“Value-Add Opportunity” What does it mean, and should I consider it?
If you have spent any time at all researching potential apartment investments within the last several years, I am certain that you have been presented with a property in which the seller and/or agent have presented the deal as a great “value-add opportunity.”
In this article, I will discuss exactly what a value-add opportunity is, how to determine whether or not a value-add program will actually work, an indication of which properties are best suited for a value-add program, and a brief discussion of specific actions you can take to make this program work best for you.
Before defining the term, it is necessary to state that, in my opinion, this term is grossly over-used.
I would estimate that at least 75% of the deals I am presented with claim to offer a great value-add opportunity.
In fact, I have looked at apartment communities that are only a few years old that claim to offer this. You will understand why this is ridiculous on its face by the end of this article.
Although there is no actual definition, a value-add deal is one in which a potential buyer could take advantage of market disparities by adding value to the property and allowing for higher monthly rents. This typically comes through a combination of a capital improvement program, re-positioning the asset, and increased operational efficiency. All of these will add value to the investment.
So, given the above definition, how do we find opportunities that offer real value-add potential? More importantly, how do we find those deals that offer the best value-add potential?
First, be careful if you’re presented with a “value-add” opportunity where the previous owner has already completed significant renovations and raised rents but is stating that you could still get another, say, 10% rent bump with “minor” additional upgrades. These are the properties that you want to be the buyer BEFORE they get renovated.
If I were to describe the ideal value-add investment, I would define it as the “weed in the flower patch”. In other words, it would be an older property that is located in an area that is highly desirable (i.e., the flower patch), but is the one property that has been neglected in terms of maintenance and/or management (i.e., the weed). It is a property like this that offers the best opportunity to increase value.
However, there are additional criteria that the property must meet in order to be successful. Primarily, the problems at the property must be both solvable and financially viable. If the property suffers from major structural deficiencies and/or extensive deferred maintenance, the cost to remediate the issues may be too high to recoup costs through increased rents. Generally the increased revenue must pay for the upgrades/repairs within 4 years to make the investment worthwhile.
Also, the property may be functionally obsolete. For example, the unit mix may consist of all studio/efficiency and small one-bedroom apartments in a neighborhood that demands larger one and two-bedroom options. Problems such as this are difficult if not impossible to solve.
So, what we are looking for is a well-located property that is below market rent and has minimal to moderate deferred maintenance and/or management deficiencies. It is this type of asset that offers the best chance for success. You’re not just betting that rents go up forever but actually re-positioning the property.
Now that we have identified the property, we need to develop our value-add program.
The best way to demonstrate this is through a hypothetical example. Let’s say we have identified an eight unit property in one of the more desirable parts of town. The current owner has had the property for several decades and has not upgraded the units more than occasional new carpeting, painting and necessary repairs. Because he has little to no debt on the property and prefers to just collect checks without doing much to make the property competitive, the rents are severely under market.
He is retired and now wants to sell the asset. The units are all two-bedrooms, and currently rent for $800 per month. For simplicities sake, we will assume the property is always fully rented. This is key – you can’t bump rents at a property that’s 85% rented. Something else is wrong.
Back to our example – the owner wants to sell the property for $600,000 or $75,000 per unit. We know that the property generates $76,800 in income annually, and through due diligence, we find that the annual expenses for this asset run at $40,000 per year. This leaves a Net Operating Income (NOI) of $36,800. With a purchase price of $600,000, the “going-in” capitalization rate (NOI/Purchase Price) is 6.1% – an aggressive but reasonable cap rate for the local market.
Now, let’s assume that we invest $6,000 into each unit ($48,000 in total) for upgrades including new laminate flooring, new appliances, new lighting and plumbing fixtures and new counter and vanity tops. Let’s also assume that post-renovation we can rent these upgraded units for an additional $150, or $950 per month.
Does this “investment” make sense? Let’s find out.
The new “cost” of the acquisition is $648,000 (Purchase price + $48,000 in improvements) and we have increased revenue (after all eight units have been renovated and rented) by $14,400 per year. So, our new gross revenue is $91,200 and our expenses remain at $40,000, yielding a new NOI of $51,200.
Using the capitalization rate we calculated at acquisition (which we felt was reasonable) of 6.1%, and applying this to the new NOI results in a new property “value” of $839,344. Under this scenario, we have increased the value of the asset by $239,344 (Current value of $839,344 less original acquisition price of $600,000) and it only cost $48,000 to do this.
However, we also need to look at the payback time for this investment. Since it cost us $48,000 to get a $14,400 per year increase in revenue, that equates to a 3 1/3 year payback ($48,000 divided by $14,400). This falls within our 4 year maximum so it will bump our returns without exposing us to an extended pay-back time frame.
However, let’s say the cost to renovate is $10,000 per unit, and we can only increase rents by $40 per month. Using calculations similar to those above results in an increased value of the property of $62,950, but the cost to renovate is $80,000. As such, this value-add scenario results in an actual “decrease” in net value of $20,000 and would require nearly 21 years to pay back. This clearly does not make economic sense.
This is just one hypothetical example, but it should provide you with a foundation to understand how the value-add process works and how to determine whether or not such a program makes economic sense.
What You Need to Know About Multifamily Real Estate in a College Town
As I often say, your success in multifamily real estate depends on one thing: cash flow.
One of the keys to cash flow, of course, is keeping your units occupied. This is what makes investing in college towns so attractive. Every Fall, you’re guaranteed an influx of renters who’ve already paid tuition and need a place to live.
