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Despite it being one of the most common sayings in real estate, investors still miss the significance of this first and most important step. Making your money when you buy simply means buying “right.”
The current bull market makes us all look like geniuses, but as Warren Buffett is quoted as saying, “Only when the tide goes out do you discover who’s been swimming naked.” When the market changes, we will find out who bought wrong. Let’s examine the main principles of purchasing Class B and C multifamily apartment communities the right way.
Forget The Cap Rate And Focus On Rents
Cap rates are only important when you sell, and everyone operates their properties differently, so you shouldn’t rely on the seller’s operating expenses. Rental rates should be the most important component you look at before you buy. Do your market research, analysis and old-fashioned reconnaissance to determine your conservative and most likely rental rate projections.
Your most likely scenario should be your value-add projected rents after you update the units, add new amenities and improve the property. These rental rates should be your goal, and the investment should achieve your required internal rate of return (IRR) and cash-on-cash return (CCR). If you have investors, always underpromise and overdeliver. Your most likely rents should be very realistic and achievable, but you should also have an aggressive model that shows the potential best-case upside if you knock your rents out of the park.
Your conservative rental rate projections should be your worst-case scenario and based on a market correction or recession. In some cases, your conservative rents will be less than what the property is achieving right now. The property should have positive cash flow even with higher-than-normal vacancy, operating expenses and a 100% reassessment of the real estate taxes. If your analysis presents negative cash flow, then you are either paying too much, overleveraging (placing too much debt) or being too conservative and need to reconsider your conservative rents and expenses. It is your job as the real estate investor to perform a thorough feasibility review of the investment and determine if the property will cash flow.
Insulate Your Investment from Market Changes
If your purchase price is 50% or less of replacement cost, you should be fairly well insulated. If your competition overpays for a property or builds a new property in your market, you will always have the competitive advantage of lowering your rental rates more than they can to keep your property occupied during tough times.
You must always keep sufficient cash reserves. When detailing your acquisition costs, cash reserves should be included in the total cost of the investment. During a recession, cash is king. A robust amount of liquidity will help you weather any storm and provide you with the resources needed to keep your cash flow positive.
Budget properly for capital expenses. One of the biggest mistakes investors make when buying is underestimating capital expenses and the timeline those expenses will take place in. Do your due diligence, and get accurate bids. Always add a cushion (15% to 25%) to your capital expense budget.
Do not overleverage. What I see in the current market is mind-boggling — investors are placing debt on top of debt on top of debt. The No. 1 downfall of failed real estate investors is overleveraging. Debt is essential to achieve a substantial ROI, but getting too greedy could one day put your investment in jeopardy. We were recently looking at a bridge loan for a 90-unit project we have under contract, and after conducting our analysis, we decided to go with traditional agency financing (10-year term, low rate, 70% to 75% loan-to-value). Although the ROI was greater with the bridge loan, we did not feel comfortable using bridge financing at this stage of the market cycle. A correction in the market would make you wish you had set realistic goals and placed long-term, low-interest debt on your property. Acquire properties with more equity, and keep your loan-to-value and debt-coverage ratios healthy for when the market changes.
Do Your Due Diligence
Trust, but verify. We recently sold one of our properties to an out-of-state buyer. During their inspection period, they walked maybe three units and called it a day. We could not believe it. They were passive investors and accepted the inspection without further discussion. Luckily for them, we had nothing to hide. During our inspection periods, we walk every single unit before purchasing a property, and you should absolutely do the same. If you don’t, you may end up with unwanted surprises.
Conduct a lease audit before you buy. In my experience, when reconciling the lease agreements to the rent rolls, I have always found discrepancies. This audit allows you to go back to the seller and possibly negotiate a better deal, or it justifies your purchase price.
Always perform a thorough property inspection. It’s very simple. Spend the time and resources necessary to get as much information on the property as possible. You will have an accurate budget, negotiating leverage and peace of mind. If you buy the property, you know you bought right, and if you decide to walk away, you also know you bought right because some of the best deals are the ones you walk away from.
Conclusion
Buying right is being smart. Always stick to your investment criteria. Keep your ego in check, and have a confident but humble attitude. Like I mentioned earlier, in this market everyone is a genius, and it’s easy to make money in a good market. Be a real estate investor who stands the test of time, buys investments the right way and makes money whether the market is going up, down or sideways.