When Do You Walk Away From a Deal? When This Happens.


I will always follow the “don’t let a deal die on your side of the table” philosophy. There is really never a reason to not offer SOMETHING to the seller.

Or, at least that’s what I used to think.

This week I was sent a deal for a 351-unit apartment community in Dayton, Ohio. I was told it is a distressed property and only 95 out of 351 are rented. The other units need rehab.

Ok, I’m cool with that. I’ve got team members that can turn that puppy around.

Seller wants 2.8MM for it and it’s been on the market for about a year.

Hmm, ok, something sounds fishy. Why has it been on market so long? But I still moved forward because perhaps it was just an unrealistic seller and now, after having property sit on market for so long, he/she will be more reasonable.

So I offer 1.9MM to get the ball rolling. They counter at 2.3MM.

Hmm, ok, sounds like we’re getting close here. I happen to be in Cincinnati at the time so I decide to take the short trip up to Dayton to view the area and the property. That way I can make a more informed offer.

When I visit areas one of the many things I look for is a McDonalds. And, I want to see how new the McDonalds is. Because if there’s a new McDonalds nearby that tells me some smart Fortune 500 people identified the area as growing. It ain’t the end-all, be-all but it’s a good indicator.

So, where do I begin about this property….

First off, the night before I leave I google the area and there’s a drive-by shooting 2 blocks from the property. And, as I’m driving around the neighborhood of the property there ain’t no Micky D’s anywhere.

So I arrive at the property and notice an iron rod fence that is destroyed. Apparently a drunk driver plowed through it and they haven’t fixed it yet. The most impressive part is the fence is on a 10 foot hill.

Anyway, as I walk up to the leasing office I notice a NO GUNS sign. I’m glad it’s there although later I’d be wishing I was packing some heat. When I tell the leasing agent that I’d like to rent an apartment they tell me point blank “you don’t want to live here.”

Hmm, yeah, you’re right I don’t but I tell her “well, I would like to see what you have available.” They don’t have anything available now but will be able to get me a good deal in about a month. I ask where it would be and they say “we’d put you right next to our office because the closer you are to us the less drama there will be.”

I have a feeling “drama” is code for something.

Still, that wouldn’t deter me from buying the place. As long as the numbers make sense. I know the seller bought it for 1.1MM cash so they don’t have mortgage on it. That means opportunity for me because we could do some owner financing.

Well, turns out they only have 45 apartments leased and none available now because of “renovations.” I tour a “renovated” apartment and…it…is…d.i.r.t.y. They even show me an apartment that just had someone move out – it was TRASHED. I was shocked they would be showing it to a prospective tenant.

The 45 apartments thing is a BIG deal because the 1.9MM offer price was based on having 95 units rented which is what the proforma indicated.

Mentally my offer price just dropped 50%.

At this point I’ve only seen the renovated apartments and still need to get a sense of what the other apartments look like and, specifically, how much work is needed to get them to rentable conditions. While talking to the property manager he lets slip the following bomb:

“The owners live in California and are trying to sell but haven’t been able to yet. They need to figure something out because the City of Dayton just mailed us our last warning on our windows with broken glass. Starting next month we’re getting fined $500 per building for every building with broken glass. There are 49 buildings so that is…(he punches in the numbers on his iphone calculator) a $24,500 fine…per month!”

“Why don’t you just board up the windows,” I ask.

“We’re going to have to but that’s going to cost over $100,000,” he says.

Damn. These owners are in trouble. But still, I’m a glass is half full kind-of-guy, so I see this as opportunity to get a better deal.

So here’s what I know at this point:

–        Super motivated owners who are bleeding money

–        Management staff that’s not good

–        Out of state owners

Sounds like a perfect storm to do creative financing. But, I need to determine one very important thing:

–        How much does it cost to rehab the community and how much will I make after it’s done?

The property looked like a Hollywood movie set where they just shot a riot scene and then excused all the cast members for the evening. It needed everything major. Parking lot, roofs, HVAC and everything in between.

