Chapter 7: Apartments
Let’s switch gears and look as some multiple unit deals. Other than single-family residences, most people live in apartments. These can be duplexes on up to multi-hundred unit apartment complexes. Regardless of the size, once you get past single family, you’re into income property. First we need to examine how these properties are valued.
Back in Chapter 1 where we discussed “Getting Started,” we learned how to evaluate an income stream and then capitalize that income stream to determine the market value of the real estate. First, this is just one of the methods you should use to determine the value of the property; albeit the most important method. To review, we never buy an income property for less than a ten-percent (10%) triple-net return. We arrived at the triple net, as follows:
Total Rental Income: As though the property was 100% occupied, plus
Other Income: Such as from an on-premise laundry facility, equals
SGI: Scheduled Gross Income as though 100% occupied minus
Fixed expenses Taxes, utilities, insurance, maintenance, management, vacancy factor allowance equals
NOI Net Operating Income
When we have determined a realistic NOI, we then multiply that number by “10” to determine the maximum we will pay for a given property. What this tells us is that the renters will pay us sufficient rental income such that after all normal operating expenses have been paid, in ten (10) years, we will also have been repaid the entire original cost of the property itself. If we have financed the purchase of this property, part of the NOI will be used to make the mortgage payments and still leave In-Pocket-Net-Spendable income for us. Yet the tenant’s rent completely amortizes our mortgage loan in addition to providing this spendable income. I further suggested that even greater returns are possible thus reducing the time frame in which the rental income completely repays the entire original cost of the property.
The numerical example we used assumed we had a $15,000 SGI from a building whose fixed costs totaled $5000 thus leaving $10,000 as the NOI. We then multiplied the $10,000 NOI by ten (10) to arrive at the $100,000 market value of this property. This concept will become extremely important as we investigate how to increase the value of an apartment complex.
A second, less accurate method of determining the value of an income property is called the Gross Multiplier (GM) method. When you first become aware that a property is available for sale, many times you do not have access to the specific details of the fixed expenses such as the taxes, insurance, utilities, etc. You can still get a reasonable estimate of the market value of the property using the GM, as follows:
Frequently the classified ad will state the asking price and the SGI. Since we know we must reduce the SGI by the fixed operating expenses, we can assume an average expense ratio or percentage. Many times, the classified ad will state “7 times Gross” meaning you would multiply the SGI by seven (7) to determine the asking price. The presumption is that the overhead of fixed operating costs represent 30% of the SGI. This may- or may not be an accurate assumption. I’ve seen more efficient and less efficient properties so this is just a guesstimate. Nothing replaces the actual calculation of the NOI using actual, verified costs, but it is a quick screening technique to determine if the property is reasonably priced or outlandishly priced. So the numbers would look like this:
Asking Price: $100,000 (provided in ad)
SGI: $14,285.71 per year (calculated from ad numbers)
Gross Multiplier 7.0 (provided in ad)
Inferred operating expenses: 30% or $4,285.71 per year
We calculated these numbers as follows:
$100,000 divided by 7.0 = $14,285.71
At 10% triple net or $10,000 NOI, $14,285.71 – $10,000 = $4285.71
Recall our example used $15,000 SGI and calculated $5000 as fixed operating expenses, to determine a $100,000 market value. It this case, the Gross Multiplier would be 6.67 instead of the above 7.0. Here’s how we would arrive at those numbers:
$100,000 Advertised asking price
$15,000 Advertised SGI
$5,000 Verified operating expenses (33% operating expense ratio)
$5000 divided by $15,000 = 0.33333 or 33% operating expense ratio
$100,000 divided by $15,000 = 6.66666 = 6.67 Gross Multiplier
The sole value of a GM is to get a quick estimate of probable market value.
The third way to determine the value of an income property is to determine the actual replacement cost. Essentially, this method starts with the actual cost of the land plus the per square foot cost to build new. Then the new cost is discounted to allow for age and depreciation. Without exception, you will never purchase an income property if the replacement cost is less than the purchase price. If this were true, you’d just go find a suitable lot and build a new building. Otherwise, you’d be overpaying for the real estate itself. Rather, you calculate (and/or get an appraisal) to determine the replacement cost and then make sure that this number is significantly larger than the NOI evaluation method. Then you buy on the basis of the NOI valuation based on your minimum acceptable net return requirement.
