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Another Home Run in Arizona. And I’m not talking about the D’Backs!

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I spent the last couple of days braving the desert sun in Arizona looking at apartment buildings for sale.

As it turns out, having assets in that market I tend to find myself in the Phoenix area about every other month now and even before my Circle started investing there I spent the past three years going out there about every four months to do some market recon (that’s short for “reconnaissance” for those of you that did not grow up playing with GI Joe). So over the last four or five years I have really witnessed the resurgence of an economy.

I remember when I first went out there a few years back to begin studying the apartment market there and I saw an entire city in shambles. There were tons of vacant homes, tons of vacant strip malls, and you could just feel the hopelessness in the city.

Now when I go there you can sense a city that has gotten its sea legs once again (yes, I amuse myself at my cleverness with this metaphor) and a people that have a bright vision for their future.

I have a lot of ideas about why Arizonians feel this way which I plan to explore in detail in future post but today I wanted to talk about my adventures.

Before my trip, I had my A-Team (Acquisitions Team) pull every listed apartment complex (over 20 units) from Costar and we reviewed every deal that fit our criteria for further review.

There are currently about 110 multifamily properties for sale in the Phoenix area market with 20 or more units so we had some sifting to do.

We prefer B & C assets that need major work or repositioning so we pulled that list out first.
Next we looked at all the deals with any kind of value add component.
Next we looked at all the deals advertised with any kind of Seller Financing offered.
Last but not least, I also ran a list of available lots for sale that were entitled to build apartments on.

By doing this, we were able to narrow the list of 110 prospective properties down to about 20.

Then the A-Team got to work gathering basic underwriting information (make contact with Seller/Broker; twelve month trailing report (T12); rent roll; offering package) and began narrowing the list even further.

All and all we determined that eight properties were worth the time to go look at. We made offers (by way of Letter of Intent LOI). Only one of the eight was quickly eliminated by the broker stating that were nowhere in the ballpark and he would therefore not show us the property. We will put him on a weekly follow up sequence until his listing sells. Some Sellers/Brokers have their head in the clouds when it comes to true value and therefore will spite themselves and hope for months to find the right sucker, er, buyer to pay too much for their property… which seldom actually happens. So we will exercised diligent patience until time and circumstance changes for these kinds of unrealistic Sellers.

Anyway, so seven properties all together to go and view. I call all the listing brokers and schedule to walk each property over the next two days.

Phoenix is just under a six hour drive from my front door. Unfortunately, flying takes about the same amount of time by the time you park, check in at the airport, land and rent a car, so considering driving is cheaper and I like to be in control all the time, I almost always opt to drive.

I leave the house at 6:00am and including a few stops along the way for Starbucks and burpies (at my favorite rest stop on the AZ side), I am comfortably at my property managers office for an 11:30 meeting; right on time.

I meet with my property management company staff about the current assets we have in town and discuss marketing strategies, traffic, and personnel concerns and then I’m off to tour some properties.

Intermittently I stop off at the assets I already own just to put eyes on premises and say hi to the on-site managers so they know I care (about them and about my asset).

For each property I have scheduled to walk while in town my Acquisition Specialists have put together a comprehensive file. The Deal file includes a printed copy (we usually keep everything filed electronically) of the Offering Package, a current rent-roll, a T-12, an underwriting spreadsheet with current and proforma numbers, and a copy of the LOI we have submitted to the broker. For reposition deals the Acquisition Specialist will also include a detailed as possible list of improvements needed, or, scope of work. Then the Acquisition Specialist de-briefs me on each deal he or she has underwritten so I show up to the site as prepared as possible. I always write down my mission for each appointment; check this or that… “if we wanted to convert the building to have individual AC units, is there space to run ducts and install a pancake unit?” Etc… so that I can get right to the point while at the property.

At the property, I do a walk around and through the ground and parking lot of the property. I then have the broker and/or property manager unlock the best and the worst unit example of each unit type.

For example I say, “show me the best and the worst example of the 2+2 model”, and so-forth. While at the property I take careful notes of what I see, what is said, and any unique opportunities I may discover while there. I take a few pictures on my cell phone if I need to remember certain aspects of the property and I ask a lot of questions. Always ask questions you know the answer to. This is the fastest way to size up whether everything else the person you are dealing with is competent, full of BS, or worst, incompetent. At least then you can act accordingly.

So over the course of the next 48 hours I walked:
A 182 unit piece of crap reposition deal with something like 5 tenants and lots of boarded up windows.
A 76 unit reposition deal in a decent area (totally vacant, charming bones, and the lot behind it is also for sale…)
2 class B stable complexes totaling over 400 units combined with seller financing available
A sweet 140 new development deal that was class A all the way and operating very efficiently (not really on my Target to purchase but definitely worth a few hours of time for future development recon)
Two decent C class properties with some kind of value add component.
It was over 104 degrees and more humid than usual for Phoenix this week so after lots of sweat and smelling weird vacant apartment smells, I came away from my two days with some additional homework.

Our offer on the 76 unit was nearly full asking price at $35k/unit. It needs about $15k/unit in repairs (that a lot, folks) and will appraise with an SMV (Stabilized Market Value) of about $62k/door. So with a gross profit of about $12k/unit the unlevered gross return would be about 24%

35+15=50k all in.
SMV = $62k/unit leaving $12k gross profit.
12k profit/50k all in = 24%

I like this deal and it looks as though our offer will be accepted this week. It’s got charming bones; it’s on a busy street so marketing expenses for leasing will be minimal; it could be converted to assisted living if we choose; most importantly it’s in a good (and getting better) location.

