Good Numbers? Not So Good Neighborhood?

Question

I've been looking for a multi-family unit to add to my portfolio and my property manager called me with a deal that fell through and the current owner wants to unload it.

Details:

5 units - Large home that was converted to 5 units a long time ago, all separate utilities

Location: Philly (Not a very desirable neighborhood)

Purchase price - $160k (but I may be able to get it lower)

Monthly Rents - $2595, no vacancies no section 8

Monthly Expenses - $2049, estimated vacancies of 10%, 6% repairs, 7.5% ($200/month) capex, 11% mgmt fees and using the actual tax and estimated insurance numbers

I also estimated $4k for closing costs and $10k in repairs (no major repairs on needed, this is just a cushion because I imagine there is something)

======================

CoC ROI = 14.2% / $545 monthly cash flow

Pro Forma Cap Rate = 9.47%

======================

My concerns/questions:

- Am I analyzing this right?  And how good are these numbers?  Better said, how often to people see these numbers in major cities currently?

- My property manager has managed this property for years and says it performs well.  The neighborhood isn't desirable but he gets the rents.

- Being a 5 unit building, how worried should I be about resale being that it's commercial?  Same with the fact that it's a conversion?

- How picky are you about a building that was converted?  This is very common in this neighborhood given the size of the houses back in the day.

All insights appreciated!

David Faulkner · Answer

Calculators? Rules of thumb? Throw them out, all of them ... they will do you more harm than good. Learn to analyze REI from the ground up to understand the variables at play, how they are used, and why they are important.

Let's take for example CapEx ... the rule of thumb is such and such percentage of gross rents ... absolute rubbish. Increasing it arbitrarily to be "more conservative" is also rubbish (sorry but it is). Take the size of the property, the CapEx items that will need to be replaced, what they cost to replace on that property, the lifetime of those items, and figure a $/mo amount on each and every item ... add them all up and you have yourself a sensible CapEx allocation. Yes, it takes more work, especially in the beginning, but this is how you properly analyze and understand REI IMHO, not by trying to shortcut around real grass routes analysis with online calculators and rules of thumb of highly questionable quality or validity. Learning to do this is a process that will take time, but try to short cut around it at your own peril, and in the end you will still learn the right way if you stick with it, it will just be via the trial-and-error school of hard knocks (which is an expensive yet excellent teacher). Good luck.

David Faulkner · Answer

Accounting ... CapEx tend to be higher dollar items that wear out over long time periods, so you replace them and capitalize your expense on your taxes over the life of the item (Eg: a roof). Repairs are smaller ticket items needed to keep things in working order that you expense on your taxes the entire amount on the year which the expense was incurred (Eg: leaky faucet). The really important thing is you account for ALL of these expenses in a reasonable (not a % of gross rents) and conservative manner in your analysis (regardless of if you call them CapEx or Repairs), and when they occur, you address them immediately as small problems can become big problems if differed.

David Faulkner · Answer

No, you are not analyzing it right IMO ... a few glaring mistakes that I can see so far ... CapEx should not bet a percentage of gross income. The roof costs what it costs to replace when it goes out, the roof does not care what gross rents are, so don't try to estimate the expense as a percentage of them.

Cap rate is an input used to calculate the fair market value of the property for a given NOI. It is set by the current market for that location and asset class. It is not the output of a calculation as you have it.

I'm not familiar with that market, so can't comment on if it is a decent deal or not. A lot of other details missing, like what class of neighborhood is it (sounds like C maybe)? Are rents low, at market, or high? Are expenses low, about right or high? The units are all physically full, but are all those tenants consistently paying rent in full and on time? Have you verified all of this data. Is the conversion permitted and is it zoned for the current use (do public records for the property match for square footage, number of beds, number of baths, multi-unit zoning, etc.)? If it is such a great property, why is the current owner selling it? If it is not such a great property, do you have the skills and capital to fix the deficiencies and will the resulting increase in NOI and price make it worth your effort? A few extra things to think about...

Frank Mancuso · Answer

That totally makes sense to get to a more precise estimate.  I have something that can help me with that, too.

Frank Mancuso · Answer

Thanks, guys - these are all awesome points and I appreciate the feedback.  A few things and maybe I can tweak it even more.

Capex - I figured a reserve of about $200/month on a go forward basis and entered it in the rental calculator as a % (that's the only option).  That said, I did reserve $10k for estimate repair costs since I imagine it will need something.  Maybe I can up that to be a bit more conservative given the property is older (76 years old)

I was primarily looking at CoC ROI but know that many commercial properties focus on cap rate.  Is there a rule of thumb here that I'm missing?

All the extra data you provided is excellent food for thought.  Rents are average in the C neighborhood, expenses are probably lower but I anticipate/estimated them to be higher given the age, and it is nonconforming but legal (I checked that there is an approved variance from 1988).  As for the seller, he is elderly and selling all of his properties.

Also, the 11% management fee is conservative.  The guy I use now charges 7% but I wanted to account for his finder fees which are a FULL months rent.  Oh, and the the vacancy, capex and mgmt fee are part of the 2049 expenses.

As for the remaining items, I'll chew on them a bit.

Aaron Smith · Answer

@Frank Mancuso are the vacancy, CapEx, and Mgmt Fees part of the @2049 Expenses? If not, then your cash flow will need to be adjusted accordingly. There's nothing wrong with a bad neighborhood, as long as rent is being paid, and you have GOOD tenants. Sounds to me like it's a C- neighborhood. That's all fine and well, in my humble opinion. As long as you don't run it like a slumlord and treat your tenants well.

And HOLY HE!! man, 11% management fee? I'd see if you could get that down a couple of points. Especially if they're charging you the fee plus a % when they place a tenant. And if you're saving $10k for repairs, then you don't need the additional 6% in your calcs. Just keep that 10K set aside and use that as needed, if that makes sense.

If it's common to see homes converted in that neighborhood, then it shouldn't be an issue. Future buyers will be (or should be if they did their homework) aware of this.

@Michael Randle CapEx (Capital Expenditures) are those costs which, when incurred, will be amortized over a fixed period of years (Roof, new electrical, plumbing, windows), where as repairs, as @David Faulkner pointed out, are minor and are expended in the year they occurred (leaky faucet, new garbage disposal, clogged sink/toilet, one broken window, etc). A few lenders will REQUIRE you set set aside CapEx funds as part of the loan deal. And even if they don't, YOU SHOULD! Better to save that money now and not need it for a while.

Michael Randle · Answer

Newb question. What is the difference betwen CapEx and Repairs?

Good Numbers? Not So Good Neighborhood?

Most Popular Reply