But, of course, renting in a college town raises all sorts of concerns. What if the students aren’t qualified? What if they wreck my property? What if the college goes under?
In this post, I want to share the pros and cons of investing in a college town, followed by some advice for how you can wisely take advantage of this great opportunity.
Pros: Why you Would buy Multifamily Real Estate in a College Town
There are plenty of reasons why multifamily real estate does well in college towns:
- Consistent Demand — Every year, like clockwork, you’ve got a fresh batch of renters ready to come in and take over. While this may cause some trouble with timing (see below), higher demand means lower vacancy and higher NOI.
- Built-in Rental Increases — With revolving occupancy comes built-in rent increases. You may prefer to rent long-term, but the benefit of an ongoing parade of 1-year leases is that you can increase regularly without “losing” a tenant.
- Stable Rental Market — Consistent demand also leads to a strong, stable rental market. So long as the school is operating well and its financial position is solid, there’s virtually no danger of the bottom unexpectedly dropping out on you.
- Appreciation — It’s hard to escape the pervasive effect a healthy school has on its surrounding economy. As the neighborhood thrives, so will your investment.
- Decent Return on Investment — Lower vacancy, higher NOI, a steadily advancing rental market—all these factors add up to make for healthy returns on college town multifamily investment.
Cons: Why you Wouldn’t buy Multifamily Real Estate in a College Town
Even with all the pro’s I mentioned above, there are some potential drawbacks to buying a multifamily property in a college town:
- Turnover — Tenant turnover is the bane of every landlord’s existence. Even if you stack leases one after another (which you certainly should), you’ll still have to deal with the typical headaches and expenses of turning a unit. Keep in mind, however, that smart college landlords work leasing and cleaning fees into every lease. In most college towns, these conditions are par for the course.
- Timing/Competition — Each town is different, but you’ll normally encounter a narrow window when renters swarm the apartment scene looking for units for the next year. In general, this is a good thing. But, if your tenant breaks a lease early and you find yourself off cycle, it can be difficult to find a renter “out of season.” Don’t forget, though, not all college town renters are students.
- Parties & Problems — This is the standard worry for every college landlord. The last thing any of us wants is for one of our properties to end up as everybody’s favorite weekend party house.
- Poor Upkeep — College students rarely know how to take care of a property. After all, this is likely the first time they’ve ever lived alone or outside of a dorm. That means you can expect plenty of deferred maintenance at the end of the year.
- Management Intensive — If you self-manage, you can expect college students to require more interaction than your typical tenant. Again, they’re not used to living on their own. You can also expect added nuisances like noise complaints, roommate conflict, and early lease breaking.
Advice: How to Succeed with Multifamily Real Estate in a College Town
On balance, I think the pros outweigh the cons college town multifamily investment. That said, there are a few steps you should take to ensure you protect yourself:
- Do Your Homework — Find out what’s happening with the school itself. Is it growing or is it shrinking? What do on-campus housing rates look like? Does the school impose a cap on neighboring rental rates? Also, what’s the ratio of on-campus to off-campus housing in the area? The last thing you want is to be undercut by an oversupply of cheap on-campus housing.
- Skip the Undergrads — Unless you’re local, focus on property classes that serve mid- to high- level demographics. In other words, invest in the kinds of properties that will serve graduate students, faculty, and administrators.
- Get Professional Help — Especially if you’re not local, take the time to learn the market from experienced investors who are already there. On top of that, find an experienced property manager who knows the market and works specifically with college housing. With a nuanced read on the renter population and experience with the school, they’ll be able to help you edge out the competition.
Do you have specific questions about a particular property or market? Bring them to our Multifamily Real Estate Investing Group on Facebook. There, you’ll find more than 20,000 investors ready and eager to help you succeed in multifamily investment.
Evaluating Expenses-Tricks of the Trade
As part of normal due diligence, an in-depth evaluation of expenses by line item is critical in understanding the past performance, and forecasting the future expectations for the asset.
In this article, I will walk you through most of the major expense categories that are associated with apartment properties, and offer insights regarding what you should be looking for.
However, before getting into specifics, let’s be certain that we are focusing upon the proper data. Of primary importance is the most recent twelve months of actual property performance, often referred to as “Trailing 12’s” or “T-12’s”. Also of importance are the two or three years of similar data for those years prior to the most recent 12 months. Evaluation of this data will provide a basis for comparison as well as provide insight into trends being evidenced at the property.
What you should not be focusing on are “pro-forma” projections provided by the seller and/or his or her agents. This is not a knock on either, but you will be best served by constructing your own projections, and avoid relying upon data provided by those who have a financial interest in making the data seem as positive as possible.
In many instances, the transfer of ownership will trigger a re-assessment of the property by the local taxing authority.
OK, let’s get to work. The first expense item I would like to address is property taxes. I cannot overstate the importance of really understanding this expense in order to get an accurate assessment of a property.
Property taxes are typically one of the largest expense items for a real estate asset, and that alone makes an understanding of them vital. However, what is of far greater importance is how taxes will respond to the purchase of the asset.
If the property has not been assessed recently and is currently being taxed well below the “fair market value”, a sale and re-assessment of the asset could result in a new property tax liability that is dramatically higher than what is currently being charged.
It is critical that before purchasing an apartment property that you contact the local taxing authority and gain a clear understanding of how your purchase will affect property taxes.
