Buy Low, Sell High

Fellow investors, let me share some intricacies with you. The path to profitability in virtually all forms of investment is to follow the age-old admonition: Buy low and sell high. Eh … you say you’ve heard that before, but it’s never really helped much? Well, I’m not surprised. The problem is those advocating this strategy never get around to explaining how you recognize high and low.

The fact is, many of the persons advancing this slogan never really developed criteria by which to establish value. And without a set of practical guidelines, it’s a guessing game. With this said, I’d like to introduce you to the parameters I use in my specialty – apartment investment.

I’ll concentrate on the buy portion of the equation; if you can arrange this, you’re mostly home free. In reality, the determination to buy low is often more easily said than actually accomplished. Accordingly, I’ll modify my advice somewhat to: Buy soundly. But enough of generalities; it’s time to get specific.

To begin with, there’s an inherent relationship between the value of a rental property and the income it produces. The matter can be approached – if you choose – in a highly contrived fashion, as does the Institute of Real Estate Management (IREM). This organization, affiliated with the National Association of Realtors, headquartered in Chicago, Illinois, and dating back more than 70 years, confers the designation of Certified Property Manager (CPM) on its members.

These practitioners normally determine value through what’s known as capitalization of net income, a complex technique requiring broad knowledge and sophistication. However, in the practical world of apartment acquisition, such value determination is neither necessary nor advisable. Unhappily, most properties you consider for purchase offered in this manner cause doubt. The typical presentation of income and expenses, known as “Brokers Net,” is normally far too unreliable to be used with confidence. For this reason, I believe the price to be set must be determined a bit differently. How do we go about it? I’m glad you asked me that question.

My approach to establishing value relates to gross income, not net income. Actually, a fair portion of the multi-family residential sales brokerage industry ties its listed asking prices to gross income through the use of “Gross Rent Multiplier” (GRM). The method is fundamental enough.

Take the case of a building containing 20 two-bedroom apartments, each generating rent of $1,000 per month, with an asking price of $2,300,000. Potential monthly gross income is $20,000 [20 X $1,000]; annual gross income is $240,000 [$20,000 X 12]; GRM is 9.6 [$2,300,000 / $240,000]. As a general rule of thumb, I limit my purchase price to a GRM of 8.33 – reflecting a monthly rental price of one percent of purchase price.

In theory the decision by you, as a prospective buyer, becomes the evaluation of an acceptable GRM. It’s at this point the wheels in your head must begin to turn. The very first item to question is gross income; recall each apartment unit “… generating rent of $1,000 per month.” Does this figure represent the current rent schedule or is it based on alleged market rents in the area? Are all the units rented at this time or are there unfilled vacancies? Is it possible the owner gives two month’s free rent to each new tenant? In short, the real question devolves as to whether you’re using dependable annual gross income in your analysis.

Though you may now sense some uncertainty, I’ll put your mind at ease on this matter. It doesn’t matter a whit what statistics you receive from the seller. The numbers which really count are those relating to the property when its operation rests in your hands. This requires your thorough knowledge of the local market and of the property’s potential.

You’d better not make an offer to purchase anything until you possess information on rental ranges and available vacancies. You’ll talk with brokers and rental agents, canvass the area, answer rental ads pretending to be a prospective tenant, and cast a critical eye on whatever seems to reflect value.

With your establishment of gross income you must then evaluate the range of expenses the property will likely incur. This step is vital to guide you toward an acceptable offering price. The less inherently cost-efficient the operation, the lower must be the GRM. Some of the numbers are predictable, such as property taxes, mortgage payments, and cost of management and routine services.

The three major uncertainties are normally utilities, recurring maintenance costs, and reserves required for replacement. Finally, you’ll need to see what specific idiosyncrasies are present.

Numerous factors influence how you gauge this. Does each unit possess a separately metered hot water source? Is air conditioning provided, and at whose expense? Is the roof efficiently sloped or is it a high maintenance flat top? Are the planted areas designed for high or low maintenance? Is there a swimming pool serving no real purpose? In what condition are the premises? These and others unmentioned matters are what you must ruminate on quickly.

Admittedly, experience comes in handy. Until you’ve developed a feel for it, some assistance might be advisable. An excellent source of guidance may be the Certified Property Manager I previously mentioned, but it must be one with no involvement of any sort in the property analyzed.

Once you’re fully aware of what rental income a particular property will generate, and recognize its likely expenses, you’ll know whether it’s worth owning and at what price. Let me lead you through an example to give you a feel for the practicalities. And rather than a hypothetical situation with numbers simply presumed, I’ll give you a real one, based on a property I purchased in July of 2015. So slip into your inspection clothes, grab your calculator, and join me in the real world of investment.

I found a 32-unit complex in the Coachella Valley desert city of Indio, Calif., containing 16 one-bedroom and 16 two-bedroom apartments. With then-existing rents averaging $635 and $725 respectively, the property grossed about $260,000 annually. Neither the grounds nor the buildings appeared modernized in any way since its construction 47 years earlier.

The roofs were tar-and-gravel flat-tops, and each unit housed a separately metered hot water heater. In the central courtyard sat a 30-foot rectangular swimming pool, while 32 carports adjoined an alley to the rear of the property. My analysis confirmed vacancy rates to be near zero, with similarly-sized, but modernized, apartments commanding rents of $750 and $850 respectively.

I paid $2,150,000 for the property, reflecting seller’s GRM of 8.3. Factoring in market rents, my GRM became 7.0 – obviously a more favorable number. But to generate the enhanced rents, I anticipated renovation expenses to average $5,000 per unit, requiring an additional $160,000 investment. Fortunately, this wasn’t an up-front, out-of-pocket expense; I paid for it over several years from the cash flow produced by the rentals. And today, five years later, the property generates an annual gross income of approximately $430,000, thereby yielding nearly double its initial cash flow.

In retrospect, I thank good fortune for my opportunity to have acquired a fine property at a bargain price … as well as the disparaging benefit of much maligned inflation.

At this point, fellow investors, I’ll take my leave. For those of you willing to search for value, do your homework, and expend the required time and effort, there can be a handsome reward in rental real estate. But, of course, the same sorts of rewards are available in a host of other endeavors, for those persons willing to carefully analyze what they’re doing and what future benefits they may anticipate.

So to conclude, I’ll now pass on two pieces of advice. If it’s successful investment you crave: (1) Don’t rely upon your salesperson to perform your analysis, and (2) Buy low and sell high.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. Al may be contacted at al@abjacobs.com