After several years of being a successful single-family foreclosure investor in my hometown of Seattle, Washington, I seemingly changed courses and began embarking on a strategy of buying multi-family projects of 50 units or larger, thousands of miles from my home. A lot of people thought I had lost my marbles and could not understand why I would turn my back on an obvious cash cow and embark on something as risky as being a landlord in another state.
Several factors weighed in my decision to go this route. While I changed my focus from single family to multi-family, I still enjoy finding great single-family deals and rehabbing them. I never stopped doing this, I just do it on a much more limited basis than when I had 5 projects going at a time. I also want to stress that far from becoming a “landlord,” I have become a businessman who delegates the function of landlord to professionals who work for my projects.
I deal with high functioning professionals and affluent investors who tend to be creative, enthusiastic, and incredibly energizing to work with. It is truly a dream job, that has proven to be very predictable as well as profitable, and a true beacon of hope over the couple of years when most of the business world was in desperate straights.
I have made a lot of money in my lifetime patiently nurturing businesses over a three to ten year period and this success made multi-family investing very attractive to me as the most typical strategy for multi-family is to buy, stabilize and sell over a three to ten year horizon. Imagine what happens when a motivated and disciplined owner embarks on a 5-year plan of simply watching expenses and gradually increasing rents after buying a project in an emerging market using basic tried and true business principles.
NOI and Cap Rate
Before you get started investing in multi-family, you must first understand how to best value these projects. The value of most any commercial property is determined by the projects income, also know as NOI (Net Operating Income) when it is measured by it’s Cap Rate (the percentage return on purchase). Â
For instance, a 50-unit apartment complex that produces an NOI of $100,000 per year that is sold at a 10 Cap will trade at $1,000,000 ($100,000/10%). Stated differently, the buyer of this complex was willing to pay $1,000,000 for an asset which would provide him with $100,000 of operating income per year. If this buyer had no debt on the property and the property needed no capital improvements his net return would be 10% on his $1,000,000 investment.
One of the beauties of this business is that these numbers are relatively easy to verify and gain agreement upon so pricing properties is not that big of a mystery. Now that this buyer has gained control of this building it is his goal to increase its value. There are two basic ways that this happens:
One: The buyer (now owner) improves the NOI of the property through a combination of increasing revenues and/or reducing expenses (more on that in a bit).
Two: The Cap Rate in the market for that type of asset goes down or “compresses” due to improved business climate and/or infrastructure investment by local government.
The Magic
Let’s assume that when this complex was purchased the average monthly rent per unit was $400 and monthly expenses were $233, this includes all maintenance and general repair as well as fully funded, on site, property management. Also, for the sake of easy calculations let’s assume that the complex always enjoys 100% occupancy.
In this initial scenario, each unit would produce $167 of NOI per month or, approximately, $2,000 per year for 50 units or $100,000. If you divide that by 10% (the Cap Rate) you can see how the buyer arrived at a $1,000,000 purchase price.
Now let’s assume over the next 5 years that the owner is able to increase rents a modest 4% per year (this would be modest in most emerging markets, and very aggressive in a bad market) while keeping the growth of expenses at 2% per year so that beginning in year six the average rent is $480 per month against monthly expenses of $256. At these new levels of rent and expense the monthly NOI per unit equals $224 or $2,688 per year. When multiplied by 50 units the NOI for this project is now $134,400. By applying the purchase cap rate to this new NOI this project is now worth $1,340,000. That is an average gain in equity of $68,000 per year on top of the annual cash flow generated by the operation of the project.
Most people would consider an investment that worked out like this to be a glowing success, but this scenario is very conservative…why is that???? It is conservative because we have not taken into consideration the possibility of the Cap Rate going down from your purchase to sale
Cap Rate Compression = Home Run
If we take the year six NOI from the example above and apply a new Cap Rate of 8% (versus 10% when we bought it)Â based on renovation in the area and new businesses moving into the sub market, the owner will now have an asset worth $1,675,000. That is $675,000 of equity gained in 5 years from doing a very basic job of managing the project. The truth is that most projects have several other streams of income on top of rents that only serve to make these numbers look gaudier.
