Income Properties Portfolio

Interior and Exterior Rehab

Cosmetic Rehab is work such as granite counters, flooring, etc. These items add the most value to the tenant because that’s what they see. Structural rehab is work such as foundation repairs, replacing electrical boxes, plumbing work, etc. These items are absolutely necessary to provide a safe living space, but they won’t be appreciated by the tenant because they can’t see it.

If you are just starting out, you want to stick with projects that don’t require too much structural work because they are more expensive and require a lot more experience. The process to source for labor is the same for both.

Do not be intimidated by rehab work. Your goal is to get a property at a discount so that you can spend money on rehab and add value. Your rehab budget can be financed just like the purchase of the property. It’s rolled into the total deal value. There are many factors that determine your rehab budget. We will discuss all those points in this presentation.

This is the biggest factor that will determine your total rehab budget which will determine how big your loan and mortgage payments will be which will eventually impact your returns. If you use a general contractor, you will pay more because they make money on buying material used on your project and obviously labor. When you hire a general contractor, it’s a turnkey operation. You walk through the property and tell them what all work you want to get done. They will give you a detailed quote broken down into different tasks. You don’t have to worry about labor, material or managing the project. Of course you coordinate dates and which units to work on. But for the most part they take care of everything.

Now if your goal is to understand every little detail of the rehab process and manage the work, you will need to pull up your sleeves because it is a lot of work and takes a lot of responsibility. You need to source material for quality and price.

Multifamily Insurance

This is one of the most overlooked line items, almost as an afterthought. But taxes and insurance take a bite out of revenue. For larger properties, partners are paying about $275/unit annually (on 300+ unit buildings). On smaller properties that may be as high as $700-$800/unit.

Some of the big things:
1. General liability insurance- Insurance against things like someone tripping and cracking their head.
2. Property Insurance- wind, fire, storm, etc. related damage.
3. Flood insurance

Make it a rule to get at least 10 quotes so that you know where the market is. Quotes will vary. Typically you will be going to an insurance broker and they will ask you for basic property information so that they can get to work to get quotes.

Flood insurance can really impact your quote. It depends if it’s in a flood zone depending on the flood map. Your provider will request elevation certificates which the seller should provide. Elevation certificates will basically determine how prone the property is to flooding. You will also get loss runs for the last 5 years which will show what claims the seller has made to the insurance company. Things that will impact the rates are prior assault/battery claims, wind or hail claims, etc.

Insurance is just a part of doing business. But it can impact your NOI which will reflect in your stabilized value.

The Syndicator

A syndicator is an individual who leads the syndicate (also knows as sponsor). The syndicator forms the syndicate to pursue a large property that he/she could not individually close. With each investing a certain amount, together the syndicate can close on the property. In order for the syndicator to gain the trust of investors and get them to invest, the syndicator must have knowledge, skills and expertise. In addition, the syndicator must also invest some amount in the syndicate to show “skin in the game”. The syndicator raises capital from investors only when the property is under contract, all costs are determined, has a business plan on what to do with the property and has secured financing.

The business plan developed by the syndicator must cover all the operations and finances of the property. There should be complete clarity on how value will be created and what the returns will be. The syndicator must have a team together. If the building requires rehab work, the syndicator must have a construction team and architect. Also part of the team are real estate attorneys and accountants who specialize in real estate.

One of the major tasks a syndicator must perform is market research of where the subject property is located. This is part of an extensive due diligence process. Some of the other tasks of the syndicator are:

1.Profit & Loss Statements audit

2.Income & Expense Analysis

3.Title & Zoning Study

4.Terms & Conditions negotiations

5.Tax Analysis

6.Operations of the Property (management)

7.Supervising construction

This is not an exhaustive list. We will discuss each in detail later.

The Syndicator- Real Estate Syndication

1.Profit & Loss Statements audit

2.Income & Expense Analysis

3.Title & Zoning Study

4.Terms & Conditions negotiations

5.Tax Analysis

6.Operations of the Property (management)

7.Supervising construction

This is not an exhaustive list. We will discuss each in detail later.

Why Form a Real Estate Syndicate

What is a real estate syndicate? It’s when two or more people come together to make a real estate investment. In this type of a formation, one person takes an active part in management and operations of the investment while the others are generally passive investors. Most of the capital required is raised from these passive investors. Although, the syndicator also invests capital as the investors want to see skin in the game from the manager. The manager also receives other forms of compensation in addition to the return on invested capital in the form of management fee. We will discuss this later.

