In an earlier post, I mentioned that my family is selling our 22-unit apartment building in La Habra, California. Escrow is scheduled to close in mid-January 2016, just about a month from now. In the meantime, I’m researching rental properties so when escrow closes, I’ll be ready to roll my investment forward into a triplex or fourplex of my own. But first, I need to figure out how to choose an investment property.
There are a lot of criteria to evaluate when selecting an investment property. Most of my evaluation focuses on the straight-up numbers: current rental income, square footage, price per square foot, price per door, cap rate, etc. (Redfin and LoopNet are good at showing details about current rents and the like.) But numbers aren’t the whole story. You also have to look at the city, the local demographics (City-Data.com is a good source for this), vacancy rates in the area, crime rates in the area, whether there is sufficient parking for your tenants and their guests, and any other factors that make a place nice to live—or not.
How to Compare Properties Based on Recent Market sales
When we were preparing to sell our apartment building in La Habra, I ran local comps to see how much we might sell it for. I looked at other similar buildings, and created a big Excel spreadsheet with all of the property data on it, including the address and city name for the property, the year it was built, the square footage, the total number of rentable units, the unit breakdown (how many 1-bedroom, 2-bedroom, or 3-bedroom units), the list price, the price per square foot, the total actual rent, cap rate, and gross multiplier. If it sounds like a lot, that’s because it is. But it’s really important to me to have all of the information in one place, so I can easily compare the properties. My spreadsheet looked like this (click to open full size): Once I had all the data populated into the spreadsheet, I could use Excel to sort by cap rate, price per square foot, number of units, you name it. I identified the best comps for our property and took an average of the cap rate and price per square foot for each of those. I also took average stats for properties selling this year, and in the past 3 months, to see if there was an upward or downward trend. By using this spreadsheet, I was able to pretty accurately predict what our building might sell for. We stretched on the listing price a bit, with the idea that it might take a little bit longer to sell, but the market is so hot right now for larger rental buildings in Southern California that we figured we could be patient and find the right buyer looking to acquire it in a 1031 exchange. So far, it looks like we did that. (Fingers crossed that everything goes smoothly with the closing.)
How to Choose an Investment Property: Make a List of Comps for Available Properties
So that’s the spreadsheet I used when determining how much to sell our investment property for. When I consider how to choose an investment property to buy, the spreadsheet is very similar, but there are a couple of tweaks because now I’m on the buying side of things (click to open full size):
As you can see, I’ve added a few fields to show the listing date, the number of days on the market, any price changes that have occurred since the listing date, etc. Those pieces of information matter, because they might indicate whether there is any flexibility in the listing price. (Also, my spreadsheet included the street addresses of the properties, but I didn’t list them here because I don’t want anybody to scoop my favorite properties!)
Estimating Gross Rents—Use Actual, not Pro Forma
I calculated the gross annual rent from the actual rents listed by the seller. I did not use the pro forma numbers, which may be accurate or may be total B.S. In some cases I’ve seen listing agents use sky-high pro forma numbers that aren’t realistic at all, and in some cases I’ve seen listing agents use the actual, below-market rents as pro forma numbers. Even though I have a pretty good idea of what the market rents would be based on my experience with our current 22-unit apartment building, I use only actual rents because those are proven to get tenants in the door. That’s the “gross rents” number about 2/3 of the way across on the spreadsheet.
Estimating Expenses—Use Your Own % Ratio and Ignore the Seller’s Claimed NUmbers
Also, for this particular investment property search, I’ve assumed that expenses are a flat 35% of gross rents. It may turn out to be a little more, it may turn out to be a little less, but I think 35% is a good starting number, since I’m planning to manage the property myself. If I were using professional management, or if the landlord is expected to cover all utilities, I might use a 45% or higher expense ratio. But for me, I think 35% is a pretty reasonable estimate. The “net rents” number just to the right of the gross rents number reflects the gross rent amount, reduced by 35% for expenses.
Note: I never use the seller’s estimate of expenses, especially on triplex and fourplex properties. I’ve found that the bigger properties (16 units and up) tend to have more experienced real estate agents who know what the expenses are supposed to be, and who more accurately report them. The real estate agents who list the smaller 3-4 unit buildings tend to be regular residential real estate agents, and most of them have no clue what they’re doing when it comes to investment properties. There are some who accurately list expenses, but there are many others who include tenant-paid utilities as expenses, which overinflates the expenses, and there are some who don’t list any estimate for repairs and maintenance, and list just the insurance and current property taxes (WRONG!—you have to list what the property taxes will be after the sale). So I think it’s better to just choose an estimated expense ratio and go with it, adjusting upward if necessary to account for an older building, deferred maintenance, or landlord-provided utilities.
My Unusual Loan Situation
To the right of the net rent column, you’ll see one for “family loan” and then “cash flow.” This property purchase is a bit of a weird situation because of the family loan. Our current 22-unit apartment building was partially financed by the bank and partially financed via a pass-through loan from another family property (with different relatives as owners). That pass-through loan was recently refinanced and has a prepayment penalty, so it would cost us about 3% of the loan value to just pay it off. Further complicating matters, that pass-through loan is part of a larger loan to that family entity. So if we pay our part off early, we would put the other borrowers in a bad spot. Let’s say there are three co-borrowers: we borrowed 40%, and each of the other two borrowers borrowed 30%. So when the bank is looking for $10,000 monthly payments on the loan, we pay $4,000 of it, and the other borrowers each pay $3,000 of it. Now let’s assume we pay off our portion of the loan early. Even though the loan balance will decrease, the bank will still be looking for the same $10,000 monthly payment from the rest of the borrowers (unless the bank is willing to recast the remainder of the loan payments—we already asked, and the bank said no). So if we pay off our 40% of the loan, the remaining borrowers will have to pay $5,000 per month in order to make up the shortfall. That’s not really fair for us to do to them.
So instead, I came up with a proposal. I asked my uncle if I could take that loan with me to a new property. The interest rate is about market anyway, and we could avoid the prepayment penalty and prevent our other co-borrowers from having to ramp up their monthly payments. Thankfully, my uncle said yes, after evaluating my financial ability to pay back the loan. (All those years of frugality and maintaining positive financial momentum have paid off!) This is great not only because the partners in the 22-unit apartment building are avoiding the prepayment penalty, but now I can make an offer on a property as an all-cash offer, which might make it easier to get the property I want at a good price!
So I’m taking that loan with me, which has a balance of about $580,000, and which has about 25 years left on the loan. Add to that my portion of the proceeds from the sale of our 22-unit building, and that’s the amount I have to spend on a new property. My budget caps out at about $975,000 at the tippy top. Because the loan amount is fixed, my loan payments aren’t any smaller if I choose a cheaper building. So for me, the cash flow after the payment of the loan is a key factor in choosing a property.
The Final Contenders
After sorting my Excel spreadsheet by the net cash flow number, I can see some really good candidates for investment properties. Once I’ve gotten it narrowed down to just a few choices, I can see if there might be some wiggle room on the price, especially for the properties that have been sitting on the market for some time and that haven’t already adjusted their listing prices. I can also take a closer look at the actual rents and see if any of them have rents that appear to be below market. I can also go out and take a look at the buildings in person and see if it looks like there is any deferred maintenance that will need to be taken care of.
Have you gone shopping for an investment property, and if so, what criteria did you evaluate? Do you have any other ideas for how to choose an investment property?