Insurance is another significant line item, but is also one of the easiest to verify as accurate. Discussions with a few local insurance agents should allow you to ascertain exactly the type and extent of coverage you will need as well as an associated annual cost.
Like insurance, utilities are fairly straight forward in their assessment. A review of previous bills for items like electricity, water/sewer and natural gas will give you a clear understanding of monthly and annual costs.
Repairs & maintenance can be another significant line item, but is also fairly easy to quantify. The due diligence period is the time to thoroughly inspect the property and the utilization of a professional to assist with this is advisable.
The age of the property should also be considered, as logically, a new property will typically require only moderate annual repair costs while an older property will be the opposite.
In most months, a property (especially larger properties) will have new tenants move in and existing tenants move out. Turnover costs are those that include the cost to bring a vacated unit back to rentable condition. In most instances this includes a fresh coat of paint, a thorough cleaning and perhaps minor repairs and possibly carpet replacements. While variable in nature, these costs can usually be accurately estimated by applying a reasonable expected turnover rate to the property and combining that with the average cost to bring the unit back into rentable condition.
Personnel costs can be significant, but in the case of smaller properties (probably fewer than 50 or 75 units) there is no need to provide full time, salaried staff. For larger properties where salaried staff is advisable, the annual costs are typically quite verifiable, especially if you intend to keep the existing employees on after closing.
The advent of social media and the internet has allowed most properties to significantly reduce their leasing and marketing costs. This expense item is usually quite predictable, but may vary depending upon the current status of the property. For example, a property suffering from high vacancies will likely require increased marketing costs, at least over the near term, in order to stabilize the asset. Conversely, a fully occupied property whose tenant base is largely older will require only modest marketing, as older tenants are typically less likely to relocate.
Management fees will also need to be quantified. For smaller properties, self-management is often a viable option, and will obviously reduce or eliminate this cost. However, larger properties often require professional management, and while negotiable, the final cost is easily calculable. Typically a percentage of rental collections, the number will usually be higher for small properties and lower for larger assets, with costs generally ranging from 3% up to as high as 10%.
There are other expense items that may need to be evaluated, but in general the ones discussed above are those that you will encounter in most instances.
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Nobody goes into a multifamily investment expecting to
default on their mortgage.
Still, it happens. And if one of your properties has slipped
into foreclosure, the odds are you’ll likely lose that property.
So, what happens next?
The Basic Question: Recourse vs. Non-Recourse
The answer to that question depends on whether or not your loan includes or excludes recourse for the lender. What’s the difference?
A recourse loan is one in which the investor personally secures the loan. In the case of default, the owner becomes personally liable for any difference between the loan balance and the property’s value upon sale. The lender can go after the owner’s assets to recoup their losses.
Obviously, this puts the lion’s share of risk in the investor’s corner. Why would an investor agree to it? In general, recourse loans are less strict in terms of loan requirements. Underwriting is a little more relaxed, and time-to-close is sometimes shorter. Since the lender takes on less risk, recourse loans usually offer more generous terms than their non-recourse counterparts.
Why would an investor agree to it?
The major downside, as we saw above, is personal liability. Even if you were to put your properties in an LLC—an absolute must—most lenders will require that you sign a personal guarantee on the loan. This effectively establishes whatever loan you acquire as a recourse loan.
Common Types of Recourse Loans:
- Commercial Bank Loans (Conventional)
- Hard Money Lending
- Bridge Financing
- (Some) Portfolio Loans
For more on multi family financing options, check out my free coaching videos on Facebook
In contrast, a non-recourse loan is a financial product secured entirely by the property itself. In the case of default, the lender will have no recourse to the owner or investor‘s personal assets. In other words, the lender eats the losses in the event of a default.
The distinct advantage of a non-recourse loan is its limitation on personal liability. That protection, however, needs to be taken with a grain of salt. Virtually every non-recourse loan will include some form of a bad-boy carveout: stipulations that give the lender recourse in the event of fraud, criminal activity, and/or negligence on the investor’s part.
Since non-recourse loans represent added risk to the lender, they come with additional hoops for investors to jump through.
Loan requirements are often more exacting, requiring a proven investment track record, ample net worth, and sufficient liquidity to service the debt in the absence of positive cash flow. Underwriting is more strict than recourse lending. Property requirements are more narrow. Terms are often less favorable as well with higher interest rates and lower LTV ratios.
Finally, non-recourse financing typically requires a longer term with stiff prepayment penalties (defeasance)—making it less than ideal for any form of a short-hold strategy.
If you’re not planning to hold on to the property for a long time, non-recourse probably isn’t for you.
Common Types of Non-Recourse Loan Opportunities:
- Fannie Mae
- Freddie Mac
- Federal Housing Authority (FHA)
- Life Insurance Companies
- Mezzanine Financing
- (Some) Portfolio Loans
For more on multi family financing options, check out my free coaching videos on Facebook.
Which is Better?
As with many things in this business, the answer to this question is ‘it depends.’
In general, non-recourse debt is a safer bet than recourse.
In addition to careful business structuring, non-recourse loans will help an investor protect his or her assets in the event of an unavoidable (or strategic) default. These loans are perfect for stabilized, long-term properties with an established track record in a reliable market.
Even so, recourse loans still make up the majority of commercial financing products out there. The liability aspect isn’t ideal, but the variety of products available with more favorable terms ends up translating into a real financial incentive to go with recourse financing. For renovations and repositions, the shorter terms on these loans better facilitate short-hold investment strategies.
