Many real estate investors coming from the single-family, fix-and-flip world look at multi-family real estate as the next great mountain to climb. Their success in finding fixer-uppers and then turning them into beautiful swans for consistent profits may give one a false sense of having a Midas touch that can be transitioned to any other aspect of the real estate world. Be careful. These two business models have real estate in common, but the similarities sometimes end there.
Let’s look at a hypothetical example to prove this point. Let’s say that you have two, 100-unit apartment complexes directly across the street from each other. They are identical in every way; they purchased their appliances at the same time, the have the same wear and tear, etc. The fact that they are located across the street has no demonstrative impact on their value. The only difference is this; one property has 100% occupancy and the other has 100% vacancy. Which one has a greater value?
The ‘Flipper’ might say that, using the sales comp method of valuation, the properties are equal in value. All you need to do is increase the occupancy and you are all set.
Nothing could be further from the truth.
These properties may be identical in every way from a real estate point of view, but their value is not. One of them would be able to command top dollar in the market, the other would be worth the land value less demolition costs. But how can this be? What is the real difference between these two properties?
The answer lies in what one property has over the other, that is – lease contracts. When you are in the multi-family business, you are technically not in the real estate business; you are in the “contract” business. When you analyze a multi-family investment, the number one thing that you have to look at is the leases and the second thing you need to look at is the ‘factory’ that generates those leases. That’s right; you have to look at the real estate as nothing more than a factory that produces a product.
When you think of a multi-family property as a business that generates a product, you will begin to view the buildings in an entirely different light. Using the above example, let’s change a few facts. Instead of it being two identical apartment complexes across the street from each other, let’s say that they are two identical factories and that you are buying the businesses that are housed in those factories.
Now I ask you, which one is more valuable? Of course, you can’t answer that without knowing what products they are manufacturing. If one builds Ipads and the other builds Wang computers, I think you would easily find more value in one business than the other. The same is true when looking at lease contracts when evaluating an investment.
When you understand multi-family real estate in this frame of mind, you must realize that you are not buying real estate, you are buying a business. As such, you must understand how to value these businesses and then, you need to know how to run these businesses.
When a bank looks at making a loan on an apartment building, part of their analysis is on the viability of the leases that exist on the property. They want to understand trends in rent increases/decreases, and turnover ratios of units just to name a few benchmarks.
As the potential owner of the property, you want to know much more. You need to review each and every contract to understand who your new “customer” is going to be and whether they are going to be a good customer or someone that you would like to see follow the old owner out the door.
Some of the elements of a good customer/contract would be the length of time that the resident has been staying on the property. The upside to long-term residents is that it shows stability. Another element to look for is systematic rent increases. Do they exist? Many people might walk onto a new property and see that the rents are well below market and think, “Wow, the old owner hasn’t raised rents in years. Look how much money I am going to generate off this property if I just bring the rents up to market.” Unfortunately, it doesn’t always work this way. There might be a very good reason why he has not increased the rents in years. Maybe his residents can’t afford anything higher! And that creates a whole new set of issues when attempting to understand the potential for a property.
Many of my clients make the mistake that the most important aspect when evaluating a property during the due diligence process is the property inspection. They line up the inspector, negotiate the fee and then follow them around the property like puppies as they crawl up in attics, go into foundations, etc. I am here to tell you that the value of the deal is not in the inspector’s knowledge. It is in the filing cabinets back in the manager’s office.
Don’t get me wrong. I would never buy a property without having another set of eyes, more experienced in inspections and buildings than I am, go through the property. But the fact remains that anything that an inspector can uncover as being wrong with the property can be fixed with one thing – Money. Either negotiated pre-closing or spent out of your pocket post-closing.
But a leaky roof will not destroy your investment overnight. What will? In my experience, one thing that will clear out an apartment building and change its reputation overnight is this – Criminals; more specifically, felons and child molesters. Nothing could be worse than a property having a reputation among the criminal crowd that it is a haven for felons and child molesters. Once you have them living on the property, you can watch an A asset turn to a B, then a C in very short order. Your ability to evaluate leases will help you quickly identify whether this business has this problem or not.
Many investors move their way up the property food chain and view multi-family as the panacea of the real estate world. As an experienced owner/operator, I can tell you that success in the multi-family world is entirely dependent upon approaching it the right way. If you are a good business owner, you will do great. If you can’t read a profit and loss statement, you will have a very large learning curve.
Regardless, never go it alone!
Charles Dobens, Esq., of Dobens Law, LLC, The Multi-Family Lawyer, provides legal and consulting services to multi-family investors and those interested in becoming owners of multi-family property. Their experience in real estate and securities matters is the result of counseling a diverse and dynamic group of investors throughout all aspects of the process of acquiring multi-family real estate assets throughout the country.