I’m looking at a FSBO building that includes six residential apartments and one commercial/retail space. What do you all think? Here are the numbers:
Gross rental income: $48,780
Neat operating income: $23,330-see below for what’s included in my NOI.
What should be my purchase/offer range, and how should I initiate the negotiations? Specifically, this property is not officially on the market but the owner, whom I know, is moving across the country soon and will sell to me. He wants me to make an offer. In his own words he would like to get out and is motivated, but doesn’t need to sell. The building is in very good condition with no updates needed in the foreseeable future, and is in a solid rent area. This would be my first commercial building purchase. I am thinking a max purchase price of $210,000. This would give me a cap rate of 9.68%, and a 12.74% first year return on $55,000 cash investment.
Expenses include:
Vacancy: estimated by me at 5%
Management: estimated by me at 4% annually (although I will me managing it)
Repairs: estimated by me at 8% annually
Heat: $12,250 (new boiler but an old building in a cooler climate)
Insurance: $2,600
Electric: $1,800
Water: $800
Trash: $600
Advertising: estimated by me at $200
ChickenSpears: Thanks for the reply. According to my calculations my monthly cash flow would be $584 - not exactly the deal of the century!
javipa: Thank you. If I use 10% for each management and maintenance estimates, I would need to purchase at around $175,000 to get a 12% return on the initial cash. How do you feel about that scenario?
There’s more than one way to make money on a real estate investment. We can capture equity at the time of purchase, force appreciation and capture potential equity, or we can capture cash flow, or we can capture equity, realize potential equity, and cash flow both.
It depends. The less leverage we use, the more cash flow, and the lower the return on cash invested. The opposite of that is also true. More leverage, less cash flow, and higher returns.
So, 12% gross return, to us, sucks drain water. If it was a 12% net return after expenses and taxes we would call it good.
The issue is we can’t usually get the uber returns on our money and time, if we’re buying performing properties. Anybody can buy a performing property and park their money and make a modest return. But to make the big bucks it takes a different approach and a different focus.
On the property in question, the only value play here (that you’ve revealed) is reducing the heating bill. Perhaps, back-billing the tenants for this might be a right move, if not installing insulated windows, insulating the attic/crawl spaces, sealing cracks, etc.
We think the best way to begin recovering this money is to introduce a flat-rate billing for heat/hot water to our new tenants. Next we consider introducing a flat-rate, back billing to our existing tenants.
We want to go slower with our existing tenants by easing in these costs. After all, they rented from us with the understanding that these costs were included in the rents, and we don’t want a mass exodus, because we misjudged the market.
There’s a couple ways to approach the existing tenants with this increased cost. Before we do anything, we need to know the market rents. Are other landlords including utilities for similar rents? Let’s say that other landlords ARE including utilities, but the rents are $60 to $80 more per month. At first blush we might think that we can only charge another $80 dollars for utilities. Maybe. Maybe not.
Of course nothing’s this simple. But at least we have some idea of limit.
So, assuming $80/u is the market limit we can charge our existing tenants and reduce our overhead by, we send a notice to our existing tenants that reads in part, “We will no longer be providing 100% free utilities.”
Of course nobody expects to get things for free, do they (don’t answer that), so the “100% free” part is the operative term to include in this message. And it implies that some part, or all, of that 100% is going “bye bye.” Of course, the next question that comes to the tenant’s mind is how much this will cost him.
Now, we’re framing this extra expense to us, as us providing a freebie to the tenants. So, naturally all freebies come to an end. And this is how this freebie is going to end:
We send a notice to all the existing tenants of a change in the lease terms. The terms take effect in 90 days (not tomorrow).
Then we share the actual costs of the utilities as being $145/mo per unit (it might be effective showing a summary of the utility bills for the year).
Then we share the good news, that we’re discounting 50% of the tenant’s utility bill, “because they are such good customers.” Now we’ve framed the change in terms as, “the tenant is getting a generous 50% discount on his utilities,” not just getting reamed for half of them…
Then we itemize the new, flat-rate bill as "hot water and heat for $145.00 with an $80.00 discount for “on time payments.” We want to provide an incentive to pay within a certain time.
