All Forum Posts by: Erik Nowacki

@David Faulkner and @Michael Swan you have both outlined your end games so I thought I would share mine. I'm trying to build up a portfolio of apartments by forcing equity and 1031 exchanging into successively larger properties. However, my end game is to 1031 exchange all of the apartments into commercial NNN leased properties. I'm thinking Walgreens, CVS, McDonalds etc. in areas of the country where the population is increasing. These leases are typically 20 years with 2-4 extensions of 5 years each and have no landlord obligations. The tenants pay the taxes, insurance and handle their own maintenance, simply mail box money.

The current problem with those properties is that the interest rates and cap rates are so low, i.e. prices are very high. I'm afraid that I would buy a CVS at a 5 cap and in 10 years things are trading at a 10 cap and I've lost half of my value. The cash flow would still be the same, but if I had a loan coming due at that time, it could really hurt. These NNN properties trade more like long bonds, if interest rates go up while you're holding a 20 year bond, your value is going to take a hit. Other than the interest rate risk, the biggest risk is that the lease won't be renewed after the initial 20 year period, in which case you have to scramble to find another tenant; but you can spread that risk out over a few properties and it won't make too much of a dent in the cash flow.

So, for now, I'll keep plugging along with my apartments until interest rates and cap rates go back up again. The NNN leases won't produce the same cash flow as the apartments, but on the other hand would not require any time to manage either. When I'm gone, I would hand over a portfolio of cash flow to my wife and/or son; neither of which is up for doing heavy rehab of 125 class C- in Memphis...

Happy investing

Erik

@Paul B. and @Michael Swan I have done a few seller carryback deals.  Keep in mind that I do heavier rehabs, which means the properties are usually difficult to obtain financing on, which in turn makes them difficult to sell.

My San Diego property is 23 units.  When I bought it in 2013, 8 units were down, 4 of which had been off line for 4+ years and in need of structural repairs.  Very few banks will finance that kind of property.  That leaves the owner with two choices, either carry back a note and get a reasonable price or accept a lowball all cash offer.  I could have used hard money and lowered my offer price, but felt more comfortable with the longer term and much lower rate seller carryback.  The seller got far more money for the property and I ended up doing very well with the property after repairs.  A win-win situation.

I repeated the process with the 178 unit fixer in Memphis.  The seller got a higher price for the property by accepting my seller carryback offer and I got 5% interest only for 10 years.  That locks in my cost and gives me a long timeframe to get this property up and running again. 

The Memphis property was owned by a couple of out of state investors who were relying on an incompetent property manager and a criminally negligent contractor to steal anything and everything they got their hands on.  By the way, and as a public announcement and warning, this is a fairly common problem when out of state investors buy apartments in Memphis and try to run the project from afar.  I'm sure I would have had a similar experience if I hadn't moved here.

So, by having the seller carryback the financing, they were able to get out from under a huge problem and a complex that was probably within 6 months of shutting down entirely.  I started with 35 occupied units, took it down to 18 by getting rid of the undesirables and non-payers.  Now I have built it back up to a little over 50 tenants, needing another 5-10 units filled to get to break even. 

This is not easy!  Don't try to do this from another state.  Yes, you can buy units in Memphis for $5k per door and I know how tempting that looks for a California investor, but it's a contact sport and you need to be physically present to do a project like this.  In a year or two, I should be able to tell you how it all went in the end...

Happy Investing

Erik

@Dan H. I'm going to disagree with one of your statements.  You stated that the rent appreciation is related to the value appreciation.  The problem I ran into was that the rents were not keeping pace with the appreciation.  I ended up with a property that almost doubled in value between 2010 and late 2014, but the rents only increased from $700 to $850 during the same timeframe.

So, my equity exploded, but my cashflow hardly budged.  It's a good problem to have, but it was a major factor in my decision to sell and exchange out of California.

I agree with you that I could have kept that San Diego property and done well with it, without a lot of the work I've done to my Memphis property; but for me the risk of having my equity wiped out in the next downturn and the limited cashflow made it more attractive to 1031 exchange.