Let’s look at several examples. My second income property was a 4-unit building in Long Beach, CA in 1960. Each unit was 1-bedroom, 1-bath, living room and separate dining room and full kitchen, 1100 sq ft with two units at ground level and the other two as second-floor, walk-up units. Three units were unfurnished and one was furnished. The building was built by the owner and his father in 1932 and had survived the Long Beach earthquake of 1934. No electrical or plumbing upgrades had been incorporated. The tub-wash basin were combined. The washbasin sat on top of the tub at the drain end of the tub. The tub was the old fashioned type on four legs. The washbasin faucet had a handle on top of the spout. If the handle was facing one direction, the water flowed into the washbasin. If the handle was turned 180 degrees, the water filled the tub. Both the washbasin and the tub drained through a common drain line. I’d never seen anything like it before or since. Kind of makes me wish I’d saved one set as an antique. There was no shower, per se, but you could attach a flexible hose to the spout end that filled the tub and use it as a hand-held shower.
The units all had hardwood floors. In the upstairs units, the closets over the stairwells contained Murphy beds. If you’re not familiar with that name, these beds folded-up vertically to make space during the daytime. The living rooms had elaborate crown moldings around the ceilings and wide door moldings with crowns on top. All units had large picture windows in front with French windows on each side, but both were comprised of small panes of glass in wood frames. There were 3 individually enclosed garages with alley access and the lot size was 50 feet by 150 feet.
One unit was rented for $50 per month. Two units were rented at $55 per month and the furnished unit was rented at $65 per month. Two of the garages we rented for $10 each per month. As such, the SGI was $2940 per year. The asking price was $22,000 and the owner would carry back a first trust deed at 6% for 30 years. I offered $20,000 with $1000 down and my offer was accepted.
$20,000 Purchase Price ($5000 per rental unit not including garages)
- 1,000 Down payment (5% of the purchase price)
$19,000 Financed by seller at 6% interest for 30 years; $113.91/month PI
Using our evaluation formulas, I paid $5000 per unit (excluding the garages) but it would have cost $9500 per unit to replace with new construction. Yes, I know that’s only $8.64 per square foot ($9500 divided by 1100 sq ft), but remember this was in 1960 prices. With a SGI of $2940 per year, my GM was 6.80 ($20,000 divided by $2940). That means I had a 32.0% allowance for fixed costs not including mortgage payments (10 minus 6.80 = 3.20 or 32.0%). I obtained access to the prior owner’s operating costs, too, and was able to verify that from the start, I had achieved slightly better than a 10% triple net return. So far, so good.
$2940.00 Scheduled Gross Income (SGI)
- 840.00 Operating expenses (taxes, insurance, util., maintenance, etc.)
$2100.00 Net-net-net income after expenses at a 10+% triple net return
(In-pocket net spendable from which to pay mortgage)
-1366.92 Annualized $113.91 mortgage payments (P+I)
$ 733.08 Discretionary positive income after all expenses have been paid
Now comes the fun part and the reason multiple units are so widely embraced by knowledgeable investors. My plan was to modernize the units and raise the rents thereby increasing the total property value. Here’s how it works. I plan to spend money improving the units which would then enable me to raise the rents which would then increase the NOI which would then increase the property value to the next owner while still maintaining a 10% triple net return for the new owner.
Briefly, I removed all the crown moldings and replaced the wide door moldings with the narrow wedge modern moldings. I covered the 5-panel doors with door skins to make them appear modern (yes, the 5-panel doors are now back in vogue along with the wide door moldings and crown molding). I took out the tub-washbasin combinations and installed then-modern tub-showers with separate Pullman washbasins. I removed the old-fashioned front window glass and replaced with used, solid plate glass for a more modern appearance. I replaced all the light fixtures with modern, up-to-date units along with new wall switches and wall outlets. I re-stuccoed the outside and then put flagstone and redwood board-on-board trim on the building front to help modernize the appearance and improve the curb appeal. I planted attractive bushes and flowers to improve the eye appeal. All four units were completely repainted. The hardwood floors were sanded and refinished. I spent a total of $2500 on these improvements.
For my efforts, I was able to raise the rents. I then had 3 units at $80 per month and the furnished unit rented for $95 per month. I raised the garage rents to $15 monthly. The new SGI was now $4380 compared with $2940 when purchased. The increase was $1440 per year of NOI. Maintaining the 10% triple net return ratio, the rent increases just increased the property value by $14,400 (ten times $1440) for a $2500 fix-up expenditure. The reason the NOI increased dollar-for-dollar is that no additional operating expenses were incurred to create this additional income. In fact, the existing operating costs for maintenance were dramatically reduced because all of the previously deferred maintenance had now been completed. I had what amounted to a newly updated building similar to what we did with the tax lien house in Chapter 5. This is not new math. It is the multiplier effect that is facilitated by being able to increase rents. Be sure you understand the importance of what you just read. I only increased the rental income by $1440 after spending $2500 to be able to do so. That means I spent $1.74 in order to only increase the rent by $1.00 ($2500 divided by $1440). Yet because of the NOI multiplier, I increased the value by over $14,000. Stated another way, you can afford to spend $2 or even $3 just to raise the rent by $1 and still make a tidy profit. I then used these results to aggressively price the property at $37,500 and advertised if for sale or for trade.
