The Multi-Family Property Purchase Process

We want to talk about the transaction process to get a multi-family property from a target to in-the-bag.  It doesn’t hurt to quickly review why we’re buying a multi-family property instead of single family rental homes:

  • Cash flow – This is pretty simple; more rental units in one location multiply cash flow and reduce cash flow risk. A few vacant months with a single family home are 100% lost-revenue months.  A couple of vacancies for a few months in a 10+ unit apartment project result in around a 20% loss in cash flow.
  • Economies of scale – When you concentrate multiple units in one location and/or under one roof, you gain some advantages in the cost of services and supplies. You save money in the areas of maintenance and purchases of major appliances and supplies.
  • Hired management – It’s much more difficult to transition from self-management to hired management with single family properties. With multi-family you are ready with the cash flow to pay for it and you can dump the tenant relations headaches.

As we launch into this process, we’re assuming that you’ve already done your initial due diligence to determine the basic financial condition of the property, cash flow, costs, net operating income, etc.  In other words, you’re ready to buy.

The LOI, Letter of Intent

In most single family property purchases, you will be submitting a purchase contract offer, and that’s a binding document if accepted by the Seller.  In multi-family and commercial transactions, it is common to use a Letter of Intent.  This offers several advantages.

You aren’t locking yourself into anything with the LOI.  You are presenting your basic major offer price and terms, as well as other transaction components for the Seller to consider when they respond.  It’s not binding, just a starting point to move toward a contract in an organized way.  A good LOI will cover most or all of these points:

  • Purchase price – You’ll make your initial offer based on your research and due diligence to that point. However, even if the Seller accepts this offer, it’s not binding in the format of the Letter of Intent.
  • Financial terms – You present your earnest money offer, describe your financing contingencies; how long and funding terms that are acceptable for you to complete the purchase.
  • Inspection(s) & due diligence – Outline the inspections you expect to do on the property, and the timeline for delivery of those inspections and reports. This includes further financial due diligence; such as lease audits to verify income.  Be clear here as to any documents or supporting information you will need for your due diligence and the timeline for their delivery.
  • Brokerage commissions or fees – Unlike residential transactions with the usual splitting of a commission paid by the Seller with the buyer’s brokerage, commercial transactions are more varied in brokerage compensation. You may be paying your broker/agent, or you may want the seller’s commission split with them.  Outline that here.
  • Timeline for contract preparation/acceptance – This is actually three different deadline items. You want to give the Seller a deadline for acceptance of your LOI, then another for preparation of a contract (including who is to prepare it, you or the Seller).  The third item is a hard deadline for acceptance of the contract or for a counter offer.
  • Other contingencies or conditions – There can be other conditions or contingencies you want satisfied before it’s a done deal. An example might be the removal of certain items from the property, perhaps some storage structures, etc.  This section can have virtually anything else of consequence that you want part of the deal.
  • Closing date – You specify an “on-or-before” date for closing the deal and taking possession.

Your LOI goes to the Seller and follows a path as you’ve just outlined.  They respond with either an acceptance of the Letter of Intent’s terms or some counter offer or terms.  You may do some more negotiating, including changing schedules for different parts of the transaction, such as your inspections.

Inspections

This is a crucial piece of the multi-family property purchase.  It may involve some code or governmental requirements over and above your normal structural and other concerns.  You may need to do inspections on:

  • Structural integrity, foundation, roofing, etc.
  • Pest inspections.
  • Each unit inspected for damages or necessary repairs.
  • Age and condition of appliances, heating and cooling equipment.
  • Any required or desired environmental inspections; example being nearby recorded hazardous material sites.

Basically, you want to know what you’re buying, the current condition, as well as a projection of coming repairs or replacements that may be necessary.

Financial Due Diligence

You’ll definitely be carefully examining all financial data, tax returns and doing a rent audit.  You need to be certain that the rents stated are actually being charged and paid.  If any trade-offs of rents for services are happening, it should be fully disclosed.  You also want to look at late rent histories, lease expirations and opportunities to increase rents.

It’s in this phase that you can uncover any opportunities to increase cash flow and NOI by reducing costs.  Some properties may be paying too much for services, and you can uncover that in your financial due diligence.  Sometimes you can even find enough to trim to improve the cap rate number for the property.

Maintain the Schedule

Between the LOI and the contract, you should have a transaction schedule to closing that has hard deadlines and you don’t want to miss any of yours.  You also want to hold the Seller(s) to their delivery and other deadlines.  Moving through the transaction on time is the goal.

Part of this whole time thing is your analysis of the leases, especially expirations, payment histories and the current rental market.  If there is an opportunity to raise rents, you must balance it with the market, not raising if demand is soft.  Tenants with late rent histories may go on your list to vacate at the end of their leases.