Meantime, we ease in the billing over three month’s time, so that the tenants can adjust to the change, and/or check the market to realize they’ve still got a deal going. Or remind themselves they can’t get utilities in their own name anyway, so they’ve got no choice but to pay the new bill.
FWIW
I kind of rushed through this, so if it makes any sense, it’s a miracle.
Thank you for the information. Was a Good read. Looking for more information.Nice article! You definitely did a good job of explaining this issue really clearly. I’m anxious to read some of your other posts.
javipa: Thanks again for the input. Most apartments rent hear with heat included. Assuming ‘heat included’, what do you think is a good offer range?
Summary:
Gross income: $48,780
All expenses (with your recommended 10% management and 10% maintenance costs), including finance costs, but excluding income tax: $29,718
Gross rental income: $48,780
Neat operating income: $23,330 -see below for what’s included in my NOI.
I am thinking a max purchase price of $210,000. This would give me a cap rate of 9.68%, and a 12.74% first year return on $55,000 cash investment.
Expenses include:
$ 2439 Vacancy (5% of GSI)
$ 4878 Management: estimated by me at 4% annually (although I will me managing it) (10% of GSI)
$ 4878 Repairs: estimated by me at 8% annually (10% of GSI)
$12250 Heat (new boiler but an old building in a cooler climate) (25.1%) of
Income Tax and Finance Costs are figured after the NOI, not before.
Here’s what I get, using your numbers, and adjusting for the MGT/MNT.
[s]Not bad looking, but I don’t know your market. Is an 11.1% CAP good enough for your area and your goals?
Since this building was built during the Kennedy administration (or earlier), your maintenance costs are NOT going to be 10% of the GSI. Just saying. If you’ve got a flat roof, this is going to cost you an extra $1,000 a year to maintain. If you’ve got galvanized plumbing …you’re screwed.
A GSI of $48780 equals $580/mo per unit.
An 11.1% CAP brings the unit cost to $30,000.
I’ve seen worse deals. If you reduce the NOI by $1,000 to cover the roof, the CAP becomes 10.6. If you have any hiccups with this building, such as broken window a/c’s a major leak, requiring an insurance claim, or a parking lot that needs resurfacing (which at this age is likely), the CAP is likely to drop a couple of points.
I think the $150,00 price offer is more wise, because the NOI in real life is going to be less than $20,000. Even at $20,000, the CAP drops from 11.1 to 9.5%. And that’s not a lot of extra expenses we’re talking about.
I like 13-15% CAP on old buggers like this. The issue is that smaller buildings usually sell at higher CAPS because there’s less to them, and more people can get their minds around a project this small. If you focus on what every Tom, Dick and Harry can easily buy, you’ll pay more.
FWIW.
P.S. Don’t put too much weight on my opinion of value, because frankly I’m not excited about this size property, and it probably comes out in my writing.
These cheap properties are risky (I don’t mean a catastrophic type of risky), because they are much more vulnerable to financial hiccups than are larger projects. The actual profit in dollars on this project are small, and so the actual hiccups make a big impact on the bottom line.
Be sure to check the correction I made to the earlier post about your deal. I forgot to include taxes (estimate). I outlined all the expenses and came up with an NOI of just over $16,000.
This changes the results dramatically.
At a 12 cap, the price you need is $135,000. :banghead
hey Javipa, it seems like you have a lot of experience managing rentals, multiplex.
My long term goal is to own at least a couple rental properties. Since you love to write feedbacks, and they are so great, why don’t you write a book “how to evaluate/manage a rental property”?
By the time I reach my goal your book should be ready and I will be sure to buy it!
Always verify with a local real estate lawyer that you can change existing residential lease terms in your area. You could not do this in my area.
Also, get more info on the insurance policy and talk to an insurance broker. If it’s an old building, it may have old wiring or other issues that may lead to the insurance costs doubling or even tripling the following year because most insurance companies will not underwrite new policies on old buildings leaving you at the mercy and whims of the existing insurance carrier.
Dave,you brought up good points about insurance and a real estate attorney. In our business it is essential to know who to go to for this information.
There is a fine line between making money on investments and foreclosures, and losing money. It could just be as said, old wiring or the wrong kind of electric that will not pass an inspection.
In many areas of Florida you have to have an occupancy permit before you can have somebody move in. All must be in good shape to get this permit.
You have to do your homework and network what you do not know.