Who’s Going to Take the Risk?
Another way to look at this question is to acknowledge that, one way or another, someone is going to take a risk in financing this property: you or the lender. Reduce that risk, and you’ll lower the cost of shouldering its burden. Reduce it far enough, and the savings and flexibility involved with recourse lending may outweigh the protections of non-recourse.
How do you do that?
Multifamily investment is always going to involve a measure of risk. With careful market analysis, patient due diligence, and a willingness to learn from others’ mistakes, you can cut those risks down significantly. While my preference is to use non-recourse financing to mitigate risk further, that doesn’t mean I’m willing to rule out recourse financing in some scenarios.
So, be smart. Triple check your numbers. Stress test your deal. Structure your business properly. Carry the right insurance. Concentrate on cash flow from Day 1, and you’ll give yourself all the protection you need to feel comfortable enough in going with recourse financing.
Triple check your numbers. Structure your business. Carry the right insurance.
If you want to know more about recourse vs. non-recourse financing—or if you need help evaluating the terms of any specific loan product, come join us on Facebook. We’ve got over 20,000 multifamily investors who’d love to collaborate in order to help you reach your goals.
7 Core Questions to Guide Your Due Diligence
Due diligence is one of the most critical aspects of any real estate deal.
I don’t care how confident you are in a deal; shoddy, incomplete due diligence will invite disaster into your real estate portfolio. If you’re lucky, you’ll only leave a few thousand dollars on the table. If you’re not, you’ll saddle yourself to losing investment.
Due diligence takes time, focus, and scrupulous attention to detail. It’s easy to get bogged down in the weeds of document review. To help keep you from losing the forest for the trees, here are 7 questions to guide you through your own due diligence process.
Where’s the paper?
- 3 years of operating statements (including year-to-date)
- 6 months of bank statements
- Utility deposit register
- Utility bills for the last 2 years.
- Property tax bills for the last 2 years
- IRS Tax returns and addenda for the last 2 years
- Rent roll for the property for the last 2 years
- Security deposit register
- Payroll records
- All current lease agreements (including ad hoc concessions)
- Written property policies (pets, parking)
- Commission agreements
- Current management contract
- List of outstanding maintenance requests
- Maintenance/capital improvement history for past 3 years
- Litigation history on the property for the past 5 years
- Service contracts (pool, trash, laundry, extermination, etc.)
- HVAC repair history
- Elevator maintenance report
- Insurance policy and claims history for the past 2 years
- Operation manuals
- Business license
- Deed and Title policy
- Site plan, property survey, and architectural plans
- Inspection and Environmental Repo
When you drop in, chat with a few tenants and neighbors. Try to get their read on the neighborhood. These are the kinds of insights you’ll never get from a seller or his broker.
If you find the reality on the ground fails to live up to the picture you’ve painted in your head, then either adjust your analysis and projections accordingly or walk away.
Who can I talk to?
The seller’s not the only one you’ll want to talk to about a property. Here are a few more people you’ll want to reach out to:
- Contractors – Take a look at current service contracts and past repair receipts. Call those contractors and ask for their sense of the property. Some will have no idea what you’re talking about. Others will open up and give you a dissertation on everything you need to know about the physical condition of the property.
- Chamber of Commerce — It’s always a good idea to figure out what’s happening in the market. Contact the local Chamber to learn if there’s any new economic activity on the horizon, how demographics are shifting, and whether there are any financial incentives for investing in the area.
- City Planning Officials/Assessors – Head down to City Hall and do a little digging on the physical and economic history of the property. Does the property density confirm to zoning requirements? Have there been any code violations? What permits have been pulled? How has the assessed value changed over time? Have the owners contested the assessed value recently? What was the outcome?
- Tenants/Neighbors – Visit the property at least twice: once during the day and a second time at night. What do the vehicles look like? Do you feel safe? Talk to a few tenants about their experience. Do they enjoy living there? What would they change? Do they plan to stick around after their lease runs out?
What shape is the property in?
This question begins with the obvious details: property age, curb appeal, deferred maintenance, etc., but it doesn’t end there. Whether you do it yourself or hire a property inspector (recommended), the property’s going to need to be torn apart—inch by inch.
This part of the process is critical. Take your time and look at every single unit—not just a handful of them. Snap pictures. Record videos. Take careful notes.
Don’t be afraid to call in additional help. If the foundation looks sketchy, get a structural engineer out. If the HVAC looks old, get a qualified professional to assess it.
This might take a while, but you can’t afford to rush this part of the process.
What do I know about the neighborhood?
If you haven’t already, due diligence is a great time to get intimately acquainted with the neighborhood. Here are some essential questions to ask:
- What are the crime statistics for the area?
- How walkable is the neighborhood?
- Who are the major employers in the area?
- What sort of retail stores are nearby?
- Where is the closest grocery and pharmacy?
- How far are schools and parks from the property?
- How far away are the police and fire stations?
- Is there nearby access to public transportation?
Don’t forget to zoom out and look at the rental market data. Take this opportunity to re-run your analysis and check your projections against what the market is actually doing.
How has this property been run?
Dig through your paperwork (see #1) and talk to management about the current state of the property. This is where you can learn whether the property is underperforming or overperforming, as well as what you can do to improve its performance after closing.
- What is the current tenant mix?
- What has vacancy looked like (physical and economic) over the past 3 years?
- Is overall occupancy dropping or improving?
- How do the property’s occupancy rates compare with the neighborhood?
