Beau Knows Biz is an informative Question and Answer forum where Beau and the team answer questions about the who, what, when, where, why, and how's of sound multifamily and commercial real estate investing. Have a question you'd like us to answer? This email address is being protected from spambots. You need JavaScript enabled to view it.

What constitutes an apartment asset as "student housing" in terms of financing?

Lenders typically consider a property to be "student housing" if 40% or more of the occupants are students and that will dictate the type of financing offered. The owner of the asset, however, may not always consider their property to be a “student housing property” if only 40% are students and 60% are conventional. Owners tend to view their proprety as student or conventional by how they market and lease it; whether they have set move in/move out dates (August to July is more typical in student), or whether they offer student packages (furniture, cable, internet bundles).

Generally when is the most optimum and least optimum time of year to list an apartment complex to sell?

Frankly, multifamily will sell at any time of the year because it is such a sought after asset class. That said, based on our research there are more optimum times when you consider holidays, competition, etc. The short answer is that the most optimum time is between March and August and the least optimum time is between mid-November and end of February. I would encourage you to review our study on this subject.

 

At what cap rate do I need to buy apartments at in order to receive the benefits of leverage in boosting my returns?

The answer depends on the interest rate, LTV, and amortization to name a few. But watch this video for a detailed explanation.

 

How do lenders typically underwrite vacancy for properties with multiyear vacancies of near zero?

A lender source Charles Knighton III, MSRE wrote,  “According to appraisers and underwriters, 5.0% vacancy is 100% occupancy.”

 

I watched your “Multifamily Due Diligence Checklist” video on YouTube. What due diligence (DD) should be done for a NEWLY built multifamily acquisition?

That depends on whether you are buying a newly built apartment deal that has just been fully leased or whether it is still under construction and the lease up hasn’t occurred. Typically an investor would be buying the property once certain occupancy has been completed (90% or more) so my answers will focus more on that scenario. The video referenced can be found HERE.

1.  Instead of asking for income tax returns or P&Ls during your DD period, ask for the pro-forma the developer provided to their lender to get financing for the project. Remember to also do your own research on market rents and expenses too.

2.  The rent roll need shouldn’t change, you’ll still want to know the unit mix, rents for each style, deposits, size of units, lease end dates, etc.

3.  Instead of asking for the last three to six months of utility bills you’ll want to know what utilities the landlord will be responsible for and the projected cost of each, which should be within the pro-forma the developer gave to the bank. Verify these projections by calling the local utility company and getting their thoughts.

4.  Instead of asking for a past property tax bill (which would only be a vacant land valuation), the best way to estimate taxes on a new construction apartment deal in the first full year (first full year is the year following a Certificate of Occupancy was granted by the building department), go the property appraiser website and do a property search for apartment complexes that were built in the last 3 years and then calculate what the assessed values were, per unit, for the first full year of each of those projects. That will give you an indication of what yours will come out to. See how that compares to the developers pro-forma assumption give to his lender. It would be smart to also have a “true up” clause that survives the closing on new construction projects. This basically means that the seller agrees to reimburse buyer for any increase in property taxes that was some percentage above the projected property taxes on the proforma at the end of the first full year. That won’t fully reimburse you for the cap rated value you paid but it helps a little.

5.  As for insurance, this should already be in place and you’ll want to review the “dec” (declaration) pages to makes sure the proper amounts are in place. Shop his/her dec page around with other carriers.

6.  Obtaining the title and survey during DD is still customary in a new construction deal.

7.  You’ll still want copies of all leases and any amendments. Because it is new construction, and there will have only been one lease done, it isn’t necessary to obtain estoppels from all the tenants but that is up to you and your lender.

8. As for the “5 Year Capx List” mentioned on the video, since this is a brand new deal you’ll want to instead obtain all the warranty information for all the major components of the project (roof, HVAC, appliances, etc.). It would be a good practice to set up in your management software how long each of these components last per the item specs and enter that info ahead of time so you don’t have to search for it years later if/when something breaks. You’ll want to know the vendor, install date, contact person, warranty period, care info, etc.

9.  You will still want the environmental report that was required of the developer by their lender. Your lender may also want either a new report or the current one updated by the same vendor.

10.  You will still want to run a crime report, you’ll want to see the leasing traffic log, and you’ll ESPECIALLY want to make sure there are no open permits on the project prior to closing.