A real estate syndication is not a form of legal structure. It’s just a word used to describe the group. Some of the legal structures are: Limited Liability Company, Join Venture, Tenancy in Common, Corporation, Investment Association, Real Estate Investment Trust, General Partnership, Limited Partnership

There are many reasons people chose to invest in a syndicate. At the top of the pyramid is free cash flow from operations. This is the cash that is generated from operations of the asset and left over after paying expenses and servicing the debt on the asset. This return is typically quoted as return on invested capital. Most syndicates return 10-12% per annum in the form of equal quarterly distributions.

Another reason is to control more real estate through the use of leverage. Leverage is when you purchase a property worth several times the owners equity. Speculation on the value of the property or the land is also one reason people choose to invest. Although one must not enter into a real estate deal purely for this reason as cash flow is king. The appreciation achieved on resale is a bonus. Most syndicates have a hold period of 5-7 years, so one needs to be aware that their capital will be locked up for that long.

Fatal Mistakes in Real Estate

Getting the right financing for each property is critical. It’s a good thing if the real estate fiasco of 2009-2010 is still fresh in your mind. It should make you extra careful. Some of the key factors in commercial loans are: interest rate, term, amortization, recourse vs. non-recourse, balloon payment, etc. It gets more complicated for real estate syndications. We won’t cover that in this book. Relationship with lenders and capital markets expert is critical. We are lucky to have Robert Damigella on our team who is a capital markets expert who can raise debt and equity, fast!

If you go in for an adjustable rate mortgage, you could face much higher payments when interest rates rise that could kill your cash flow. You need to be aware of these potential changes before you buy the property and the math should still work. Our underwriting model factors in these interest rate changes and spits out expected returns and cash flows. We at Income Properties Portfolio are more cautious than optimistic when evaluating a deal and love to play devils advocate. We have seen too many times where new investors are just so eager to acquire that first property that they sometime overlook the very basics that could make or break the deal.

As it goes with real estate, it’s all about location, location, location! It’s true. If you buy a property in a part of your city that is falling apart, there is no way you will get quality tenants. You can expect things such as late or no payments, vandalism, break-ins, robberies, abandonment, etc. As mentioned elsewhere in this book, you want to lease to tenants who have something to lose, people who have decent or better credit, good employment or studying and the financial ability to pay rent. All these things can be verified before you rent it to a tenant. This is why we see very little evictions across my own properties or my partners 1,400 units.

Over estimating rents and growth in rental rates can also kill your cash flow. Anything that kills cash flow means you might have to dip into your pocket to pay for expenses and the debt service. You NEVER want to be in that situation. You need to have a solid understanding of your market and what rents you can collect for your property. You also need to be aware of rate of increase in rents. This is critical because this will have an impact on your cash flows and investors’ return on investment. We discuss these in detail in our Saturday strategy session.

Finally, you need to have a good general contractor. Reputation matters. GCs (short for general contractor) are notorious for underestimating the cost and time when giving you a quote. Of course the good ones will not play those games. But if you cheap out, you will run into someone who quotes you say $50,000 but the actual bill turn out to be $75,000. For smaller properties, banks generally don’t finance construction costs so you might have to fork that out of your pocket. That kind of a sudden surprise can completely ruin a project and ruin your financial situation because remember you still have to make payments on the property while the contractor is working on it. So you need to know what you are doing.

Real Estate Mistakes People Make

Due diligence is absolutely critical and if we end up working together, you will see that we spend a lot of time conducting our due diligence. One of the first questions that comes up is, how do you value a property? A lot depends on sales comps, talking to people who are experts in that area and doing your own home work.

If you are taking over a property that has tenants in place, you need to go over the leases. These will be provided to you by the owner. Don’t assume that just because there are tenants in place that it will continue to be the case. A lot depends on the quality of the property, which will determine the type of tenants you have.

You can’t trust the seller and what they say about the property. Remember, the seller just wants to get rid of the property at the maximum possible price. If you are just getting started in the industry, you need to be very careful. This is why an experienced partner or mentor is very handy because they can prevent you from making fatal mistakes. Sure, you learn a lot from mistakes, but a fatal mistake can kill time and cash, both of which are precious.

