How to Be a Real Estate Tycoon

Fellow apartment investors – and aspiring apartment investors – let me share some advice with you. The pathway to profitability in multi-family residential investment isn’t necessarily the standard exhortation to buy in elegant areas and rent to the elite. Eh, you want to know why not? Well, let me explain. The problem is those advocating this strategy never get around to explaining how these properties might be valued or purchased wisely.

Fact is, it just may be many of the persons supporting this technique never really developed criteria to determine in what price range properties should be acquired. And without a set of practical guidelines, it’s a guessing game. With this said, I’ll introduce you to the parameters I use in apartment acquisition, and I’ll concentrate on the buy portion of the equation. If you get that part right, you’re mostly home free. It’s my belief neither the ritzy nor the slum properties are what you want. I’ve found, from harsh experience, what the British disdainfully refer to as lower middle-class is where the best returns are to be garnered.

Now, on to the details. 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 in a highly professional fashion, if you choose, 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 80 years, confers the designation of Certified Property Manager (CPM) on its members.

These practitioners normally determine value through, a complex technique called capitalization of net income, which requires broad knowledge and sophistication. However, in the practical world of apartment acquisition, such value determination is neither necessary nor advisable. Most properties you select for purchase will not offer information you can depend upon for the capitalization procedure. The typical presentation of income and expenses, known as a broker’s net, is normally far too unreliable to be used with confidence. Thus, the price offered must be determined a bit differently. So how do you go about it? I’m glad you asked me that question.

My approach to establishing value relates to gross income, not net income. In particular, a major segment 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. 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. 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 X $240,000]. In theory, the decision by you, as a prospective buyer, becomes the evaluation of an acceptable GRM.

It’s at this point where the wheels in your head must begin to turn. The very first item to question is gross income – recall each apartment unit is “… 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, normally referred to as pro forma rents? Sellers invariably quote pro forma, which are often contrived values. Next, 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 becomes whether you are using dependable annual gross income in your analysis.

Though you may now sense some uncertainty, I can put your mind at ease on this matter. It doesn’t matter a whit what statistics you receive from the seller. The important numbers 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’ll not make an offer to purchase anything until you possess information on rental ranges and available vacancy rates. You will 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.

There is, however, one ingredient from the seller you must not ignore: Are there any leases or government edicts to which you, as the new owner, will be bound? If so, this must be ground into the mix.

Now that you’ve established the gross income you may reasonably expect, you must 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 your GRM. Some of the numbers are predictable, such as property taxes (unless California Prop 13 opponents get in the way), mortgage payments (though with a special caution to you adjustable rate fanciers), and cost of management and routine services.

The three major uncertainties are normally utilities, recurring maintenance costs, and reserves required for replacement. Numerous factors influence how you gauge them. Does each unit have its own 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 purpose? In what general condition are the premises? I could go on, but I think you get the idea. The more you know about every aspect of the property, the better you’ll do.

With all this now under your belt, you have a fair idea of what to look for – and of equal importance, what to look out for – as you go through the steps necessary to begin acquiring one or more respectable apartment buildings. You’ll need experience, of course, so I’ll conclude by describing an actual acquisition … and I’ve picked a somewhat unique purchase to make a particular point. So slip into your inspection clothes, grab your calculator, and join me in the real world of investment.

In November 2012, as the nation continued to wallow in the worst real estate recession since the Great Depression of the 1930’s, my real estate broker referred me to a 2-story, 23-unit apartment in the modest city of Hemet in Riverside County. The property, first appearing on the market earlier in the day, was scheduled for foreclosure only a week later. Consisting of one studio, twenty 2-bdrm, and two 3-bdrm apartments, it appeared for sale at $1,150,000, in a city with mortgage loans essentially unavailable. A quick inspection of the two-building complex with swimming pool, revealed it to be in deplorable condition; seven unoccupied apartment units were being cannibalized for repair parts for the occupied units, some probably occupied by nonpaying tenants. Rents were reported as $595 for the studio, $695-$775 for the 2-bdrm units, with both 3-bdrm apartments vacant. Within a half-hour I instructed my broker to submit a full price all cash offer, condition as is, no inspection required, escrow to close within three days. I’ve owned the building ever since.

I can understand if you believe me to be certifiably insane at the time I took the action I did. However, I knew the area well and recognized a bonanza when I stumbled upon it. Although Hemet is still a somewhat troubled community, it’s not a demographic basket case. The building, though badly maintained, appeared to be sound. I considered the numerous vacancies to be a plus, as it reduced the number of possible evictions required. Upon close of escrow my well-trained resident manager took charge at once; we wasted no time in putting the property into good habitable condition.

Today the building is filled with satisfactory renters, grossing $22,850 monthly, and the studio apartment is now generating $750 a month as a 1-bdrm unit (I’d rather not explain how). Hemet is still a troubled city, so the credit ratings on our prospective tenants must be checked closely. Nonetheless, it’s a manageable building which I acquired at an actual GRM of about 5. In the apartment acquiring business this qualifies as “manna from heaven.” For those of you not Biblically attuned, the phrase relates to the food miraculously supplied to the Israelites in their journey through the wilderness. It’s as close to a gift from the Almighty as you’ll ever be fortunate enough to receive.

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