I recently bought a multifamily property. The seller never told me that the roof leaks badly. Is there anything I can do?
Always consult your attorney, but buying commercial property is caveat emptor, or buyer beware. You are generally permitted to do any inspections you want but you’re not required to do any. If there turns out to be a problem after closing, it’s your problem. Unlike in residential property, the seller isn’t required to disclose any defects. The seller, however, cannot make false statements like "The roof doesn't leak a drop" if indeed he knows it does. We advise our buyers to have a property inspected and, typically, suggest having an environmental study done. Better to spend a little now rather than a lot later.
I have a buyer for my multifamily property but can't close because the title company says there are open permits?
It's a common oversight for sellers. Before going to market, check for any open or expired permits on your property. It's easy. Do a Property Search with the city or county, which costs around $50 but reveals open permits. Open/expired permits are for work that a contractor did on your property and they didn’t have the final inspection performed by a building official. Sometimes to close the permit the original vendor just has to reopen the permit and have the building official inspect it for final closure (assuming the work was done properly). Other times the building inspector may require the contractor to perform more work in order meet current building codes. Get all this taken care of before going to market or it could really hold up your closing, or worse, kill the deal if too much time passes! Anytime you as an owner have work done requiring a permit, you should insist that vendor bring you a "Certificate of Completion" showing the permit is closed, preferably before your final payment to them. This simple step can save time and money.
What is a lender’s rule of thumb on an investor’s personal financials when buying?

A lender source Charles Knighton III, MSRE wrote, “…the investor’s net worth must be equal to the loan amount.  In addition, they want to see your post-closing liquidity (readily available cash) equal to 10% of the loan amount (or 9-12 months of principal and interest payments).”

I don’t want to overpay for a property so I want to make my first offer really low. Is that a good idea?
There is a term in our business called “low-balling” and refers to making an offer way, way below asking price. In my experience, this backfires more often than not. It tends to offend the seller and gets negotiations off to a very bad start. The seller will often not even respond and any further discussions become a test of egos. It’s a better tack to have your realtor do a market evaluation and let you know what the fair market price would be. You can then make an offer somewhat below market but reasonable depending on how much you want the property. Your realtor can even include the justification for the offer in the presentation. The seller will likely respond with a price closer to what he or she will actually accept.
I want to sell a multifamily property that I’ve owned for 20 years. What tax costs should I be concerned with?
Of course check with your CPA but, in general, you’ll have 2 tax concerns: depreciation and capital gains. You have most likely been depreciating your initial investment each year. A percentage of that base value has been an annual tax deduction and now you get to pay for that privilege at the sale. 25% of the total depreciation must now be paid as a “recapture” tax at sale. In addition, you will owe capital gains on any increase in value in your property. Your CPA should calculate this for you as it isn’t just your sale price minus what you bought it for and the rates vary from 15-20% depending on the investor. There are other considerations like closing costs, commissions, attorney fees, and capital expenses that get factored in. You can defer the taxes by making a 1031 Exchange but that’s a topic for another day.
What are the Top 3 Criteria For Hiring a Competent Commercial Realtor or Team?
1) Experience in the form of deal making, you want to see significant sales/lease volume and lots of deals. The more sales and deals the better and make them provide their stats. Do you want a heart surgeon that does 100s of surgeries per year or one that does a couple? 2) They are extremely dialed in and savvy in the use of technology. They have an outstanding contact database, access to all the listing websites including the local MLS, LoopNet, Costar, all the social media platforms, use of video, big data, mailing services, and the list goes on. 3) Lots and lots of written testimonials from clients. What better measure of a commercial Realtor than to hear from dozens of their customers (many of whom you may know) who speak highly of their performance. If the Realtor can't produce at least 15-20 immediately, then you may want to look further.
What do lenders think most about when underwriting a deal and reviewing the borrower?

A lender source Charles Knighton III, MSRE wrote “Think about it like this:  when a bank lends you 75% LTV on your asset, they are inevitably purchasing your property for 75% LTV.”  “You have to look at it as a risk.  Mitigating that risk is what’s important to getting your loan funded.”

