There is no shortage of opportunity. There is only a shortage of those who will apply themselves to the basics that success requires.Jim Rohn, American Entrepreneur
Sorry for the delay in this getting out there and thank you for your patience! We thought we had set this up to automatically post and had some technical difficulty. But! Without further ado, let’s jump into this.
So far, you’ve heard about our property at Glenville Circle and you’ve had a general overview about my path into real estate investing. In the fall months of 2018, I dug deep and devoured literature about tax strategies, rental income, property management and more. Finally, around the beginning of December, I was ready to pull the trigger; I was ready to buy my first investment property…which you will hear about in the next post. Before I jump into the story of South Street, I want to tell you about how to underwrite, or “run the numbers”, because they say “numbers don’t lie”. I promise we will get to the absolute ridiculousness of our rental properties, but I first want to set you up with the tools for success.
The Three Immutable Laws of Real Estate Investing
Regardless of your particular investing strategy, Joe Fairless, author of the Best Ever Apartment Syndication book and host of the only daily running real estate investing podcast, Best Real Estate Investing Advice Ever, offers these three Immutable Laws of Real Estate Investing:
- Buy for cashflow, not appreciation. That’s called speculation and it got a lot of investors in trouble in 2007-2008.
- Secure Long-Term Debt. If your business plan only runs 3-5 years, you should get a loan term that at least covers 5 years. Sometimes a bridge loan or a hard money loan is the way to go—like for a BRRR, for example—but be sure to have loan extensions or a way to refinance when the term length expires.
- Provide adequate cash reserves. In previous posts about Glenville Circle and future ones about Carver Circle, you’ll see I didn’t anticipate the amount of cash reserves I would need to cover the inevitable maintenance issues or capital expenditure repair. Inadequate cash reserve can eat into cashflow or completely destroy months or even a year of cashflow. Expect the unexpected.
With these three rules in mind and Melanie McDaniel (my real estate agent) by my side, I began the search. “Running numbers” or underwriting real estate deals was something I was not familiar with but coming from an engineering background, I was ready for task. Underwriting, from the perspective of a real estate investor, means analyzing an asset based on the available financial information and market comparisons to determine an appropriate value. For smaller single-family rentals (SFR) or multifamily homes (MFH), this consists of two general categories: income/price and expenses.
You Make Your Money When You Buy
Determining a properties’ current income is easy; determining the potential income however, requires a deliberate approach. Some examples for evaluating potential rent for your property, if you are buy and hold:
- Look at “comps” in the area and comparing them to your asset in terms of quality, location and price. For example, if I’m looking into buying a multi-family property that primarily comprises two beds and one bath, I want to see what similar properties are going for.
- Evaluate current rents in the area to determine your potential income from the asset in question. I like to use sites like Apartments.com, Rentometer, and Trulia. They are user-friendly, provide pictures, and are able to give you an idea of the quality of the property you are looking at.
- Walk the property and the units and determine what additions could garner premium rents.
- Kitchens—think new appliances, granite counter tops (if it is worth it in the area), matching stainless steel, upgraded cabinets (think of just refinishing the ones already there for a more budget-friendly option), etc.
- Bathrooms—matching fixtures (i.e. nickel, oil-rubbed bronze, brass, etc.), replacing laminate with luxury vinyl plank (LVP) or tiling
- Flooring—are the carpets stained and threadbare or is there cheap vinyl throughout the unit? Consider LVP, or new carpet. Look out for seasonal sales on flooring and other upgrades around Memorial Day and Labor Day if your timeline allows.
Once you have an understanding of the rents in the area, you can ascertain what price makes the numbers work. For larger multifamily deals, this is all based on current net operating income (NOI) and cap rate, which I will cover in a later post. For smaller SFRs or MFHs, price is practically driven by comps in the neighborhood. Questions you can ask yourself: Has this property been renovated more recently? Are the kitchens or bathrooms modern? Is the flooring of good quality material and newer? How many bedrooms does is have compared to mine? With questions like this in mind, is your property of higher or lower quality and therefore worth more or less?
Most of the properties I evaluate have a “value-add” aspect to them, in that they are not operating at max rent potential due to quality of the units, type of tenant, location or simply because the owner didn’t raise rents. These value-add assets are typically older properties that may need a large capital expenditure budget to turn them around. Capital expenditure (CAPEX) items are big-ticket items that are semi-permanent portions of the property that have a lifetime expectancy: roof, parking lot, HVAC, foundation and water heaters to name a few. Newer homes need less money put towards CAPEX and older homes need more. I typically underwrite for 5-10% of income towards CAPEX and 5-10% for normal repair and maintenance issues (replacing toilet flaps or house calls by an electrician).
When running my numbers on expenses for SFR or smaller MFH—apartment buildings are different—I look at 4 main costs: 1. CAPEX (covered), 2. Repairs and Maintenance (covered), 3. Vacancy and 4. Property Management. Let’s look at these last two.
Vacancy rates can vary based on location but are important nonetheless. Vacancy is the amount of time or number of units vacant at any given time. This may not seem like a big deal but vacancy can be a huge expenditure in terms of lost potential income, especially in Class C-D neighborhoods. I account for 10% vacancy in my deals, just to be conservative. I would rather put aside the money now to support continuous cashflow than draw higher cashflow (or more for my investors) and hope for the best. You will have vacancies; it is only a matter of when. Another way to mitigate vacancy is to buy a property with more units. For example, a single vacancy in a SFR is 100% vacant but a single vacancy in a 100 unit apartment complex is 1% vacancy.
Finally, property management is the last big and most important expense. Management fees can vary from area to area and on the number of units but generally you will see 8-10% for SFR or smaller MFHs. This fee covers most of the expenses a property management (PM) company incurs during the management of your asset: tenant screening, rent collection, periodic inspections and more. Although this management fee will normally be all you pay, be cautious of PM companies that have fees hidden elsewhere: eviction fees, leasing fees, lease renewal fees, handyman fees, and court fees just to name a few. Just as a property management company can make or break your business plan, their fee structure can bankrupt your cashflow. Full-service PM companies should be just that: full service—from screening to eviction (if it comes to that). They should have your back and everything handled with minimal effort on your part.
To sum up expenses, 1. CAPEX (5-10%), 2. Repairs and Maintenance (5-10%), 3. Vacancy (10%) and 4. property management (10%) for a total of 30-40% of income. These are not all the expenses you will need to account for however. The mortgage, insurance, and taxes still need to be paid and if you decide to pay for utilities, those as well.
Thanks for reading through the technical jargon! I promise time we will finally start delving into the excitement of South Street, shortly followed by the long-awaited “What’s Up with Carver” chronicles.