My partner and I recently bought a 12-plex in Moorhead, MN. This is after we purchased two 4-plexes in Fargo, ND in March 2015 (we bought the 4-plexes for $165k each, 8.5% cap rate). So far, so good in finding decent valuations in a "hot market". My threshold for decent is an 8% cap rate or better.
I work as a farm finance consultant and I wrote this piece for my farm clients yesterday to help them get familiar w/ the math behind rental properties.
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We’re going to step off the farm with this blog post.
Given the recent meltdown in stock markets around the globe, I thought it would be timely to share some details with you on another asset class. Rental properties.
I believe farming + off-farm cash flow-oriented investing is a great recipe for long-term wealth generation.
On December 30th, a partnership that I’m involved with bought a 12-plex apartment building in Moorhead, MN. My involvement is small as I’m a 5% partner but I do most of the financial analysis.
Two highlights to start.
– I like numbers. I don’t want to be a property manager. We outsource that!
– The total analysis below took me 10 hours from the time the deal came to me until closing. This doesn’t have to be a time suck.
I was approached by a real estate agent in October who had a motivated seller. I’m not a big fan of buying “at-the-market” deals as they are usually priced very rich. The other properties we’ve purchased (two 4-plex buildings in Fargo, ND) were both off-market deals that I found by sending letters to local apartment owners.
I was expecting this deal to be marginal, at best. But it turned out to be a reasonably attractive deal that warranted a further look. See below for the high-level financials sent to me by the agent.
- Asking price: $560,000 ($46,667/unit)
- Net Operating Income: $45,982
- Cap Rate: 8.2% (NOI/Purchase Price)
I was surprised to see this deal meet my minimum cap rate which is 8%. Now it was time to take a deeper look at the numbers and the deal as a whole. Here were my findings.
- The neighborhood is an older B-C class area. Not a real hot neighborhood to live in.
- Average rents are $541/unit. I feel market rents in the area are $600-650
- The building is fully occupied but they weren’t including any vacancy expense which isn’t realistic. I plugged in 5%.
- They only included a long-term repair reserve of $1,500/year. I doubled that.
- My revised Net Operating Income came in at $42,407
I then took my updated NOI and divided it by my minimum cap rate and came up with a revised purchase price of approximately $530,000. The formula is NOI/cap rate or $42,407 / 8%.
We offered $525,000 and they countered back at $540,000. We figured that the seller was motivated to move the property before year-end and the neighborhood was marginal so we held to our guns and only moved our offer up to $528,000. They accepted.
Now the fun begins. Lets dig into the actual numbers behind the deal.
My partner is risk-averse so we chose to apply a downpayment of $200,000 (38% of the purchase price) which is more than what almost all banks will require. We were able to obtain financing terms of 20-year amortization with a 4.4% interest rate. There are also going to be a total of $8,500 in transaction costs with the two largest being the underwriting fee from the bank and the appraisal fee.
Here is my financial analysis on the deal that I sent to the bank (along with a lot more due diligence material).
An 8.2% cash-on-cash return is far from a home run but this assumes no increase in rents (which we are going to do over time) and no property price appreciation. With a smaller downpayment, we likely could’ve pushed that projected return to 10+% but we want more margin-for-error.
As I mentioned by partner would like to retire in 10-years and they don’t need any cash return today so we’re going to apply all of the excess cash against the debt. If we are able to apply an extra $15,000/year to the debt, we’ll be able to pay it off in 11 years.
While we’re looking at projections, let’s look at a case where we’re able to raise the rents over a few years to $600/unit (up from $541 today).
Our net profit in this scenario is approximately $50,000/year.
Here is what excites me most about this asset class. Our total downpayment for this property is $208,500. In 10-12 years the property will be paid off and its very likely that it will be spinning off $50,000/year in pre-tax cash flow. That’s hard to beat in my opinion!