I understand there is a way to sell my multifamily property and defer my tax obligations?
You’re talking about a 1031 Exchange. There are legalities that must be observed so first consult your attorney, but the essence is that you can “roll” your equity from a commercial sale into another commercial property and defer the capital gains and depreciation recapture taxes. Owners will do this for a variety of reasons, such as a purchase offer too good to refuse, wanting a newer property with less maintenance, wanting fewer tenants, wanting to own a property with fewer headaches. The basic rules are you have 45 days from closing on your current property to identify 1-3 properties you want to purchase. And you have to close on one of those properties within 6 months of your property closing. I’ve simplified the process greatly but it’s not that complex and is done by savvy investors all the time.
I'm selling a multifamily property that I've owned for 30 years and don't want to pay for title insurance. Why should I?
It will be very difficult to sell a property without being able to prove you have clear title. In most of Florida, the seller typically pays for title insurance. By doing that you're saying you have the right to convey the property. Even if you've owned a property for decades there may still be outstanding permits or problems with the survey or easement challenges or a myriad of issues. No one wants to buy a property with "issues" that may limit their ability to maximize the use potential. The cost of obtaining a reputable title insurance policy is small compared to the value of being able to say I'm selling this property "free and clear".
I’d like to buy some investment property and keep hearing about CAP rates. What is it?
A CAP (short for capitalization) rate is simply the annual rate of return for an investment property. Just like bonds or CD’s, different investments have different returns depending on the amount of risk. It’s calculated by dividing the NET Operating Income (income minus expenses) by the purchase price. If an office building nets $35,000 in income and you buy it for $500,000, the CAP rate is 7%. This number is calculated without factoring in any loan costs you may have. An investment with minimal risk, such as a McDonalds, would be sold at CAP rates approaching 4%. A riskier apartment complex that has shaky tenants in a non growth location may sell at a CAP rate of 8% or higher. The CAP rate is a benchmark used by virtually all investors because it seeks to quantify the question of risk vs. reward.
What are the Top 10 mistakes in commercial real estate deals?
1) Don't get greedy. Weigh the costs of your property sitting on the market vs. doing a deal. 2) Don't reach too high on list price. Trying to set a world record for pricing can cost time and money. 3) Avoid ego. Don't try to "win" a negotiation; keep your head in the game and focus on solutions for all. 4) Don't be a know-it-all. If you're not immersed in real estate, don't dictate terms against the advice of those who do real estate for a living. 5) Don't dilly-dally. Time kills deals in real estate. You need to respond to offers within 48 hours. 6) Don’t be your own attorney. Get legal advice from a real estate attorney, not your brother the divorce attorney. 7) Don't make changes out of left field to a contract at the 9th hour. That ticks people off and they'll walk away because they don't trust you. 8) Don't ignore simple math and market data. It doesn't matter how much money you have in your property or what your cousin said you could sell for. 9) Don't take it personally. Let’s face it, some people have irritating personalities. Stay thick-skinned and work to make a deal, not prove a point. 10) Be sympathetic to the other side and try to understand their needs. The objective should be win-win.
Can getting a mortgage loan to buy multifamily investment real estate increase my returns?
Simply put, using less of your own money to earn the same rental income will yield a higher rate of return. Here is a simplified example. If you bought a $100,000 property with cash with NO loan, and it earned $10,000 in net income (income minus expenses), that would be a 10% rate of return on your money. Using the same example, if you obtained a $75,000 loan to buy the property, you'd now only be using $25,000 of your own money. That $75,000 loan, using today's average commercial terms, would cost you about $5,700 a year in principal and interest payments. Stick with me here. If you subtract the $5,700 loan payments from the $10,000 in net income you'd now have $4,300 in cash flow that you're earning on your $25,000 investment. This equates to a 17.2% return! It pays to use someone else's money!
I’m interested in investing in commercial real estate for income. What types of properties have the best return with the lowest risk? Retail, Office, Industrial, or Multifamily?
All of them and none of them. Not to get cute but the return vs. risk equation can really be the same for each of those commercial classes. Your return is not determined by the asset class but more by the quality of the property, reliability of the tenant, ease of re-leasing the space, cost of maintenance, and likelihood of appreciation. In other words, you can make a great return from a retail, office industrial, or multifamily property or you can get whacked by any of them. The trick is to buy wisely and weigh those factors carefully. The more successfully you can do that the better your return.
Why is the Debt Coverage Ratio so important to lenders?

A lender source Charles Knighton III, MSRE wrote, “Many lenders in today’s market need to see a debt coverage ratio of at least 1.25x on multifamily and 1.30x on other property types.  This shows that the cash flow is healthy and if the property suffers a 25%-30% decrease in income it will still produce enough to pay the annual debt.”