$4380 New SGI
- 2940 Initial SGI at time of purchase
$1440 Increase in SGI due to rent increases
x 10 Multiplication factor for a 10% triple net return
$14,400 Increase in actual resale value of the property
$4380 New SGI
- 630 New Fixed expenses (reduced from $840 due to improvements)
$3750 New Net-net-net income after remodel
x 10 Multiplication factor for a 10% triple net return
$37,500 New Market Value of the property after remodel
A builder/developer answered my ad and we ultimately agreed to exchange my 4-unit building for his brand new 14-unit building. This occurred long before the IRS codified the 1031 tax-deferred exchange program (yet to be described). Tax laws were much simpler in those days. The builder accepted my equity as the down payment and I then qualified for the existing mortgage loan on the 14 unit building. Of course I verified that I was buying the 14-unit at a 10% triple net before we completed the exchange. As an aside, when you are trading up, you can negotiate a better price for your property than you will be paying for the larger property. Owners trading down are more interested in reducing their real estate holdings than strictly adhering to any specific triple net return formula.
As part of our exchange agreement, the builder agreed to build the mirror image of an identical 14-unit building on the adjacent lot so that I would have a 28-unit complex when finished complete with a common courtyard and swimming pool. So far, it is all sounding pretty good, isn’t it?
Remember I noted earlier that if nothing can go wrong, it will go wrong and at the worst possible time? Bingo! No sooner had I completed the 28-unit complex than the City of Long Beach passed a new off-street parking ordinance. They virtually doubled the off-street parking required for new construction. However, they announced this new policy in October but the new requirement would not become effective until February of the following year. Can you guess what happened? Every multi-family zoned property in the city that just had an old California bungalow on it was immediately put under construction. The old house was scraped and a new 5-unit spec building built in its place. The construction boom occurred in order to beat the new off-street parking requirement. After the new requirement became effective, the same lots would only accommodate 2 or 3 units instead of the current 5-units. Because they were spec buildings and because they were all started and completed at the same time, virtually thousands of vacant apartment rentals came on the market at the same time. My units were upscale quality and now I had to compete with spec quality units for a limited number of potential tenants. It was a tough time in that rental market.
I tell you this because it substantiates why it is so important to demand a minimum of a 10% triple net return. With a positive 10% or greater cash flow at the onset, you have some wiggle room when the going gets tough. Yes, I had to limit my rents to a lower schedule than the units would normally bring, but because I had a positive cash flow, I was still able to survive the couple of years upheaval created by the sudden building boom. What happened is that I did not make as much profit as I expected considering the size of the project.
I was anxious to continue my accumulation program so I offered the 28-unit complex for sale. What I accepted was an offer for some cash, for a brand new 5-bedroom, 3-bath, 3500 sq. ft. house on 2 acres, and for a 2nd trust deed (note). I accepted because I figured I could easily sell the house and use the trust deed as a down payment on still another apartment building. I did, in fact, use the trust deed at face value (no discount) alone as the down payment on still another 12-unit apartment building. We decided we liked the 5-bedroom house and moved-in while renting-out the home in which we had been living. Our new home was on 2 acres and included 110 avocado trees that were completely irrigated. We stayed for a couple of years and then sold the house for double what we had originally agreed the valuation to be when we accepted it as part of the payment for the 28-unit complex. You may be interested to know that this property is valued at almost $2 million today because it is located in a very desirable neighborhood in Orange County, CA. While you’re masterminding your real estate empire, remember it’s okay to enjoy some of your acquisitions along the way. You may very well find the home of your dreams while you’re looking for investment possibilities, and you’ll most likely be able to purchase that home on very favorable terms.
One of our grown sons has become active in real estate investing in the Houston area. He was able to buy a 7-unit complex in the shadow of downtown Houston in what has now become a redevelopment area for $1million condos. His property is situated such that there are city streets on three sides of his property. Furthermore, there was a vacant lot at one end of the property when he bought the complex. Later, as the developers continued to buy-up old properties, a 4-unit building two blocks away became available to be moved off the property. For the cost of moving this old building two blocks ($3500) and then the renovation cost to rehab the structure, he now has 11 units continuing positive cash flow after all expenses. All he is currently doing is land-banking his property while the property gives him a positive in-pocket net spendable. Some builder will come along and pay him $1million just for the land. In the meantime, he can afford to wait because the property generates an excellent positive return. There is no limit as to what you can do with rental properties if you buy them correctly.
NOTE: Stay tuned for Part 8 Commercial & Industrial