One really nice thing about San Diego real estate and the very low cap rates is how much you can increase the value of your property by increasing income or reducing expenses.  At my remaining San Diego property I have a lot of outdoor lights that are on from dusk to dawn.  I calculated that by replacing the incandescent bulbs with LED bulbs, I can reduce the expenses by $50/year.  As I'm wandering around replacing lightbulbs, I realized that at a 5% cap rate, I'm increasing my net worth by $1,000 per bulb!!  Not bad for 5 minutes of work...

So, I like San Diego real estate, but I don't want to put all of my eggs in that basket.  Especially since the appreciation comes and goes in spurts.

Happy investing 

Erik

@David Faulkner the common denominator is San Diego real estate.  My equity increases were both market and forced increases, I believe Swanny's increases were mostly market (he hasn't mentioned major rehabs) and I'm not sure if you have forced appreciation on your properties.

For my own portfolio, I kept one property in the San Diego market, since it is cash flowing nicely, and 1031 exchanged the other two properties from San Diego to Memphis in search of cash flow and forced appreciation opportunities.

I saw in 2008-2010 that market appreciation is not linear or predictable and my full time business is to improve my properties.  The opportunities available in the San Diego market were very limited in 2015.  There were plenty of "opportunities" in the Memphis market.

@ Ryan K we're not selling California real estate, one of us is staying entirely in that market, I'm moving most of my business to Memphis and keeping one property in San Diego and Swanny is moving all of his equity from San Diego to Ohio.  Just three different ways to invest, no sales pitch.

The San Diego market from 2010 has been great for David, Swanny and myself, but now it's getting really hard to find deals that cash flow.  I'm uncomfortable betting entirely on future appreciation.  David and Swanny read the market a little differently and are adjusting (or not) their portfolios accordingly.

Happy Investing 

Erik

I thought I would summarize some thoughts on this topic.  It's not about right and wrong, it's about getting educated, then getting started, then figuring out what you like doing and do more of it.

@David Faulkner invests in single family in California.  @Michael Swan and I invest in multifamily in cheaper areas.  Neither is right or wrong, simply what we prefer to invest in.  Each has drawbacks and advantages.  California single family has had great appreciation, but little cash flow relative to the equity, Memphis and Ohio multifamily has much better cash flow, but little appreciation.

David invests without leverage, Swanny invests with investors and conservative bank leverage and I invest without investors but using as much leverage as I can find.  David is giving up a lot of appreciation by not using leverage, but he's very protected in a down market.  Using leverage can be a great way to multiply your returns, but it can also be a fast way to lose everything if the market turns when you need to refinance or if your cashflow dries up.  Bringing in investors is another great way to multiply your efforts, but as a downside, you have to deal with investors and provide regular information to them. 

On the management side, David runs his own show (I believe), Swanny uses outside management and I manage in-house with staff.  I don't want my tenants having my number, but I want to control what's happening at the property, so I have a couple of managers on payroll.  David knows nobody cares about the properties like he does, so he does it himself; which is not that difficult with single family properties located near him.  Swanny must spend some time staying on top of the manager, or his properties could crash before his next visit.

The beauty of the real estate business is that you can mix and match techniques to come up with a business that works for you.  You don't have to follow in our tracks, make your own path.

I don't want to do what David is doing, because he's too conservative and leaving too much potential gain on the table.  That doesn't make him wrong, it's just not my style.  I don't want to follow Swanny and take on investors and using third party management, I need to be on top of the property and I don't want to have to explain myself to investors.  It works great for Swanny, but it's not my style.

If you've read this far in this thread, you should be ready to figure out for yourself what you are willing to do, what you like to do and what fits into your lifestyle and improves it?  If you try something and don't like the results, change it and try something else. 

One thing David, Swanny and I agree on is that we love what we do, mostly because we have each developed a style that matches our personalities and allows us to sleep well at night.

Guys, apologies if I have misrepresented you in any way, this is based on our discussion here on BP.

Happy investing.