I’m relatively new to buying and selling multifamily real estate but it seems like every deal is difficult. How do you manage to close so many deals?
Ha, I sometimes wonder. Yes, there are very few simple commercial deals. That’s largely because money is involved and so many owners and buyers or tenants approach deals as a test of wills, rather than with rationale and a cool head. Plus, both parties typically have different objectives. Our job as a commercial Realtor, besides procurement, is to be the objective arbiter, appreciating the perspective of both sides and communicating those perspectives effectively to one another. We have to smooth out the rough spots and find the areas of compromise so that both parties are content, if not happy. We have to be the calming influence and problem solver and have the attitude that any challenge can be overcome. That’s why we get paid. As long as God keeps making every human uniquely different, we'll continue to be in high demand.
I manage my own apartment complex because I want things done right. Is that wise?
Probably not. Some investors manage their own property because they've had a bad manager experience. My answer is, get a better property manager. A good manager will more than pay for themselves in increased rental rates, decreased vacancy, quicker turn around on vacancies, and they generally have better "buying power" than you when it comes to getting repairs done or supplies ordered. Think about it, if you were a landscaper, would you give a small apartment owner a better price on maintenance than a large reputable management company that could potentially put you on 25 other properties? Those savings get passed to you. Same with HVAC guys, general repairmen, plumbers, roof replacements, and the list goes on. The value of your asset is tied to your Net Income. Generally speaking, a good property manager will increase your Net Income.
What should I be doing or not doing so brokers send me good multifamily investment properties?
What you should do: 1) Update your broker a couple times a year to stay on their mind, 2) Show the broker proof of funds with docs from your lender, CPA, or financial adviser, 3) When an investment is brought to you, act extremely fast in reviewing the deal, 4) If an unlisted seller won't pay the broker for procuring you as a buyer, it will go a long way with that broker if you pay him for bringing you a deal, and 5) Close on deals. The more you close, the more deals you’ll see. What you should NOT do: 1) Never go around a broker directly to their client, 2) Don't renegotiate a contract with a seller unless there is some huge surprise 3) Never sit on a deal the broker brings you. It's ok to pass on one, just tell your broker quickly 4) Don't give a broker impossible purchase criteria, and 5) Don't ever ask the broker to reduce his or her contractually negotiated fee in order to solve a problem in the transaction that has nothing to do with brokerage services. You may violate one of these DON’T'S above and get away with it, but it could cost you in future opportunities you'll never see.
The FED is raising interest rates again; does that mean borrowing rates are going up as well?
Not necessarily. Talk to your banker but the interest rate controlled by the FED is the rate at which one bank can borrow from another for a day. Have you ever borrowed money for a day? The mortgage interest rate, which you are more familiar with, is a long term rate that changes based on a myriad of market forces, and correlates with inflation among other indicators. So, the Fed rate (think short term rate) and mortgage rates (think long term borrowing rates) are mutually exclusive. If the "market" thinks higher inflation is coming, long term interest rates will likely rise in order to make up for the perceived loss in your purchasing power. Are you confused yet?
I've been working with a commercial agent looking for an investment property. He's shown me several opportunities and is pushing for me to buy. I worry that he doesn't have my best interest at heart. How obligated am I to continue working with him?
Unless you have a signed buyer's agreement with that agent you have no obligation. It's great to be loyal to one agent provided you feel he or she is acting in your best interest. A good broker, through communication and market knowledge, should be able to clearly demonstrate why you should or shouldn't buy a given property. If your broker is just trying to make a sale, it may be time to switch.
My broker was telling me about Real Estate Investment Trusts. What are they and how do they work?
A Real Estate Investment Trust or REIT is an investment tool that typically combines funds from a variety of sources for the purpose of investing in real estate. A local example is the sprawling Springhill development proposed for the area around NW 39th Avenue and I-75. The property is owned by the Pennsylvania REIT. Some REIT’s are so large that they are publically traded and some are privately owned. Established by Congress in 1960, REIT’s are currently popular with investors because of the strong real estate market and the fact that REIT’s are usually required to pay out at least 90% of their taxable income as dividends to shareholders.
I keep hearing that buying apartments for rental income is such a great investment. What’s all the buzz?
I believe through up and down markets, apartments have proven to be your safest bet because people still have to live somewhere no matter what. As home prices continue to rise across the U.S., rental demand is only going up for the foreseeable future. Another advantage is vacancy risk. A $1M apartment complex in Gainesville, Fl may be 20 units. If three tenants move out in one month that is only 15% vacancy and you'd hope to rent those units again within a month. A $1M office investment in Gainesville may have 3 tenants tops. You lose just one tenant that is 33% vacancy and it could easily take 3-9 months to find another tenant. Would your rather have 20 tenants paying down your mortgage or three?
I'm good at finding real estate investments, and pretty knowledgeable, but don't always have enough money to invest. How can I stop losing opportunities?