Underestimating closing costs is another mistake rookies often make. Let’s say you are buying a $5,000,000 building, it’s easy to assume that you need just 25-30% “down”. In commercial real estate, closing costs can add a couple of points to that. Of course it depends on the price of the property, the more expensive the building, the lower the ratio of building price to closing costs. Some of the costs you will encounter relate to the financing aspect, such as loan origination fee, loan guarantee fee, etc. These will be covered later.

If you are purchasing a large 500 unit building, it’s important for your team and you to walk through each unit. Sure, the inspector and his team will be the one doing most of their work, but you need to walk with them. My partners who run syndicates don’t themselves walk through each unit since they have employees who do it for them, but they do nevertheless have eyes and ears on the ground during the due diligence phase.

You also need to be very familiar with what the competition is doing. You need to be well aware of what properties like yours are renting for. You need to know what concessions are offered to tenants. It’s easy to figure these things out. Either you can drive around your property and look at comparable apartment buildings, call them and ask them about their rates and concessions as a secret tenant. Or, you can do a reverse Google Search for your property to find where the property is listed for rent. Owners and property managers often times list the property for rent on various listing sites. You can find them and see what they charge.

Don’t underestimate the work that needs to be done. It’s easy to get swayed by success stories or from people who make it sound easy. If it were easy, everyone would be doing it. It takes vision, persistence and lot’s of learning to be successful.

Starting out in real estate investing

Real Estate investing can be daunting when starting out. The natural tendency is to look online for information. Some sources, such as Bigger Pockets, are credible. But it’s important to not drown yourself out in information. I will touch upon some important basics.

The first thing is due diligence. This is what makes or breaks the deal you are conducting your due diligence on. For larger properties that involve institutional investors, we look at Annual Cash Flows- Property Level, Institutional Cash Flows Base, Investor Cash Flow Refinance, Year 1-5 Pro Forma, Closing Cost Analysis, Monthly/Yearly Cash Flows, Unlevered Returns, Lever Returns Property Level, Returns Net To Investors, etc. It gets complicated. We use our own proprietary underwriting model which has more than 30 sheets in excel with hundreds of formulas. It’s something we discuss in great detail in our strategy session. For ex. if the rehab involves 300 units, you need to know how the returns will be affected as those units are rented out post rehab. It gets messy. But for smaller properties this level of analysis is rarely necessary.

Another critical factor that will determine returns is property management. Most investors of dream of being absentee owners, but the reality is that you will have to be more involved than you think. Many owners choose to manage their own properties, which is fine. But it’s all about your goals and the income you seek. However if your goal is to eventually form a real estate syndicate, you will have to work with property management firms. My partners however own the property management side as well. The benefit of that is they control quality of the operations rather than depend on a 3rd party firm. Property management is generally not a very lucrative business.

For rehab projects you need to be aware of how to work with a general contractor. Often times they will under budget and underestimate the time needed to complete a job. This is bad because it hurts your bottom line. If the property is not habitable, that means you spend more time without collecting rent. My partners who control almost 1,400 units also control the construction side. The benefit of that is we again get to control the quality and also make money on the construction side.

Lastly, as a landlord, you need to know how to find good tenants. These is a screening process that we use when offering our properties to tenants. One of the basic principles is rent to tenants who have something to lose. For ex. any tenant who has a good job, decent or better credit, etc. will not leave your property in a bad condition, abandon it or avoid paying rent. If you rent to deadbeats, you can expect a lot of problems. Quite frankly it’s surprising to hear stories of landlords suffering. Sure, once in a while a bad tenant will slip through the cracks. But often times it’s a pleasant experience. We rarely have had to evict a tenant. But again, it also depends on the type of property you own. If you own a Class D apartment building, you are generally catering to the more blue collar tenant and as a result you can face slightly more problems than renting out to a young professional at Bank of America.

Value of a Mentor

Let me be upfront and say it out loud: It’s scary to start alone because these properties are often times a couple of hundred thousand dollars or more. Most times are people are not able to muster the financial commitment needed. But what really creates fear? If you know exactly what you are doing, would you still have the same amount of fear as a novice? No. You would push ahead. You need to understand every little aspect of real estate investing to avoid the deadly pitfalls. Lack of knowledge makes you think, “what if it doesn’t work? I’m screwed!”. And it’s true, you could ruin yourself.

