Starting to invest in a stabilizing market - bad idea?

Question

Hi, I have a question about starting out as a multi-family investor in a stabilizing market... I was wondering if it's a bad idea. Naturally, it seems like the best deals are to be found in a down market, so I'm not sure what to do...

Should I keep making offers (that keep getting declined) at the price I want the property at?

Should I lower my operating expense projections which would give me a higher NOI that would let me raise my offer? (currently using 60% for operating expenses because owners, for the most part pay water/sewer/trash)

Should I add more money to the down payment to insure cash-flow? (Instead of 25% down, put 40% down)

Should I just become comfortable taking a lower cash-flow?

Thanks again for the input...

Sharon Tzib · Answer

Your broker (if he or she is any good) should know the exact process for this, and knowing your new, would have hopefully been advising you of next steps.

But in any purchase agreement, there is a due diligence period where you can review any aspects of the property, from physical to financial and so on.  Have your agent send a request to the seller's agent requesting, at a minimum, the following things:

Rent Rolls

?Leases

?Estoppels (near close of escrow)

?Bank Statements

?Credit Card Statements

?2 years Tax Returns

?2 years Utility Bills

?Property Management Reports

?Invoices for recent capital expenditures

If others on the forum have anything else to add, I'm sure they will.

Sharon Tzib · Answer

Hey Taylor - my pleasure to help you out. No, you should not be trusting at all of the seller's numbers. In fact, the best money you'll ever spend is hiring a CPA or Attorney who specializes in analyzing tax returns, P&L's, etc. for MFH investing, especially in the beginning of your investment career.

What you want to do is take their P&L's and compare them to their tax returns (at least two years worth). It is rare a seller will over-report income on their tax return, so this is a great place to catch them if they are trying to over state their numbers.  Also, get bank statements. Make sure those rents have been deposited in equal amounts to the monthly rents they are claiming. And the lease amounts need to match too.

In regards to expenses, ask for as many years of utility bills. If they have a property manager, get their reports. Also don't forget to ask for credit card statements.

Amanda Han, a CPA, has written several excellent posts on due diligence very recently here on BP - you should search for them. Be sure to read not only the posts but the comments - priceless stuff in there.

Remember, trust no one and verify everything!!!

Sharon Tzib · Answer

Hey Taylor! I don't pretend to know 1/10th of what Dion does, but I will try to chime in with some of my thoughts on your questions:

Q.  Should I lower my operating expense projections which would give me a higher NOI that would let me raise my offer? (currently using 60% for operating expenses because owners, for the most part pay water/sewer/trash)

A. No, absolutely not! First, most investors on BP, whether they are single family or MF, use the 50% rule as an initial test to see if something is worth pursuing or not. This is especially true if the owners are paying any utilities, as these can be deal killers and an everlasting drain on your cash flow should you buy.  Second, if at all possible, try to get actual numbers from the seller before making your offer (and make sure it's not proforma). I really can't imagine making an offer if I didn't have this in front of me first.

Q.  Should I add more money to the down payment to insure cash-flow? (Instead of 25% down, put 40% down)

A. No. Someone much wiser than me taught me never to inject more money into a deal to make it cash flow. Run your cash flow projections as if you are getting 100% financing, even if you’re not. That way you are not forcing cash flow into the deal by paying more for financing.

Q.  Should I just become comfortable taking a lower cash-flow?

A. No, I think you should become more comfortable with doing less deals. Some guys on BP only do one deal a year because they refuse to compromise on their criteria. Also, you may have to go to alternative methods of finding sellers, instead focusing on motivated ones, where your criteria will be more acceptable.

Good luck and I hope this helps some.

Dion DePaoli · Answer

Some of this depends on what you plan on doing and what type of peace of mind you want.

A stabilized market is simply a market which has established an equilibrium of value.  It is not void of volatility but the volatility is a little more predictable and the peaks and valley discrepancy is a smaller percent number.

There seems to be some logic that points to you under evaluating some of the assets you are looking at.  The offers are being rejected.

Many newbies I think suffer from this.  Likely stemming from a rigid application of guiding numbers and percents.  While it is not clear what your finite projections look like, if you are simply applying 50% or 60% on all financial projects you may be doing yourself an injustice.

A good way to recalibrate your assumptions is go look at the properties you did make offers on and see where they sold at.  How is it those investors, who purchased said property, are making their Sale Price work and you are not?

We can assume, that investors seek similar rates of return in comparable risk situations.  This too might be what is throwing you off.  If investors are willing to take 12% returns and you price offers at 15%+ you won't get many accepted offers.