If you're truly talented at finding good investment properties and know how to buy and manage them, there is always money available to you. There are structures that exist where you can put in a small amount of money while someone else (the money man) with plenty of money puts in the rest so you can secure the loan. The money man gets what is called a "preferred return" on their capital, which means they get paid first up to their stipulated return on investment, and the rest of the cash flow is shared between both of you, but more in your favor. This uneven sharing after the preferred return is called the "promote" or "waterfall". The more money the property makes, the more you make since you get the bigger share after the preferred return. If the property is doing poorly however, you'll be working for free.
What are the Top 6 Drivers of the commercial real estate market?
To summarize notes from a top broker I know in another market: 1) Employment is the #1 driver of a healthy CRE market. Simply put, the more people working, the more they spend, the better our economy. 2) Government Policy can significantly impact the CRE market, particularly regarding the capital gains rate and healthcare. Uncertainty in government policy keeps all investors on the sidelines doing nothing. 3) The Federal Reserve Policy as it impacts inflation and perception of the economy. 4) Inflation and Interest Rates - as inflation increases the Fed raises interest rates, which drives down values but also makes mortgage payments more costly. 5) Housing: the more value a homeowner thinks they have in their home, the more they will spend. 6) Good old supply and demand: typically lower supply with strong demand drives up prices (our current market). Conversely, lots of supply is usually the result of lower demand and hence, lower values.
How big a deal for commercial real estate is the current administration's proposed decrease in capital gains tax?
Huge. We currently have several investors sitting on the sideline waiting to see what the administration does as it relates to removing the former administration's 3.8% Net Investment Income Tax (NIIT). The NIIT, which is the tax rate on capital gains, dividends, interest, and most other yields on investments, went from 20.0% to 23.8%. To use just one example, we have a family wanting to sell two apartment complexes for $30 million to a buyer we've already secured. They've owned these assets for decades so their basis for tax purposes is nearly zero. After deducting 3% in closing costs they'll be taxed at 23.8% on $29,100,000. They'll owe $6,925,800 in taxes. If the 3.8% NIIT is removed later this year to bring capital gains back down to 20.0%, that same transaction now results in taxes of $5,820,000, a difference of $1,105,800. That's a lot of money. Some owners will sell anyway, many won't. The implications are enormous when multiplied by billions and billions in transaction volume across the U.S.
Why do investment "bubbles" happen throughout time? Don't investors for the most part stick to some sort of fundamentals?
Ha, one would think but greed always triumphs. A "bubble" is when the selling price of investment properties gets too high to sustain. A top investment broker I follow wrote, “In a perfect world investors would always adhere to sound investment principals which would provide a more stable market… the problem is that only lasts a short period of time because greed always creeps in.” Our market is getting stronger and stronger every day, investors are making more and more money, prices continue to increase until the famous "bubble" is created. Then the market has a correction. Investors freak out and do nothing... they just sit on the sideline until one bold soul does a deal and actually makes money. You know what happens next. Five investors do a deal and make money, then a few years later greed is back to rule. This cycle has always occurred and will continue. Sound fundamental investing will never ever be a long term phenomenon.
The multifamily real estate market seems really hot. What is some sound advice for investors in this part of the cycle?
Robert Knakal, a highly regarded investment broker in NY, had several great quotes I try to remember. "When financing is available for everything from every source, soon thereafter there will be no financing available from any source for anything." Another quote is, "When money is easily accessed by borrowers, sellers are those who receive the benefits, not the buyers." And, "Financial models never incorporate recessions and capital shortages, but reality often does." I also like, "When everyone believes a 'paradigm shift' has occurred and the market will never fall, it is about to." Another favorite is, "The real risk of using short-term financing is debt rollover renewal, not increases in interest rates." Lastly, he wrote, "Leverage is wonderful when all goes well, but extremely punishing when things go wrong." Words to invest by.
A friend of mine sells houses. Can I ask him/her to help me buy an apartment building?
I certainly understand wanting to work with a friend, but here’s the reality. While some residential Realtors are well versed in commercial real estate, most aren’t. So it’s kind of like asking your dentist to do your taxes. Commercial real estate and houses are very different arenas with different protocols, forms and requirements. By using a residential Realtor you may potentially cost yourself money or end up with a property that blindsides you with serious issues.
According to lenders, what are their Top 5 Favorite and Least favorite commercial real estate deals to finance?
I surveyed several local lenders and here were their combined average answers: Top 5 Favorite (1 being favorite): 1. Owner occupied anything (esp. SBAs), 2. Stabilized income producing commercial, 3.Stabilized income producing multifamily, 4. Landlord improvements on stabilized income producing assets, 5. New construction development for signed lease tenants Top 5 LEAST Favorite (1 being least favorite): 1. Raw Land, 2. Restaurants (non brand), 3. Speculative mixed use development, 4. Speculative residential development, 5. Tenant improvements for businesses.
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