I did a napkin estimate of 4M – 5M renovations.

Ok, fine. So what would it be worth after the rehab?

Well, the property is the largest in its submarket and the submarket’s average occupancy is about 85%. That means the much smaller properties are having a hard time leasing and if I have 351 units ready to be rented I’m going to have a VERY HARD TIME (i.e. impossible) renting them out.

It’s called “absorption”. Yeah you’ve got 351 units but that doesn’t mean people want to live in that area! Plus the rents on the existing 45 units were already very low.

I determined that if we did the 5M rehab then it might, MIGHT be worth 8M IF we could get it 85% occupied. And I just didn’t see any way of making that happen.

So, when do you walk away from a deal?

  1. If the seller isn’t realistic about their property’s worth after you do your due diligence
  2. If the cost and time to rehab the property is more than the after repair value

I scooted out of there having learned a very good lesson.

As far as the property goes? If I were the seller I’d recognize I made a bad investment because I didn’t know the area. Because that’s the key to all of this. If the area was ok or growing then you could make it work with a rehab. But the area simply won’t support the amount of rehab that’s required.

I’d actively market it everywhere and tell people to name their price. I’d take whatever I could get. Including, but not limited to, a 6-piece chicken nugget from the McDonald’s in the neighboring town.

 

 

 

 

 

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Quickly Run Numbers on Apts

Let’s talk about how to quickly evaluate an apartment building deal. It’s important because there are tons of deals out there and you have to quickly know which ones you should pursue and which ones aren’t worth your time.

Here are the 5 questions you should always ask:

  1. What’s the NOI?
  2. What are they asking?
  3. What is the upside?
  4. What is the deferred maintenance?
  5. Why are they selling?

 

Here it is in more detail:

First, get the Net Operating Income (NOI). That’s the #1 thing because you have to know what type of income it’s bringing in and the expenses that are going out. You’ll punch holes in their alleged income and expenses later but for now just use what they give you.

Then you’ll simply take the NOI and divide it by the asking price to determine the cap rate (the financial return of the property if you paid all cash).

For example, if the NOI is $35,935 and the asking price is $650,000 then the cap rate is 5.5%. Better be in a darn good area.

If you don’t know the asking price OR are trying to determine what you should offer for it then you need to determine the market cap rate for similar properties in that area. This is found by asking brokers or property management companies.

For example, you know the NOI is $550,000 and the market cap rate is 9%. Therefore, all things being equal, a fair price would be $6,111,111.

Some rule-of-thumb assumptions to help you run #s if you don’t have all the info:

–        No expenses given?

  • Assume between 3k – $3,500 expense per unit per year

–        No clue on debt service?

  • Assume 25% down payment, 5.5% interest rate, amortized over 25 years with a 10 year balloon payment

NOTE: there are exceptions to these assumptions and this is ONLY to be used to initially run #s and see if it meets your buying guidelines. You’ll need to get the concrete info from the seller to truly analyze the deal.

Now that you know the basic financials on the property, it’s time to dig deeper. Here are the top 3 questions you must always ask about the property.

–        What is the upside?

  • Lower than market rents?
  • Bad management?
  • Good area but property needs to be revitalized to enjoy market rents?

–        What’s the deferred maintenance?

  • Current residents treating units poorly so all move-outs will incur substantial costs to get rent ready?
  • Roof in need of repair?
  • Plumbing not where it should be?

–        What’s the seller’s motivation?

  • Is it an estate sale?
  • Is it an investor looking to quickly liquidate so they can move on to bigger properties?
  • Is it a local investor simply testing the market to get maximum value for their baby?

Here’s what we didn’t cover in this post: Market fundamentals. And, investing in the right market is the #1 most important variable of if you’ll be successful. Buy in a bad market and you’re in trouble. That’s a longer conversation for another day but just know the above post assumes your market checks out.

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