- Is the current management offering improvements, concessions, or incentives to get people in the property?
- Are any of the utilities included in the rent?
- How many leases will expire within the next 90 days?
- When was the last time rents were raised and by how much?
- How do rents compare with the market rates?
- Has the income been consistent every month?
- Do you see any inconsistencies in the income data?
- Does the P&L match the bank statements and tax returns?
- Do the maintenance expenses look realistic or are they low?
- How does the expense ratio compare to other multifamily properties in the area?
- How consistent have the expenses been over the past 3 years?
- What is the current NOI? Has it been trending up or down?
- What percentage of the gross income does the NOI represent?
What do the numbers say?
Speaking of projections, it’s vital that you check and re-check your numbers at the end of the due diligence process. Now that you’ve been able to flesh out current operating income and expenses as well as market rates, vacancy, growth, etc., you’re armed with much better information to draw an accurate picture of the property’s viability.
On top of that, your inspection will have given you a more comprehensive picture of repair and improvement costs. Taking those numbers into consideration, you’ll be in a better position to assess whether the terms of your current deal justify moving forward.
Often, they will not. But that’s not the end of the story.
What’s it going to take for this deal to make sense?
At the end of the due diligence process, you’re going to have the opportunity to either walk away or renegotiate. As you make that decision, ask yourself if there’s a number at which the deal would make sense to you. If so, what is that number?
This is why careful due diligence is so necessary. We’re not talking about guesswork here; we’re talking about a precise evaluation of the property as it is and the terms you’ll need to justify moving forward.
If you’ve done your homework, you’ll know how to come up with that number. More than that, you’ll have a bulletproof case to make to your reluctant seller.
It takes time to develop a consistent due diligence process that you can run through every time. But once you dial in the particulars and get absolutely methodical, you’ll have a reliable program to run through on every deal. That’s the kind of systems-building that leads to a successful long-term career in multifamily real estate.
For more on due diligence, check out my free book, How to Create Lifetime Cashflow Through Multifamily Properties. As always, if you have questions, come on over to our Facebook community. You’ll find 20,000 members there eager to share their wisdom.
Investing Outside Your Home Market? Do This First!
I once had a student come to me with a 40-unit property in Eden, North Carolina for an unheard-of $13,000 a unit. The seller claimed he was getting $650 per unit in rent, but when we looked closer, we found only 40% of the property was occupied. Red flag #1.
We decided to investigate further. As it turned out, the major employer in town had just shut its doors, the area was sliding into a depression, and 3-bedroom houses were renting for $395 a piece. Red flags #2, 3, and 4.
We could’ve made the property work, but in the end, we decided to pass.
When you purchase a commercial multifamily property, you’re investing in a future income stream. It’s not enough just to see cash flow today. You need a reasonable level of assurance that your income will grow over time or, at the very least, remain stable.
Eden offered no such assurance, so we decided to let it go.
Why Analyzing Income Growth Matters to Your Multifamily Business
Income analysis is especially critical when you start looking to buy outside your home market (what I like to call your “backyard”). When you branch out into other markets, the stakes are higher. You can’t rely on anecdotal experience or personal knowledge; you have to dig into the numbers and get to know the market on paper.
It helps to think from two angles:
1.) the property;
2.) its context.
As you analyze a property, it’s important to know the specific ways you could improve it after closing. Where can you add value? How far are your rents off of the market? As I’ve written elsewhere, there are plenty of ways to increase your net income on a property. Scout out those possibilities beforehand and factor them into your analysis of every deal.
But looking at the property isn’t enough. You need to understand its room for growth in context—i.e., its neighborhood. You’ll never be a fortune-teller, but with patient attention to the relevant data, you can forecast an area’s stability and potential for growth.
Looking at income growth from both angles will give you important insight on every potential deal. More than that, it’ll help you grow in your market knowledge for a given area. Over time, you’ll be able to check your forecasting against actual market performance and learn to judge that market’s behavior more accurately.
Better judgment = stronger deals.
Where to Find Reliable Income Data
In a moment, we’ll talk about what you need to look for when analyzing a market’s income growth potential. Before we do, here’s a list of the best sources for the data you’ll need:
Some of these sites (Costar.com, Geometrx.com) charge for their services. They may not be necessary for the early stages of your multifamily business but are definitely worth pursuing as you grow and expand into markets outside of your home territory.
What to Look For
It’s important to reiterate here that you’re not trying to tell the future. There’s a difference between reading data and reading the stars. More than your “gut sense” of a healthy market, you need a set of specific indicators to look for when evaluating the data.
That said, here are the most important questions to ask:
- What is the current population in this market/neighborhood?
- How have the population levels changed over the last 10 years?
- Has the population grown consistently over the past 5 years?
- Do you see job growth in the neighborhood?
- How have unemployed levels shifted over the past 5 years?
- What are the income demographics of the area?
- How have per capita income rates changed over the past 5 years?
- Do those changes correlate with the broader region (city, state)?
- How does per capita income compare to the area’s cost of living? Is income trying to catch up? Or has income surpassed the cost of living?
It’s important to look for the story behind the numbers. If there is job and/or income growth, what’s causing it? What’s the draw? Are jobs opening up at a new factory? Has the state university opened up an extension site nearby? Is there a new soccer stadium going in? These are the sorts of developmental events that drive growth.
When it comes to cost of living, you ideally want to see a rent-to-income ratio of 30% or less. This indicates that the area residents have room in their budget to spend more on housing. Anything higher than 30%, and the market will be less willing to reward your efforts to add value to a property and increase rent over time.