If we are able to negotiate a little better purchase price, some repair credits, perform the scope of work for less than budgeted (not usually likely), or can lever the $50k purchase and construction project, this deal could easily turn into The Ultimate Investment Strategy type of deal, allowing us to come in with a low invested amount, do the repairs, lease it up, and then refinance ALL of our invested principle out of the deal, only to keep it for cash flow and appreciation without ANY of our own money invested longer than 18 months. We call these Home Runs!

I’ll let you know about the other deals I viewed this week. But for a couple hundred bucks invested in gas and a little sweat, I’ll take a Home Run deal any day of the week.

Know Thy Cap Rate: The Illusive Obvious

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For some reason cap rates seem to be the most misunderstood term (ratio actually) in all of real estate. I often get asked by new investors what a cap rate is and what does it mean. I never get asked the same question by commercial and multifamily brokers but often find out (in a roundabout sort of way) that many have no clue either.

So I hope to tackle this issue once and for all and if I am successful, this should be the most read blog post on the internet for new investors (brokers you can read too; don’t worry we wont tell).

So first of all the definition: Cap rate is short for capitalization rate; which means an indirect measurement on how fast the income produced by the property can repay the amount that was invested (assuming you paid cash for the property).

In other words, if you purchased a $1,000,000 asset with no loans that produced $100,000 in Net Operating Income (All income less all expenses = NOI) then the cap rate would be 10; meaning you would get 10% of your investment back each year. Therefore 10 years is the rate in which the property would “capitalize” itself.

$100,000 / $1,000,000 = 0.10 = 10%

Cap rate would also be your rate of return on investment assuming you had no closing costs and had no debt on the property.

Here are some basic formulas. Memorize them. Learn it. Know it. Live it!

Cap Rate = NOI / Value

NOI = Price x Cap Rate

Value = NOI / Cap Rate
So what does this all mean? and a better question might be, how can we as investors (and even wholesalers) use this information to our benefit?

Since most apartment buyers do not buy their properties all cash but rather employ the use of some kind of financing, it is important to realize that the cap rate is commonly used in commercial and multifamily assets in the same way that “comps” (price comparisons) are used in a single family sale.

How do you value a single family house? You find two or three like-and-kind homes with similar square footage with similar condition in a similar location and you make calculated assumption that if they sold for a certain price that your similar property should too. Then you make slight adjustments to your valuation according to any minor differences in your subject property (“well mine has fresh paint and carpet”, or “this one’s lot is slightly bigger”, or in a “better location”, etc, so I’ll add a little value to the price tag).

You will use the cap rate in the same way. You find two or three (or more) like-and-kind apartment buildings with similar square footage or unit count, with similar condition of repair, and in a similar location and you make calculated assumption that if they sold for a certain cap rate that your similar property should too.

Another thing to understand about cap rate is they are also a measure of risk.

Higher risk markets will have higher cap rates: Investors want a better return for a higher risk.

Low risk markets will have lower cap rates: Investors can settle for a lower cap rate if there is little chance they can lose.

So when I hear “guru’s” teach that someone should only look for 10 cap properties that’s like telling a new investor that they should only look for $90,000 houses. A 10 cap is relevant to the market like a $90,000 house is relevant to the market.

A $90,000 house in Beverly Hills would basically be free.

A $90,000 house in Detroit would be foolish.

Imagine calling a broker in Beverly Hills and saying “Hi, I just graduated from a seminar and I want to make offers on all the $90,000 houses in Beverly Hills”. You would not be taken very seriously. In fact, you would be laughed at.

On the other hand, if you went to Detroit and said you were looking for $90,000 homes they would flood you with everything on the market… and call you a sucker.

Beverly Hills has so much demand there is not much risk of houses becoming worth $90k.

Detroit on the other hand has so much risk that investors would not be willing to pay $90k for a house.

This is exactly the same thing for apartments.

By announcing to the world you only want to buy 10 cap properties you are saying “I like high risk markets”.

By going to low risk markets like Los Angeles or San Diego or New York (vacancy is never an issue in these markets as long as you manage the building some-what effectively) and ask a listing broker for a 10 cap you will make yourself look ridiculous.

It’s the same thing.

But let’s not get confused by this. Would I buy a 10 cap property in LA? Absolutely! But that would not be market value. It would be a deep discount. And I specialize in getting deep discounts on real estate.

So how do we use the cap rate in the real world?

The first thing you want to do when you enter a market is find out what the Market Cap is; what are real buyers willing to pay for the amount of risk that exists in this market?

If you are looking for a 20 unit building in a certain area, what are the general cap rates that similar like-and-kind properties have recently sold for? Is it a five cap? Seven cap? Ten cap?

The answer to this question will also be a tell on what kind of market you are dealing in; Higher cap rates mean your purchase price is cheaper; Sellers are willing to sell their properties cheaper when they know there is a higher risk to accommodate for.

So let’s say you go into a market and find that five buildings with unit counts between 18 and 30 have recently sold (within the last year) for 7.8; 7.9; 8; 8.1; and 8.2 cap rates.

You could conclude that this would be about an eight cap market.

Let’s say you find a building for sale and it produces a $70,000 in NOI (Net Operating Income).

Is $1,000,000 a good price? That would be a 7 cap.

Is $875,000 a good price? (8 cap).

What if you were able to negotiate an $823,000 price? That would be an 8.5 cap. Do you think someone in the market would buy that asset from you on assignment at an 8 cap? The market says that somebody would.

Do you suddenly see how cap rates are relative?

Can you now understand how you can do very well by simply playing the margins on cap rates?

Know your Market Cap.