Erik

@Paul B. that property started out in 2010 as a no money down, 9 year, lease purchase option fourplex in Old Town San Diego.  It generated $4-500/month net, which is a pretty good return on my equity ($0 at that time).  Fast forward to late 2014 and there's a lot of equity in the fourplex.  I rehabbed one unit and was able to raise rents a little; and the market took off like a rocket.  That made my return on equity look pretty low, so I decided to make a move to a better cash flowing market.  I heard a lot about Memphis and decided to check it out.

On LoopNet, I found a178 unit property that nobody seemed to want, so I made an offer which included a 10% down payment and a 90% seller carryback.  With physical occupancy at 20%, there's no way to get bank or agency financing, so it's either a seller carryback or a lowball all cash offer.  So I put it under contract, then listed and sold my San Diego fourplex and completed a 1031 exchange. 

So, the no money down fourplex has become a 178 unit fixer.  I'm not sure where I'm going, but I sure like the trajectory!

Disclaimer:  It's not as easy as it seems, but it can be done.

Happy investing.

Erik

@Michael Swan I thought I should share an experience with you.  Comparing two of my properties, one in San Diego and one in Memphis.

I have 23 small class C units in Ramona, a small rural San Diego suburb.  I also have 76 class C units in the Whitehaven area of Memphis.

The Memphis property cost $1.2M two years ago.  It was 90% occupied, but rent collections were very poor.  In the last 2 years, I have spent $200k to evict non-paying tenants and rehab 50 of the 76 units and increased rent collections from $22k/month to $33k/month.  A conservative valuation today is $2M.  So, 2 years of hard work has generated an increased value of $600K.

During the same time, the San Diego property has increased from $2M to $2.6M, with only minor repairs and rent increases.

I like the San Diego property because of its ease of management and fantastic returns on time invested.  I like the Memphis property because the results are predictable and repeatable.

When (if?) the San Diego market takes another nosedive, I'd love to get back in and ride the elevator back up.

I see my end game as being 1031 exchanges into NNN commmercial leases. What's your long term end game?

Happy investing 

Erik

@Vincent Chau if you already own the property when cap rates increase, the value of your property will go down, unless NOI increases at the same time.

As a simple example, if your apartment complex generates $200k in rents and has $100k in expenses your NOI is $100k. At a 10 cap rate, the property is worth $1M, at a 5 cap rate the property is worth $2M.

When you are looking at buying a property, you use the cap rate to compare the two properties.  The 5 cap property may be a class A, which means a higher grade property with better tenants and less problems; but also less cash flow and a lower return on your investment.  The 10 cap property will probably be a class C, more problems and lower grade tenants; but a higher return on your investment to compensate for taking a higher risk.

However, once you own the property, an increasing cap rate is a measure of prices falling.  Cap rates and prices are a function of supply, demand, interest rates, the economy, the neighborhood and a whole host of other factors.  If interest rates were to increase dramatically over the next 10 years, I believe cap rates would also increase.  Interest rates and cap rates are not tied together, but I find it unlikely that cap rates would be lower than mortgage rates for any length of time.

So, in the prior example, if you bought the property at a 5 cap rate for $2M; then cap rates increase to 10 as interest rates spike, your property has decreased in value to $1M. It's not that cap rates increase or decrease by decree or comps, it's simply a measurement of the value of a stream of cash flow. It can become a real problem with commercial properties since commercial loans are usually for a 10 year term and 25-30 year amortization and a balloon payment at the end. So, if the market tanks (as indicated by increased cap rates) during the loan term, you could end up not being able to refinance the loan and lose the property. Using the prior example, you buy the property at a 5 cap for $2M and put 25% down with a $1.5M loan. Over the next 10 years, you pay down the loan to $1.2M, but the market value goes to $1M. At the end of the loan term, the bank will offer you a refinance at 75% LTV, or $750k. In otder to refinance (and keep) the property, you need to bring in $450k...

Of course, this is a simplistic example. You would of course do whatever you can to increase the NOI of the property during this 10 year period. But, even if you double the NOI from $100K to $200K, you're simply maintaining the $2M valuation.