As you continue to invest in an area, revisit the economic data periodically. Look specifically for changes in the data you analyzed above. Here are more questions to ask:
- Has anything shifted significantly?
- Has the market grown or contracted?
- How does the present reality compare with your initial forecasting?
- Is the are still a good investment? Why or why not?
Again, it’s important to look for the story behind any of these changes. What’s the force behind the change? Has the new factory shut down? Has a new one gone in? Have folks decided to commute into the local university from another side of town? Has there been an uptick in crime?
You’re never going to be able to tell the future with 100% accuracy. None of us has that ability. Nevertheless, there is an abundance of data out there on every market in the U.S. If you’ll take a little bit of time to look hard, ask insightful questions, and seek out the story behind the numbers, you’ll set yourself up for plenty of future growth.
As always, if you need help learning what to look for, or if you have a specific question about the data you’re seeing, head over to our Facebook Community. We have thousands of professional investors who are eager to connect and help you succeed.
The Liability of Equity: Why Debt-Free Isn’t Always the way to Be
You hear it all the time from financial gurus. Debt, they say, is like slavery. And the best thing you can do is break free of those chains as quick as humanly possible.
For the most part, they’re right. When it comes to consumer debt (credit cards, personal loans, etc.), owing money all over town can be disastrous for your financial well-being.
But does that mean we should avoid all debt? Even someone as hard-core as Dave Ramsey would make an exception for one specific kind of debt: real estate financing.
Why? Real estate is in a class of its own. Land is the only thing they’re not making more of and, on the whole, real estate is one of the safest assets to invest in. Given the relative safety of a real estate investment, it makes sense to leverage your assets through debt.
That said, most of the guru-types who make room for real estate debt will still tell you to get debt-free as quickly as possible: double the mortgage payment; throw all your extra cash at principle; do whatever it takes to get that lender off your back. Debt is a liability, they say, and it’s better to get it off your balance sheet as soon as you possibly can.
Maybe, but let’s see how ‘debt-free’ can introduce you to a whole new level of liability.
The Danger of Owning Property Free and Clear
Imagine you’ve owned a property for about 10 years. You started out with a healthy chunk of equity, cash flow has been great, and you’ve been aggressive about paying down the loan. Today, the property is worth $450,000, and you own it free and clear.
Now, imagine one of your tenants slips on a set of broken stairs and severely injures her knee.
She’s going to need multiple surgeries, extensive physical therapy, and a few months off work. That all adds up to hundreds of thousands of dollars in costs to her.
You’ve decent insurance on the property, but you quickly learn just how fast medical bills and compensation losses can eat into a personal liability limit. Next stop: a lawsuit.
Thankfully, you’ve got the property in an LLC, so all your other assets are safe.
But what about that $450,000 in equity? It’s ripe for the picking.
Now, imagine the same scenario, but instead of owning the property outright, you’ve got it leveraged at an 80%. In other words, you’ve only got $90,000 worth of equity in the property, and the rest of that cash is leveraged against other investments.
For one thing, that makes you a much lower value target. $90,000 is nothing to sneeze at, but given the time and expense involved, your tenant may choose to forego the lawsuit altogether. Even if they do take you to court and win, that $90,000 hit won’t hurt nearly as bad as the full $450,000.
Using One Liability to Protect Against Another
The best way to protect yourself against scenarios like the one mentioned above—apart from fixing the stairs—is to structure your business appropriately.
First, that means holding each of your properties in its own LLC and meticulously keeping each one’s finances and operations separate from all the others. The last thing you want is for some lawyer to ‘pierce your corporate veil’ in court.
Next, you need a comprehensive insurance policy on each property, as well as an umbrella policy to protect you from any potential overages. Not only does this protect your assets, but it provides an added layer of protection for your tenants as well.
Note: Do not skimp on insurance.
Finally, you need to carry a healthy level of debt on the property.
The best way to protect yourself is by using non-recourse debt. Simply put, a non-recourse loan is one in which the property entirely secures the note, leaving the lender with no opportunity to come after you personally in the case of judgment or default.
Debt may read as a liability on your balance sheet. But, when used right, it’ll shield you from the much nastier liability of watching massive amounts of equity go up in smoke.
Is all debt bad? No! While much of the debt we bump into in our contemporary society is foolish, real estate financing is an entirely different animal.
In this post, we’ve looked at one narrow angle in which debt can be used as a tool to benefit and protect your business. But that’s only one aspect. In another post, I showed how you could use debt to increase returns safely and more efficiently put your money to work.
For more information on liability, business structuring, and multifamily real estate financing, check out my free book How to Create Lifetime Cashflow Through Multifamily Properties. As always, if you’ve got specific questions, join us on Facebook, where you’ll find nearly 20,000 investors eager to help you find answers.
Why House Hacking a Plex is the Best Possible Way to Start Investing
If you’re at all interested in multifamily real estate investment, then there are two words you need to learn right now: house hacking.
What does it mean to hack a house? The definition is simple: buy a residential multifamily (4 units or less) with strong cash flow numbers, live in one of the units, and rent out the rest.
New investors are discovering house hacking as the best way to get started in real estate investment. In this post, I’m going to share three big reasons why that’s the case.
Ease of Financing
One of the benefits of multifamily investing, in general, is economy of scale. One transaction gets you multiple income-producing units. As a result, per-unit acquisition costs on multifamily properties are typically much lower than single families. From a cash-on-cash perspective, that’s terrific news.
