. Here in Phoenix, 5% increase over prior year. Property management will obviously vary, 3% for me. R&M can be $450-$550 per unit per year, depending on year of construction, HVAC system, boiler/chiller, pitched vs flat roof, etc. General and admin, insurance and marketing are averages. Utilities is property specific. However, I expect them to be around $900 per unit per year. If they're $600 or $1,200 in the T12, I'm asking questions. Physical and economic vacancy are submarket specific. You can get most of this information from the annual IREM report.

3. So my biggest advice is don't use the T12 as an expectation of how it'll be run in the future. Like I mentioned in #2, use your own numbers. One thing to look for is their R&M. If it's way below what I'm expecting, I have to assume there's deferred maintenance. And likely a lot of it. Are utilities really high? There could be a leak. These are things you'll want to check on during due diligence.

4. Every lender will be different. We do major value add projects, so it requires a bridge loan. They like to 6 months of interest reserve. Then, we have another 4 months of interest reserve and $1,000 per unit operating reserve, that we use as working capital/reserves. On top of that, we have contingencies for roofs, HVAC, plumbing, and then an overall contingency of 5%. This all gets included in the rehab budget. Lender will also want to see around $250 per unit per year of capex reserves, that will come out of cash flow. 

5. Property management companies will tell you when you can afford them. Our property management company has 21,000 units under management. Very professional. They won't usually accept less than 80 unit properties, and that's pushing it. They like to see 100+. As a general rule of thumb, for every 100 units, you'll have one office manager and one maintenance personnel. If you go lower than that, your costs per unit obviously go up. If you can have the same personnel with 110 units (or 117 like one we just got under contract), your cost per unit goes down. 

6. See above. You will have property management of 2-4% for the big guys. On top of that, you have payroll for the onsite personnel. Labor is different in each market. Here, I can budget $50K for my manager, and $17-22/hr for maintenance. However, labor is going up, so stay up to date. 

7. That's the process. Submit an LOI. It'll take quite a few before one gets accepted. Then you start working on a purchase and sale agreement (PSA). This can take as little as one day, to a few weeks (three weeks on the 117 unit we got under contract yesterday), or over a month. It depends on the type of seller, their attorney, how many attorneys get involved, etc. They had two attorneys going back and forth most of those three weeks. I think the contract was in our court for maybe 15 total hours during those three weeks. Once its accepted, you move on to due diligence. This can be 10 days, 15, days, 21 days, whatever you negotiate. As for when money goes hard, again whatever you negotiate. Our money on the 117 units goes hard in 15 days. On our last deal, it went hard immediately. Yes, it goes towards the cash needed to close. If you want contingencies other than your inspection/due diligence period, you'll need to include those in your LOI. You might want a finance contingency. We work with the same lender, so we're able to waive that.

8. This is a hard one. Very difficult and it takes time. Let them know you're underwriting everything they're sending you. Go tour properties with them. Take them to lunch. If the numbers don't work for you, let them know why. Give them your criteria. Never say something like "the cap rate is too low." The big players don't buy on trailing cap rates. Like I mentioned, its based on returns, usually projected returns. 

Let me know if you have any questions. I'm sure @Ben Leybovich will disagree with everything I've said here, so that should be fun.