All Forum Posts by: Thomas Ashton

 Shannon,  You are not comparing apples to oranges.  Your private money lender at 10% wants to issue debt.  He wants to take, as you say, second position.  To come up with the 25% "down payment" you need an equity investor.  Now you might "guaranty" them a return but you are not contractually obligated to.  A bank that makes a loan is going to earn their coupon, nothing more and nothing less.  An equity investor gets anything that is left over.  They might make less then the coupon and hopefully they are making more.  As the sponsor it is your job to make sure they earn as much as possible.  An equity investor will also take first losses and could potentially be wiped out if your project fails.  

Look at it this way.  If you want to invest in a publicly traded company, you can invest in either bonds or stocks.  If you invest in a bond, you are going to earn your coupon, nothing less and nothing more (ignore that some bonds trade for below or above par).  If you buy a stock, you hope that the stock appreciates and you hope it pays dividends.  But the price might go down and you will realize losses if you sell.  You hope the stock goes up and it can go up 10, 20, 30 or even hundreds %.  But there is no "guaranty".  A bond investor is guaranteed their investment back.  In the event of a bankruptcy they can make a claim in bankruptcy court and hopefully get something back.  An equity investor will get nothing.  In a real-estate investment, the debt holder will get something through foreclosure (bankruptcy) and the equity investors will get nothing.

Arnie,

Nice looking building! Congrats!

I am not a frequent poster here but could not let your post go by unanswered. Granted, this is simply my opinion but I believe that your colleagues who are in the "max rent" camp are wrong. Real Estate is not a maximum rent or maximum profit business but rather a maximum revenue business. Your apartments are a perishable product. In other words, every day a unit goes by vacant is revenue you will never achieve. You cannot inventory an unsold apartment unit for resale later. In addition, real estate is a very high fixed cost business; taxes, insurance, debt service (really a liability but lets call it a cost for this discussion), payroll, etc. These costs are realized regardless if the unit is full or empty. If two of your four units are vacant then you will still have all the fixes costs associated with your asset. Your goal is to maximize the revenue over a given period. If you attempt to maximize your lease rents then you risk driving vacancy through turnover. Furthermore, turnover will increase costs due to turnover and make ready related items.

Now, with that being said it is possible to have your rents too low where you have very little, if any, turnover but you will not be maximizing revenue. Only you can make that determination from knowing your market and what other similar properties are achieving for rents. And your own comfort level.

Many big operators operate this way through the use of rent pricing software (Yieldstar, etc). Go shop a large (250+ unit) class A property sometime and tell them you want an apartment in two months. Then ask them what the price would be if you moved in next week. Most likely it will be lower then the price quoted two months in the future. The leasing agent or property manager has no say over the rent but is merely reading it off a computer screen. If you ask "what is the rent on a 2 BR" they will immediately ask "when do you want to move in". Large operators use software which have owner inputs that take into account current property occupancy, seasonality, competitive comps, etc to determine rental price. The goal of the software is to maximize revenue over a given period and not necessarily maximize the value on a rent roll for a given unit. Although this is too costly for someone with 9 units, you can still use the same principals in concept. Do you hold out for $550 rent or take $525? If holding out for $550 causes an extra month of vacancy and $525 can be achieved today then you are probably better off taking $525 today. $25 x 12 mos = $300. One month of vacancy would have cost you $550. By taking $525 you have maximized the revenue but have not maximized the rent on a rent roll.

Other industries that operate on a similar basis? Hotel rooms, rental cars, airline seats, etc. All high fixed cost industries with a perishable product that loose all revenue generating capability after the night is over, the day is over or the plane has left the gate.

Hope this helps. While your colleague is off turning units and chasing maximum rents you can be at the beach, golf course, etc knowing that your business might just be more profitable in the end.

Rikard,

This thread is killing me! No one is answering your question. In this country, the term multifamily and apartment complexes are generally interchangeable. True, a four unit is considered multifamily but you would be hard pressed to call it an apartment complex. A 160 unit apartment complex is, however, considered multifamily. One of the better trade magazines in this country is Multifamily Executive and they focus mostly on larger apartment complexes (over 100 units).

There is an old joke that goes something like this-

There are 4 cap rates to every deal. Buyers, sellers, sellers broker and the real one!

Investors need to stop focusing on cap rates. A cap rate is a tool to help one capitalize an income stream. It is not an indicator of investment value. There are 4 cap deals that are great investments and 12 cap deals that are horrible investments.

Kev,

OK, you have a property owner here, give me your pitch. I own 3 communities, with the smallest being 80 units. Tell me how I can save 40%.

On another note, I concur with the other posters. Property managers are not really incentivized to manage expenses, other then the fact that an owner will probably go someplace else if the expenses get out of line. In other words, a management compnay is paid on the revenue collected. It does not matter if the OER is 40% or 70%.With that in mind, I watch expenses more closely then revenues. How do owners know they have a good company that manages expenses well? As an owner, I would never contract with a management company that does not own a significant portfolio themselves. My theory is that the management company will monitor their own expenses much more closely than a management contract. They will set up their systems and processes to maximize their NOI. Operating under the theory that they will manage their contract properties with the same systems and skillsets as their own, I am assured they are doing it to the best of their ability. If I do not think they are, then it is time to go shopping for a new management compnay.

If you are pitching to managers that also own their own portfolio, then chances are they do not see any value in your product, service, or scheme.

Linda,

There is actually a very easy answer to your question that is legal and ethical. Simply engage in an entity transaction and not a real estate transaction. I am assuming the property is in an LLC, or if it is not then it needs to be placed in one (which not being in an LLC and placed in one before the transaction is beneficial). Instead of purchasing the property, you will purchase the LLC and all the assets it holds (i.e. the property). By doing this, there is no real estate transaction recorded, therefore no market value transaction that an auditor can base their value on. You will also save the transfer tax since there is no transfer. In essence, you are not in the real estate acquisition business but in the M&A business. If the LLC has existed for some time, the due diligence will be more extensive since you will be assuming all of the past liabilities of the LLC. Have they paid their taxes correctly? If the IRS audits and it is discovered that they were not paid correctly two years ago, then you are liable. This is why I stated that if the LLC is created just before the transaction that it would be beneficial.

This is legal and ethical, although not very common in today’s market because property values are generally going down. Everyone wants to have a transaction to record the market value to reduce the tax assessment.

Dave,

First, you do not "select" a cap rate. You observe cap rates in the market place by seeing what similar buldings in the marketplace have sold for recently. You then ascertain what the NOI is for those recently sold buildings and determine the cap rate. This cap rate is then applied to the NOI of your potential deal to determine a valuation (NOT investment return!). When the cap rate is greater then your cost of debt, you will realize increased return with leverage.

Second, debt and equity returns are VERY different. Debt returns are generally less risky then equity because the debtholder has a legal claim to getting paid back. For example, if the debtor defaults, the debtholder can sue for whatever collateral is securing the debt, which in the case of mortgage debt is generally the asset (building) that secures the debt. Equity does not have a legal standing and therefor is riskier. That is why equity holders are generally wiped out in corporate bankruptcies. SInce debt holders have a legal standing, they generally become the new equity holders.

Third, equity returns should always be higher then debt returns. The seller is requiring high interest because one of two, or a combination, reasons. Either the building is high risk or the borrower (you) is high risk. In those cases, the cost of equity would also be higher. If the buidling and/or borrower is low risk, then the interest rate on the debt should be lower since the debtholder is more assured of being paid back. Likewise, the riskier the project becomes, perhaps because of leverage, then the equity returns should be correspondingly higher.

Hope this helps.