Economy of scale matters for financing, too. Especially with new investors, lenders like to see a property with multiple streams of income. They want to know you’ll have enough cash flow to keep paying the note even if a tenant disappears on you.
On top of that, lenders will typically count 75% of the income from those additional units in your favor. That added income will help you qualify for higher dollar amount than you could on a single-family property.
Scale isn’t the only thing that makes financing a house hack easier than a commercial multifamily. Thanks to FHA, residential investors can take advantage of loan products with significantly lower down payment requirements and better rates than the alternatives.
A Smarter Way to Pay for Housing
Everybody’s got to live somewhere, right? House hacking satisfies that basic human need in one of the smartest ways possible.
Consider the following scenario:
You’ve got a decision to make: buy and live in a single-family or a duplex. You’ve only got 5% to put down, so you’re going for an FHA rather than a conventional mortgage.
Let’s take the single-family first. You find a house you love for $300,000 and put 5% down on a 30-year loan at 4% interest. Assuming a tax rate of 1.5% and insurance at $2000/yr., that’d put your monthly payment at about $2,000/month. You might decide to rent out a room or two. If not, that $2,000 is entirely on you.
Now, let’s imagine you choose a duplex instead at the same price point, down payment, and loan terms. Let’s put the rent at $1,250 (about the national average for a 2-bedroom). Congratulations. You’ve effectively lowered your monthly housing obligation to $750. Not bad.
Take that scenario a step further and imagine you went with a triplex instead of the duplex. Assuming the units you choose to rent are both 2-bedrooms, that puts your monthly gross income at $2,500. Now you’ve got a $500 surplus at the end of the month to plow into expenses, capital improvements, and so on.
This isn’t pie in the sky math. This is how house hacking works.
Of course, you’re going to have to trade off some things in the process—a bedroom or two, yard space, parking, etc. But this is just the beginning of your investment journey, not the end. Just a few years in a hacked plex will prepare you to move into the single-family of your dreams soon enough.
Learn on the Job
“Passive income” is a paradox. It doesn’t just happen; it takes years of hard work to establish a portfolio and a system that’ll put real money in your bank account every month without you having to handle the day-to-day.
One of the hardest parts of that early journey is learning to manage property. Nobody’s born with a filled-out property management toolkit. It takes time to build up the business sense and emotional intelligence needed to handle people and properties well.
The question is: where are you going to get that experience?
House hacking answers that question in the least intimidating way possible. When you hack a plex, you become your property’s on-site manager. From a tactical standpoint, that puts everything within arm’s reach. It’s much easier to manage a property from next door than from the next state over.
From an experiential standpoint, you get hands-on experience as a landlord: marketing property, showing units, screening tenants, writing leases, collecting rent, and fielding maintenance calls. You’ll outsource these things soon enough, but it’s always better that you understand these basic mechanics before you hand them off to someone else.
There’s no better way to learn this business than to immerse yourself in it. House hacking literally accomplishes just that. If you want to build a massive commercial portfolio someday, then that’s fantastic. I’m here to help you do just that.
But you’ve got to start somewhere. So, check out our Facebook page, grab a few of our free resources, and then let’s get to work on hacking your first plex.
Mind over Mechanics: Why Real Estate Investors Need More than Skill
The mechanics of multifamily real estate investment are easy to grasp.
Funding, analysis, negotiation, due diligence, property management—these are skills that anybody can learn. All you need is a couple of books, a coach/mentor, and the willingness to get your hands dirty.
But, if that’s true, then why isn’t everybody a millionaire real estate investor? Why do so many would-be investors flame out before they even get their business off the ground?
The answer to that question lies in one place: mindset.
You can learn the mechanics of this business all you want, but without a mindset that says, “I can do this,” you’ll never put those mechanics to use.
What we’re talking about is a psychology of success and the basic idea behind it is this: mechanics follow mindset. The way we think about our world determines how we interact with it. If we adopt a defeatist mentality that says we can’t, then we never will. If we assume a positive mindset that says we can, then anything is possible.
It’s just like Henry Ford said, “Whether you think you can or whether you think you can’t, you’re right.”
Here are two ways to put that psychological insight to work in your real estate business:
Seeing is Being – Visualize Your Success to Make it a Reality
When I first got into real estate, I drove an ugly old Ford Granada. I was so eager to get out of that thing that I taped a photo of a red Corvette to the driver’s side visor. Every time I got in the car, I’d look at that photo and dream about the day it’d be mine.
Guess what? It worked! Eventually, I had my red Corvette. Since then, I’ve used visualization to grow my business and build my dream home in Sarasota.
What I was doing with that photo was something called visualization. It works off of the law of attraction—a principle that says our thoughts shape our reality.
I’m not the only one to succeed this way.
In 1985, a struggling Jim Carrey wrote himself a check for $10 million and dated it for Thanksgiving in 1995. Ten years later, Carrey landed his part in Dumb and Dumber.
As I’ve seen in my own life, visualization can be an incredibly powerful tool in building a successful investment business. Here are just a few examples of scenes to visualize:
- Closing on a 100-unit Class A Apartment Building
- Quitting Your Day Job
- Sitting on a Beach, Watching Passive Income hit Your Bank Account
The best way to make visualization a practical part of your life is to develop a vision board. These boards are easy to make. Just grab a collection of photos that represent your vision, post them on a corkboard, and put it where you can see it every day.