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True Story
The first project I bought about 3.5 years ago has averaged 7% rental increases per year, compounded, and the expenses have actually dropped from $2,200 per unit per year to $1,900, and although I have yet to sell the project (I plan to keep it for quite a while) I just turned down an offer of $2,100,000 for the project which I bought for $1,435,000 in mid 2007.
If we carry the initial scenario out for 15 years instead of 5, the buyer would have an asset worth $2,022,600 at a 10 Cap and $2,528,250 at an 8 Cap, a gain of $1million to $1.5Million.
When I first had this explained to me I didn’t believe it.
I spent the next 6 months educating myself and proving to myself that these kind of results were actually achievable and that deals like these were actually done, and I have spent the last 3 years enjoying the reality that is the Magic of Cap Rate, NOI, and Disciplined ownership
It is All About Networking
In our hands-on lab classes, we talk a lot about the teams that we need to set up around us and how to leverage those teams to multiply our ability to find deals, accumulate capital, and accelerate the time that it takes to stabilize an asset. I can’t stress enough how the high level of interest that currently exists for multi-family investing will aid your ability to put together an effective team. And, while none of this is easy, it is made much easier right now due to the high level of interest and notoriety that multi-family investing currently enjoys. Once you are armed with the proper knowledge and have put together all the pieces of your team you are literally just one quality deal from significantly changing your life.
Surround yourself with positive people and do something every day to improve your knowledge base and your confidence level. Remember, the definition of luck is “intense preparation bumping into opportunity.” We can’t always control our opportunities, but we can do something every day to be more prepared.
From a practical perspective, what I enjoy the most is the fact that apartment buildings are simply small businesses. They have all of the things any other business has, namely customers, vendors, employees and owners, and if you take care of each of these stakeholders you will have a successful business.
All of my adult life I have run businesses and I have found that most of the real gains that are to be made when management changes revolve around things that really don’t cost anything. What new management/ownership usually brings to a business is enthusiasm for and appreciation of all that surrounds the business. Customers usually see an improvement in service, vendors tend to work harder to please the new management, and the new management is keen to get off on the right foot with their vendors. Employees that remain in place are generally grateful to be there and are now working off of a blank slate. So for a little while, the property should enjoy a fresh shot of enthusiasm and make some significant inroads because of it.
During this “honeymoon” period the new owners must identify and repair any systems that are counterproductive or ineffective. They must “prove” to their employees, vendors, and customers that the bad systems will be reversed and the good systems will be made better.
The most important work to be done is in making sure that “win-win” relationships are created and adhered to in all of the key relationships for the project. What I have seen more than anything else is property letting the customers win while the property loses. The property continually puts up with slow and non-paying customers, who cause trouble, and chase away the types of residents that an owner would really like to have. These people need to be spoken to respectfully but firmly regarding the requirements of the lease and the consequences of not abiding by them.
 Honestly, in at least half of the cases that is all it takes, and in the other half one or two well documented evictions sends a very clear message and gets all of the quality residents rooting for you as they had spent the recent months having to put up with the rotten residents’ shenanigans and are just as glad as you are to see them go.
For the most part, if your lease is well written you hold all of the cards and most of the issues that create tension are very rarely not simple matters of fact. Either you have paid the rent or you haven’t…this is the 5th time I have had to speak to you regarding your guests being loud at 2am as they are leaving your place…you have a dog living in your unit that isn’t listed on the lease etc. In these cases the lease outlines what the consequences of non-compliance are and the more matter of fact you can be with that the better. I don’t know how many times I have squelched an argument by simply saying “what does the lease say about this.” We then take out the lease that the resident has signed and we have our answer.
You can bet that only 1 in 4 residents has ever been treated with respect and dignity by their landlord and you can use this fact to your advantage, but if you fall into the trap of arguing and “getting even” you lose the high ground and a great deal of your momentum in improving your property.
Nothing improves the NOI of a property more than high occupancy and low turnover and in most cases improvement in these areas have nothing to do with any kind of monetary outlay. These examples illustrate how the proper mindset makes all of the difference in how your property is perceived and how that can improve your bottom line without you needing to invest a penny.
So, arm yourself with these principles and be prepared for success. Now IS the time to invest in apartment foreclosures.
Happy Investing To You All!
Coach Michal
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