All Forum Posts by: David Hadley

Hi Will,

In fact, I am talking about large multifamily commercial properties. I've been looking at properties from 60 to 200 units and the only difference I've noticed between these big boys and the duplexes of the world is that the large properties use lots of smoke and mirrors while the smaller properties either don't know, or are far less subtle in their lies and misrepresentations.

Here's an example, and by no means the most egregious one I've seen. [Cap Rate 7.75%] I have an Offering Memorandum for a 150 unit apartment complex. The pro forma (which the cap is based on, of course) shows an NOI of $452K. The actual numbers, after I got a hold of them, show an NOI of $339K. The justification that the broker / seller used to account for the difference?

Value add opportunities include:
- Upgrading light fixtures and switch plates
- Upgrading drawer pulls and cabinet knobs
- Using a two-tone paint scheme
- Improving landscaping
- Improving exterior lighting

Yes, that's right. Using a two-tone paint scheme, changing some knobs and light fixtures and planting some shrubs is going to improve the property value by $1.5M!!

Another example: [Cap Rate 13.5%] a 200 unit portfolio, actual NOI is listed at $572K (and the cap rate is based on this). The OM shows an actual NOI of $377K. The operating statements show an NOI of $311K. Who knows what due diligence will turn up?

Another example: an 86 unit complex with an advertised cap rate of 4.5% that the operating statements clearly show is losing $10K per month.

And it goes on.

Now this last one might actually be the best deal of the three because it stands to gain the most from better management. The first example I gave appears to be very well run and if there's no opportunity for forced appreciation, I'm not interested.

And lest we try and differentiate between pre-sale and "sold" cap rates as collected and reported by various brokerage houses and others, realize that:

1. They are usually prepared by the same folks who create the fictions I run across over and over again; and

2. The buyer has an incentive to keep reported NOI (and thus cap rate) high because the DSCR of their loan is based on NOI and the higher the DSCR, the more likely they are to get their financing. I'm not saying investors lie to the bank, and certainly the bank wants to look at the books, but if the buyer finds something fishy during due diligence that may reduce NOI, he has no incentive to pass this information on to the bank and if he isn't going to report it to the bank, he's certainly not going to report it to anyone else!

In short, no one has any incentive to report the true cap rate.

I suppose I could normalize all of these cap rates and then compare them, but I'm just not interested in cap rate any more after I've got enough information to be able to figure them out. As you say, I guess we'll have to agree to disagree on this one.

[Edited to add advertised cap rates for those properties.]

I agree with you. There is a supply/demand component to a market and there is a speculative component. (There are others as well, such as regulatory, monetary, via collusion, etc.) Oil prices are being driven higher by supply and demand, regulation and monetary imbalances (as you pointed out). I don't really think there's any question that this is the case. The trend line is up.

I also find it likely that speculation has created a bubble as well. If I felt I knew this with any certainty, I'd be shorting oil futures, buying puts, etc. I just don't understand the oil markets well enough to act. You have a much better handle on the oil markets than I do and your posts on the subject are interesting.

(I'm barely able to make sense of the real estate market and I put a lot of effort into that. I'm still convinced that this uptick we're seeing here in CO is just a dead cat bounce. I have good reasons to think that but it's hard to stick to my guns and stay out of the market.)

I'm primarily taking exception to your characterization about how bubbles operate in futures markets. They are very different beasts than stock markets. It's entirely possible to have a negative bubble (artificial price depression) due to speculation in the futures markets. This isn't really true of stocks, which is what people are familiar with. Shorting in the stock market is a very small portion of the volume. In the futures markets, shorting is always half the market, by definition. For every long contract position that someone bought, there exists a short contract position that someone sold.

You can't characterize the speculation in the futures markets by saying that "a gross excess of speculators [came] to the market bidding up contracts" because for every speculator that bought a contract, another speculator had to sell them that contract. Sentiment, based in reality or a bubble mentality, is moving prices, not the presence of speculators.

Speculators, as a general class, are not getting rich in the oil market (or any other commodities market for that matter) because for every dollar made by one speculator, a dollar is lost by another speculator. More enthusiasm by many, or even just a few, individuals on the long side is probably creating a bubble, and those speculators will make out well, but all of their gains will be paid by other speculators who were wrong. Blaming "speculators" for the bubble may be true in a sense, but calling for their removal from the markets (not that you have done this, but some have) makes absolutely no sense.

Isohunter, with all due respect, I think you need to thoroughly understand the futures markets before you start believing in conspiracy or collusion, not that those things don't happen. If after you thoroughly understand the markets, you still see a deus ex machina, then your theory of non-market based price manipulation might have legs. And I certainly don't think we should be modeling our actions after India.

Futures exchanges exist to provide vital liquidity to commodities markets. Without futures exchanges, there would be drastic and frequent price fluctuations in our commodities and the goods made from them. Businesses that produce / use these commodities would have to pass those fluctuations through to the consumer immediately (or at least within their credit floats), the net result being that the price of gas (or any other commodity) would fluctuate by very large amounts very often.

Speculators bear all that risk of price fluctuation in the interim between production and delivery and create the liquidity needed for businesses to lock in the sales price of a good they haven't yet produced (or the purchase price of a good they need to use in production). Without futures exchanges, and the speculators that keep them moving, businesses would have no way to plan production.

The futures markets are a zero sum game (less the vig, of course). For every contract that someone is long, someone else has to take the other (short) side. Many, many more (think 100:1 or more) futures contracts for goods exist than actual goods traded.