The Power of Goal Setting
There’s a Hebrew proverb that says, “Where there is no vision, the people perish.” That’s exactly right, but so is it’s complement: where there is no action, that vision fades.
You can visualize all day long, but if you don’t put your vision to work, you’re not going to actualize what you’ve seen in your mind’s eye.
This is where goal setting comes in.
The vast majority of people you meet are drifting through life. They have a sense of what they’d like to accomplish, but they’ve never taken the time to put it into writing.
If you want to succeed in real estate, you need to devote serious time and attention to your goals-setting. Think short-, medium-, and long-term. Write down what Jim Collins would call “Big Hairy Audacious Goals.” Break them down into manageable segments.
For short-term tactical goals, follow the SMART acronym:
Here’s an example of a great SMART goal for a multifamily investor:
Analyze 50 properties that meet my investment criteria in the next 50 days.
How does that goal match up with the SMART acronym?
Specific: You’ve got 50 properties to look at.
Measurable: It’s pretty easy to know whether you’ve analyzed a property or not.
Achievable: All you’ll need is an hour a day.
Relevant: Analyzing properties is a great way to uncover deals.
Time-Indexed: You’ve got 50 days.
Psychologically, the benefit to goal-setting is huge. It takes your vision out of the sky and plants it firmly on the ground. It gives you a concrete plan of attack for moving forward towards success. It also gives you something to which you can hold yourself accountable.
These are the most basic elements of building a business: get your mind right, craft a vision of success, and chart a path to get there. As basic as they are, though, very few investors will invest this kind of intentionality into their business.
Don’t be like everyone else. Tap into the psychology of success through visualization and goal-setting, and you’ll be well on your way to the real estate business of your dreams.
If you need help figuring out what that looks like, check out the Driving Force episodes on my podcast, Lifetime CashFlow through Real Estate Investing. There, I talk more about motivation, mindset, and the psychology of successful real estate investment.
The 10 Biggest Mistakes New Multifamily Investors Make
Zig Ziglar once said, “Some of us learn from other people’s mistakes, and the rest of us have to be other people.” The wisdom there is simple, yet profound: you don’t have to repeat other people’s mistakes. In fact, you’d be crazy to.
In my 40 years as a real estate investor, educator and coach, I’ve seen just about every mistake you can make in this business. I’ve even made a few of them myself.
In this post, I want to share 10 of the biggest mistakes I see new multifamily investors make over and over again:
Going it Alone
Multifamily investing is a team sport. To find properties, you need brokers. To finance deals, you need lenders.
To navigate contracts and closing documents, you need attorneys. To avoid mistakes, you need mentors. If you try to tackle any (or all) of it on your own, it could cost you dearly.
Waiting to Raise Money
New investors often make the mistake of finding the deal before the funds. By the time they line up their cash and/or financing, the contract’s up or the property’s gone. Save yourself the heartbreak; line up partners and lenders before you go looking for a property.
Moving Too Slow
Nervous investors wait too long to pull the trigger on a deal. Either they’re afraid to make a mistake, or they’re not sure what they’re looking for. Successful investors avoid both mental blocks by honing their search criteria and disciplining themselves to act on opportunities as soon as they present themselves.
Moving Too Fast
Other investors make the opposite mistake. Instead of moving too slow, they rush through the deal—cutting corners, skipping due diligence, and making mistakes that end up costing them tens of thousands. In contrast, veteran investors learn to operate with cheetah speed: fast, not foolish.
Buying the Wrong Property
Some new investors get into the business with a clear desire for success, but a muddy vision for how to get there. They want to buy properties, but they have no idea which ones. So, they grab at the first “good deal” that strikes their eye but end up with a property they can’t handle. To succeed in this business, you need to know what you’re looking for before you start searching. Otherwise, you’ll have no way of knowing a good deal from a bad one.
Trying to Predict the Future
To win in multifamily investing, you have to check your single-family mentality at the door. Multifamilies are about income, not appreciation. When single-family-minded investors start looking to buy low and sell high, they completely upend everything that’s good, true, and beautiful about multi-family investing.
Gambling on Cash Flow
Buying a property with negative cash flow is risky. Even if you’ve got the operating capital to sustain your debt service, things can flip upside down in a hurry—especially, if you’re new to the business. Beginners, be warned: don’t bet on future cash flow.
Ignoring the Law
Every state and municipality has its own particular set of laws governing relationships between landlords and their tenants. New multifamily investors can get themselves in trouble when they inadvertently break laws they never took the time to understand. You can’t plead ignorance in court, especially when there are plenty of resources out there to help you get up to speed.
Hiring the Wrong Property Manager
I know from personal experience that even a veteran investor can slip up and hire the wrong manager. I survived, but new investors aren’t often so lucky. Take the time to properly vet a property manager before you give them your business.
Not Reading Leases
Rookie investors often make the mistake of taking on existing leases without reading them over. They just assume that, if it worked for the previous owner, it’ll work for them. Nothing could be further from the truth. Take the time to look over every existing lease agreement with your attorney and/or property manager. Skip this step and you might inherit terms and concessions that cost you your profit and your sanity.
Those are the 10 biggest mistakes I’ve seen. I haven’t shared them as a way to scare you off from multifamily investment. Instead, I want to help you learn from others who’ve gone before you. Bad experiences are master teachers; even better when they’re not our own.
The good news: each one of these mistakes is 100% avoidable if you’re willing to take your time, learn the business, and surround yourself with people who can help.