But how do you learn about real estate investing? By reading books and blogs? Sure, you can get a baseline level from these sources. But just like anything in life, you will learn best by doing with others who have done it before. I started with partners who provided capital. My current partners run real estate syndicates who manage several thousand units and have half a dozen analysts working for them. Would it be easy to learn the industry by working with me and my partners. Sure. I’ve even taken on mentees, but the problem is they expect us to do all the work. Everyone says they are highly motivated. But the moment the going get’s a little bit tough, they bail or expect us to do all the work. We get it, the idea of having cash flow from rental properties is very appealing. But it’s not easy. It’s a competitive business.

First, let’s understand the mentor-mentee relationship. Should a mentor just give and mentee receive? Is it a one sided relationship? It’s not. Often times, we think that a mentor will provide capital, knowledge, guidance, advise and everything else that comes along and all we have to do is absorb. That’s far from it. Mentors are often busy. I run my multi-million property business and I’m looking to grow it. I hardly have time to bring someone on board who will not add any value to my venture. My partners are even busier. Why should we take on anyone who says they are highly motivated? A mentee needs to add tremendous value to bring the relationship close to equilibrium.

What should you look for in a mentor? In short, someone who has done it and is living the life you want to live. Now specifically talking about real estate, they need to have experience building a portfolio, they need to have capital, knowledge and experience. It takes years to develop skills. I’ve spent more than a decade to get to where I’m at. In the real estate industry, there are many “services” offering training for thousands and thousands of dollars, some charging $20k+ just to teach you things you can learn over time with a mentor. Don’t fall for that. You want to work with a group of people who are as motivated as you are. If your goal is to build a portfolio of assets, you need to work with people who have the exact same goal.

You have to keep in mind, mentors are busy. They are viewed as mentors by you precisely because they are successful and running their own businesses. I have been fortunate to put a group together where we continually build portfolios all around the country. I’ll talk more about this at a later time. But hopefully at this point you should realize that you don’t need to spend $20k dollars to learn or attend annoying “free seminars” where at the end the vultures try to sell you. Find a group that has a similar goal as yours and if luck has it, a mentor will be involved.

Adding Value Through Rehab

It’s important to know which rehab work will add value to your building. If you look at my properties, I’ve spent a lot of time and money making them look amazing. Why? Because that gives me a competitive edge over others in the neighborhood and it allows me to charge more in rent. By doing this, I also attract better quality tenants who will leave the place in almost a perfect condition as they found it. That’s important because I spend less money to bring it back to rentable condition. And when I do eventually plan to dispose off my property, I will get good value for it. Sure there will be minor repairs and work that will be needed, that’s natural. I will share these strategies with you another time. The purpose of this chapter is to talk about the overall work we need to execute upon to add value.

One of the things I like to add value with is by creating more livable area. This is especially useful in regions where multiple tenants tend to share a unit. This is why I like to buy buildings that need a lot of interior work because I get to redesign the interior and add more livable area. This means I get to collect more rent. Sure, it makes the rooms a little smaller, but in densely populated regions, this won’t be held against you.

I always start with kitchen and bathroom. Now you don’t need to go overboard in creating kitchens and bathrooms that look like model homes on HGTV. But good enough. What’s good enough? Slightly better than the ones in your neighborhood is a good place to start. It’s important to plan these things out before letting your contractor begin. You need to be well educated on how the various moving parts work: cost of labor, cost of material, time, etc.

It’s important to make sure your rental property conforms somewhat to the neighborhood you are in. If you do something over the top, such as painting each room with a different color or adding funny tiles to the kitchen or bathroom, you can even take away from the value. I mentioned earlier about adding livable area, it’s important to keep it in line with the property and that it fits. If you simply add a unit for the sake of it and it doesn’t mesh with the overall property, you will be taking away from the property, not adding value. Additionally, when you sell the property you will not be able to count the additional room as a bedroom, unless it meshes. So it depends case by case.

Rehabs are often intimidating to new landlords. If you are completely new to the rental property business, start with properties that need a little work. Fix them up. Don’t go overboard. My partners and I are experienced with very large apartment buildings (1,000+ unit buildings) and even we don’t go overboard. A 1,000 unit uninhabitable building would be overwhelming even for us. Mass rehab projects are usually ideal for smaller rental properties. If you are in the market for a 150+ unit building, don’t go for a building that’s uninhabitable. The units should be rentable, but still needs work that can be done concurrently. This means you will have rental income coming in and you can reinvest that income into work by working on a block of units at a time. This is what my partners do on their large apartment complex projects.