It is impossible based on the post, with little information, to comment on what you have going on the capital stack (equity plus debt) in your offers.  There is an optimal balance in capital stacks which is rooted in the overall cost of capital, both equity and debt.  Fundamentally, debt provides two things to an investor.  (1) provides capital above the amount of equity on hand to make an investment.  (2) provides capital cheaper than the cost of equity.  If you only have $10k and you need $100k, you obviously have to borrower the $90k.  Equity generally costs 8% plus and debt in today's market costs 8% or less.  The closer your debt is to equity, the less of an impact of it will have.  So if both debt and equity costs 8%, then it doesn't matter what the proration of each is, they are the same.  As such, as equity is more expensive, say 15%, it might take cheaper debt at a higher percent to get the equity return.  (I hope that made sense)

What I would do, is like I said, go look at where the assets you made offers that were turned down and sold.  Spend a little extra time to get more accurate on the exact expenses opposed to a percent application in your projections.  You should start to see a trend, if you can get a couple of properties to look at, on where the investors are willing to get into a property and what type of capitalization rate they are seeking.    From there you can play with your debt portion of the offers to see how that will affect your return.

Joel Owens · Answer

You look at the tax return transcripts from the IRS versus the seller providing you what they say they filed.

Banks statements are good but not fool proof either. Sometimes if a seller wants to be fraudulent they will go to great lengths to do so. When looking at expenses you do "add backs". These are customary inflated expenses from the seller to reduce tax base that have nothing to do with the cost of the property. Once you do that you will get the real numbers the property is performing at. Experience let's you know what range things should be falling in. If something is way out of line you investigate to see if it's something the seller inflated for tax purposes or is it really and out of control expense that is a problem you will have to fix after buying.

Joel Owens · Answer

A seller that has nothing to hide will not object. When buying larger apartment buildings sellers expect to be grilled on every point when selling because it is a large purchase with high stakes.

A seller that is objecting to everything you are asking for is hiding something or when they only give partial info they are trying to emphasize the positive and hide the negative.

A seller has a right to vet you the buyer as well before releasing information. For example to sign a confidentiality agreement, provide proof of funds, credit scores, proof of income statements ( this is especially important on 100%owner finance or when the seller is holding a second), your track record on owning other properties in the same asset class etc.

"Have you ever seen a seller refuse on the grounds that you are doubting their honesty or some such thing?"

Would you rather worry about offending a seller or buying wrong and have a multi million dollar money pit hanging around your neck?? You should care less about offending the seller but having said that there are certain ways to deal flow in a transaction that make things smoother for all parties. So the saying carry a velvet hammer rings true. You take a soft approach until they get out of line. Never let parties mistake your kindness for weakness.

With buildings if landlord pays water and the buildings are much older I have seen costs come to 65% before. You take out non- operating expenses when looking at the books. Sometimes sellers pay themselves hefty fees or other junk costs to make themselves look poor on paper for taxes. That has nothing to do with the numbers of the property so you take it out.

Ellis San Jose · Answer

Don't chase the market foolishly, or throw prudent disciplined analysis out the window.  Shift your strategy to take advantage of the market.  Target properties that you can tie up under a longer option period or long escrows & you can capture appreciation by controlling property not owning.

Be careful of the game of adding more cash to make it cash flow.  That reduces your return on investment.

Ask yourself am I in this business to buy or am in this business to profit.

Joel Owens · Answer

Taylor just remember your profile says you are in Phoenix. I have some clients from there that are searching elsewhere because that market is overheated and people are buying based on speculation and rising markets. In those types of areas it will be very, very hard to buy based on cost projections and cash flow.

Someone with a bunch of money already could care less about the cap If they are making a spec play for just tax reductions and getting a payday down the road. They wouldn't need their money to work as hard as someone who has to hit  a home run and grow the money much faster.

If you are buying any kind of multifamily building with size and the landlord pays water absolutely go 60% costs. In some really older buildings with constant repairs your total costs in some cases can reach 65%. As for the tax returns leave enough time in due diligence to get the tax transcripts from the IRS. The sellers could show you one thing but have something else filed with the IRS. The sellers might lie to you but a very few will have the b#lls to lie to the IRS.

If the sellers did try to mislead you then many times the sale can be reversed and you can sue for damages "for intent to defraud". Many states have statues for this very kind of thing.

So verify, verify, and verify some more.

Dave Lamattina · Answer

My opinion on investing in real estate in general, as long as you are a long term holder then I would not worry what kind of market you are buying in. Real estate over the long run as always appreciated in value especially when you're investing in good areas with population growth and low unemployment. If you're buying for short term (3-5 yrs) then I would focus on under valued or below market properties with substantial cash flow.

Sharon Tzib · Answer