When you leave that closing table, your multi-family property purchase is complete, but your long term management is just beginning.  Hire the right management company, do what is necessary that first year to adjust leases and tenants, and then just enjoy going to the bank.

The Rental Market & Multifamily Just Keep on Booming

The National Multifamily Housing Council and the National Apartment Association commissioned a study of apartment construction and its economic effects, and the results show strong activity.  The study covered activity in 2013, and the headline reads “…the apartment industry and its 36 million residents contributed an impressive $1.3 trillion to the U.S. economy and supported 12.3 million jobs in 2013.”

Experts will argue over whether America is becoming a “nation of renters,” but there is no argument about the boom in apartment construction in the past two or three years.  Partly the result of years of low construction after the real estate bust beginning in 2007, the market appears to be recovering quickly.  This is of interest to commercial real estate investors, as there is a lot of multifamily construction going on all around the country.  Where there’s building there’s usually a need for investment to fund it, and there is a lot of building to meet increased rental demand.

The study is based on research conducted by economist Stephen S. Fuller, Ph.D., of George Mason University’s Center for Regional Analysis.  The data cover the economic contribution of apartment construction and resident spending nationally, with regional data for all 50 states .  There is also data available for the District of Columbia and 40 specific metropolitan areas.  Construction, operations of units, as well as spending by residents are all part of the study.

Most visible is the rise in apartment construction.  The building of new apartments contributed $93 billion to the national economy in 2013.  $30 billion of that went directly to paychecks for more than 700,000 construction workers.  Of the metropolitan areas studied, 17 of them each received in excess of $1 billion in benefits from the boom.  Los Angeles lead the group, receiving $5 billion in benefits from the activity.  Others at the top of the list were:

  • Washington, D.C.
  • New York City
  • Atlanta
  • Chicago

From the report, Fuller states: “The construction for multifamily apartment buildings is a significant and growing source of economic activity, jobs and personal earnings in communities nationwide.  Construction has been rising consistently over the past five years.  In 2009, construction starts were at the lowest level ever recorded since records began to be collected in 1964.

Studies show that 300,000 to 400,000 new units are needed each year just to keep up with demand, and since the downturn that began in 2007, construction has been well below necessary levels.  Even with the level of activity in 2013, completions were only about half of those needed, at 186,000 units.

Highlights of the reports are summarized as:

  • 702,000 jobs and $92.6 billion were contributed to the economy in 2013 from apartment construction.
  • Operations of 19.2 million apartment homes supported 1.5 million jobs and contributed $190.7 billion to the economy.
  • 36 million apartment residents contributed $1 trillion and 10.1 million jobs to the economy through their spending.
  • Continuing apartment construction, operation and resident spending combine to contribute $1.3 trillion annually to the economy; $3.5 billion daily.

What’s the take-away for multi-family real estate investors from this information?  We’re still under-supplied with rental units in relation to demand.  We’re still not building enough of them to respond to growth in demand.  The Millennial generation are still not flocking to the new home market, many sharing rentals and others still living at home with relatives.  All of this combines to suggest strong demand into the near future for not only apartments but single family, duplex and tri-plex rental units.

Crowd funding is attracting smaller investors to larger apartment project investing.  However, there should continue to be strong demand for all types of rental residences.  If demand does continue, families will also be forming, and single family homes offer more to the young family than apartment living.  Multifamily investors and small single property investors alike can look forward to some lucrative years ahead.  Of course, a sharp deal pencil and lots of due diligence is also required.  The multifamily and apartment construction markets are contributing to an opportunity rich investing environment.

Net Operating Income

Multi-family residential property investments should be made almost exclusively based upon the numbers.  Ultimately, it is an investment that needs to return a certain amount.  The amount of return is partially based on what is called the ‘Net Operating Income.’  Net Operating Income is compared to the purchase costs to determine what portion of the return on investment will be.

To calculate the Net Operating Income, you add up all of the annual income, often referred to the Gross Adjusted Income, and subtract all of the Annual Operating Expenses.

Gross Adjusted Income – Annual Operating Expenses = Net Operating Income

Here’s an example that might help clarify things for you:

If a property has a Gross Adjusted Income of $121,816 and Annual Operating Expenses of $25,610, then the Net Operating Income is $96,206.  This is derived by $121,816 – $25,610 = $96,206

 

Multi-Family Properties

Multi-family properties can often be outstanding investments.  For this reason, there is an abundant supply of buyers, all of them looking for good multi-family residential property investments.

Because the returns to the owner can be so substantial for a good multi-family residential property, many owners are reluctant to sell unless they get an outstanding price.

As opposed to single-family homes, multi-family properties are intended to be an income-producing investment for the owners.  When a family is buying a single-family home, their decisions are often swayed by emotional factors.  They will often purchase a home that doesn’t completely make financial sense because they really like the home.  Smart investors in multi-family properties, on the other hand, are looking at it as an investment.  They focus on the return that the investment will give them.  In other words, buying or selling is almost completely dependent on the income and expenses, and whether or not the income is likely to rise due to market conditions or real estate improvements.