A good parallel is the bond market.  A bond is issued with a particular principal amount and a coupon rate, say 5%; resulting in a stream of payments.  The market will adjust the price of the bond to reflect the risk premium and general interest level.  Dividing the coupon payments by the market price will give you the yield of your investment.  In real estate, the cap rate is the equivalent of the bond yield.  Market forces will drive prices up and down, reflected in an increased yield/cap rate.

Hope this clears things up a little.

Happy investing

Erik

@Harrison Liu I don't mean to pick on you, but I've heard many people make similar statements to your earlier comment:

"I consider myself to be very lucky because I bought early and I did not read any rei books."

I see a danger in considering your success to be the result of luck.  If luck is a major component, how do you repeat your success?

For me, success is the result of carefully considering a project, mitigating some of the risks, then investing time and capital to achieve the outcome.  If the project is successful, it's not because of luck, but because I picked a good project, made a good plan and worked that plan.  That's a repeatable process.

If I felt like I'm rolling the dice everytime I'm considering a project, I may not move forward, even if it's a great project.  Also, if I feel like my current portfolio is the result of luck, I may not be able to rebuild it, should disaster strike.  

I know I have the skills and knowledge to rehab and rebuild apartments.  That's a repeatable process that generates cash flow and builds equity.  If disaster strikes, I know I can rebuild my portfolio larger and better than it is today.  That knowledge gives me great confidence, which I wouldn't have if I believed it was all built on luck.

Happy investing and good luck... 😎

Erik

Wow, this turned into quite a SFR vs MFR debate. I'm definitely on the MFR side. Once, I bought a house as part of an apartment complex, but I sold it since it's not my focus.

Like Swanny, I built a small portfolio in San Diego, experienced significant capital gains and then 1031 exchanged most of it for a higher cash flow market (Memphis).  Unlike Swanny, I relocated to Memphis to do a couple of hands on rehab projects.  I miss San Diego, but still have a property there to have an excuse for a tax deductible trip.

@David Faulkner I use the cap rate for two purposes: (1) to compare two or more properties I'm considering buying (not the only factor); and (2) to evaluate whether certain improvements are worth making. The cap rate tends to change slowly and is not as volatile as SFR appraisals can be. So, if I'm looking at increasing NOI and refinancing in a year or so, chances good that the cap rate hasn't changed much. This gives me a good foundation for calculating the potential value increase.

With the caveat that I don't do SFR investing, I feel that SFR appraisals can be fairly volatile, i.e. the house next door goes into foreclosure. Thus, I believe it's easier for me to predict the outcome of my planned improvements to a MFR using a cap rate than the value increase from a SFR rehab.

As far as market increases, that's more luck than skill... High SFR comps increases the value of the whole neighborhood, compressed cap rates increases the value of MFR.

There's obviously risks with either strategy.  Swanny could lose his shirt if interest rates and cap rates increase, the factories shuts down or any number of other disasters.  David could lose his shirt if the So Cal market takes a tumble, like 2008-2009.  Swanny is more comfortable with his current risk profile and David prefers his risk profile.  I'm not sure why this discussion degraded into a cap rate vs comps fight.

I'm going to be as straight as possible and say that anyone trying to do what I'm doing is nuts!  I'm taking a 178 unit complex in a C- area with 20% occupancy, first down to 10% occupancy by evicting the undesirables and non-payers, then renovating the remaining 160 units and slowly filling it up.  It's a great challenge though and if I can make it, I can basically retire.

Here in Memphis, the landscape is littered with vacant and boarded up properties that out of town investors were suckered into buying and "rehabbing."  They usually get taken for a ride by either the seller and/or contractor.  I lived on site for the first 18 months and walked the property at night with my trusty Colt 45.  If you're not willing to do that, stay out of the cheap Memphis properties.

Like both Swanny and David, I love what I'm doing and thrive on the challenge. The most important thing is to find an investment that works for your personality AND your goals. Some SFR investors will get an ulcer venturing into MFR and some MFR investors would die of boredom or old age trying to meet lofty goals with SFR investing.

Happy investing everyone and do try to get along...

Erik