If as a speculator, I buy a contract to purchase gold, for instance, at $1200/oz. in November, I'm betting that gold will be more than $1200/oz. by November. If it is, I can take delivery of the gold and sell it on the market at the spot (immediate delivery) price. If I'm wrong, and I take delivery, I will either keep it in a vault, or sell it at a loss.

In practice, speculators do not take (or make) delivery. They either liquidate their position before contract expiry or the exchange will settle their accounts against the opposite positions for cash. If you, as a speculator, hold through expiry, there is a chance you will have to take (or make) physical delivery, so in practice all speculators close out their positions prior to this. The only ones left standing, so to speak, are the actual producers and consumers, though they probably never dealt directly with each other.

Futures markets don't really move the market, though they do influence it. The markets are a way for producers and consumers to hedge (i.e. pass their risk on to speculators). The real market is the spot price of a commodity on any given day. Futures markets smooth the fluctuations in the market price out. Supply (OPEC, lack of refineries, regional blends of gasoline) and demand (from China, India, summer driving season, etc.) are what really move the oil and gas markets.

Futures markets exist almost entirely to provide hedging opportunities to producers and consumers, and to do this the markets need speculators. Lots of them.

This notion that speculators are bad for commodities markets and should be removed or reined in, is the polar opposite of the truth. "Speculators" are a convenient scapegoat for the media and politicians, and this finger pointing works because of the criminal negligence that exists in our education system that refuses to teach anyone anything not related to learning how to be a wage slave.

As far as oil as a bubble market at the moment, I don't know but I would say we are probably above the true value curve. I don't believe this enough to put my money where my mouth is, however.

I am certain that the trend in oil is up and is going to remain up due to increasing demand from the 2nd world and the general resistance toward alternative energy solutions such as nuclear power, wind, hydroelectric, domestic drilling, etc. professed by the NIMBY and Green crowds.

I have to agree, the SFH is the better deal. In terms of exit strategy, the SFH will have a much bigger pool of buyers than the duplex. SFH are mostly sold to owner occupants, not so with multis.

The only downside I can see is that a vacancy in the SFH is 100% income loss.

Let me clarify a bit. My point is that for pre-screening, cap rate IS just about worthless for the very reasons you (and I) have stated. Sellers / brokers, intentionally or not, misrepresent their expenses, over-inflate their income and get words and phrases like "actual" "pro forma" and "made the hell up" confused.

Once I've seen the P&Ls, I'm not interested in cap rate anymore when comparing investments, so for me, I don't find it useful pre-offer, pre-contract, post-contract or post-close.

Nevertheless, as an investor, you need to know what it is because everyone "uses" it and as a negotiating tool, it can be a good one, especially if you understand it better than the other guy.

I've always said, I'd rather hear a good story than a true story. Unless it's costing me money.

How about "a few hours of entertainment"? Who else's chain can you spend a couple hours yanking and feel no guilt whatsoever. Used car buying is the best sport there is.

The entire purpose of cap rate, as far as I'm concerned, is to allow you to compare one income producing property with another when screening deals.

With that said, I've got to agree with Mike here: for small properties, cap rate is useless.

I'm going to go one further and say that for large properties, it's useless too.

Why?

Because brokers and sellers LIE all the damn time. Cap rate is worthless as a screening tool because you can't trust a cap rate until you verify it with at least some pre-offer due diligence, like a couple of years of monthly P&Ls. And of course, by that time, you are able to understand the expenses to some degree and calculate some much more useful ratios, you know, like Cash-On-Cash return, DSCR, etc.

How do you know the bottom has arrived? I'm not picking on you, I'm honestly curious on how you are making that determination for your market.

For the record, I know next to nothing about the Michigan market.

It depends on whether you have a non-recourse loan or not. A non-recourse loan means that the bank's only recourse is against the property that is mortgaged. Some states provide that owner occupied houses must have non-recourse loans, some do not. My state, CO, is a recourse state.

If you have a recourse loan then what can happen at the foreclosure sale is that the lender will put in a bid that is lower than the amount they are owed. If the property sells for less than what is owed, the lender can get a deficiency judgment which can be used to attach other assets / wages.

If you work with your bank on a "short sale", which means selling your house for less than is owed prior to foreclosure, then usually part of the deal will be an agreement by them not to come after you for any deficiency. Giving the bank the house back (deed in lieu of foreclosure) is another option. In any case, you need to make sure that the paperwork states that they will be forgiving any deficiency. Obviously you'll need a lawyer to look over the paperwork.

The fun part is that if you are forgiven any debt, this may be reported to the IRS which will consider it income and tax you on it. I know that there was some legislation floating around to preclude this in the case of mortgage defaults on owner occupied homes, but I haven't been keeping up on the status.

Hope that helps.

I'm not suggesting you (or rather your friend) do anything without seeking some professional assistance.

I don't think you should paint BiggerPockets with such a broad brush either. At this point, I'm the only one that has made any such statements and I certainly don't represent BP. I have no idea if anyone else on this site feels like I do.

I assume you're talking about the new owner of the vacant land since your friend no longer owns it. Is the new owner you?

I involve ethics in everything I do. I try to avoid emotion when making business decisions.

As for the rest of your post, I have to say I read it multiple times but I didn't really understand it.

Your questions were answered, I believe, multiple times by multiple people including myself. I really don't know what else you want to hear? If you have another question, ask it and I'm sure someone will try to answer it.