Gross Adjusted Income & Gross Scheduled Income

To determine the Gross Adjusted Income, you must start by determining the Gross Scheduled Income.  To arrive at the Gross Scheduled Income, add up all of the rents for the year.

The Gross Scheduled Income is simply the amount of income scheduled to come in from rents over the next year.  You start with the Gross Monthly Rental Income.  This means that you take all of the current rents (often referred to as your Rent Roll) and add them up.  You then need to multiply by 12 in order to get the total amount of rent for the year.  This annualized number is often called the Gross Scheduled Income.  Meaning that this is how much income is scheduled to come in if there are no vacancies and every tenant pays the full amount of rent being charged for the space, each and every month.

For example:

If the property has 10 units that each rent for $1,000 per month, the Gross Scheduled Income would be $120,000.
10 units x $1,000 = $10,000
12 months x $10,000 = $120,000

Then subtract the annual vacancy factor from the Gross Scheduled Income.

The Gross Scheduled Income needs to be multiplied by the vacancy rate to produce the amount of lost income due to the vacancy factor.  This amount is then subtracted from the Gross Scheduled Income.

For example:
$120,000 Gross Scheduled Income x .07 (7% vacancy factor) = $8,400
$120,000 – $8,400 = $111,600

In the above example, $111,600 is the amount that will come in from rents during the year, after having accounted for vacancies.  If this number is calculated based on the vacancy rate provided by your lender, it may not be completely accurate, but it will satisfy the lender’s requirements for funding.  The accurate number may be higher if in fact the actual vacancy rate is lower than what the lender requires for the property type.

Once you have calculated the income from rents, you need to add in any other income from other sources.  Properties often have significant income from sources other than the leasing of the units.  In a multi-family complex, it  might include:

  • laundry income
  • garage or storage unit rentals
  • vending machines
  • game room revenues
  • advertising revenues
  • revenues from any distribution of outside services like cable, satellite or internet

The result is known as the Gross Adjusted Income.

Gross Scheduled Income (GSI) – (GSI x Vacancy Rate) + Other Income = Gross Adjusted Income

How Age & Condition Affect Multi-Family Properties

Age and condition are very important considerations when considering a multi-family property to purchase.  One reason is that rents will be reflective of the age and condition.

Newer apartments are often rented for more money.  Older units can have charm, style, and real appeal, or they can just be plain and dated, and the rents will be reflective of the age and condition.

Also, it is not uncommon in older properties to find that tenants have been there for a long time and the rents have not been raised to keep up with the market.  So you need to find out how old properties are.  Most of the time, you can just ask the current owners for the history of the property, but it also never hurts to get city planning records or the property tax records to determine age.

Age and condition are also important because older units require more upkeep, which can erode the Net Operating Income (NOI).

Look carefully at older buildings as they are much more likely to have serious problems.  Some of the problems that may surface with older buildings include:

  • Leaky windows
  • Foundation issues
  • Dated plumbing
  • Dated bathrooms and kitchens
  • Termite and pest problems
  • Life safety deficiencies
  • Mold, lead paint and asbestos
  • Roofing issues
  • HVAC problems
  • Obsolete appliances
  • Parking lot maintenance
  • Environmental contamination
  • ADA compliance issues
  • and more

Some of this is a function of the actual age of the property, while some of it is a function of the upkeep and maintenance that has been performed in the past.

Multi-Family Real Estate | Residential or Commercial?

Multi-family residential properties breakdown into two subcategories by size:

  • Properties with four units and less are typically treated as residential transactions.
  • Properties with greater than four units are considered commercial transactions.

There are two reasons that properties with four units and less are treated like residential sales and properties with five and more units are treated as commercial sales.  The first reason is that in many states the law actually draws a distinction between the two categories.  Legislators have decided there is a lesser degree of buyer sophistication among prospective purchasers of properties with four units or less.  This is because it is assumed that investors are more likely to occupy one unit themselves and rent the others.  The result is they are treated as single-family homes transactions in terms of the paperwork and disclosures required by law.  Purchasers of five units and more are assumed to have more buyer sophistication.  There is a greater assumption, in most states, that they will know enough to do their own due diligence and therefore transactions may be somewhat less regulated.

The second reason the field is broken into these subcategories is that lenders treat transactions with four units or less differently than they do the properties with more units.  With four units or less, lenders look primarily at the income and credit worthiness of the borrower and they lend the maximum their programs will allow if the borrower is qualified.  For transactions that involve 5 units and more, the loan to value percentage that the lender is offering is not a guaranteed amount, even if the borrower might otherwise qualify for it.  Instead, lenders look at the income of the property to determine how much they will lend.