3 Real Estate “Cheat Codes” (Part 2)

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As the title states, this is part 2 of the 3 Real Estate “Cheat Codes” blog series. In the last post, I covered the importance of starting small, knowing your numbers, and building a team when navigating the multifamily market. In this post, I want to touch on how a real estate investor needs to plan for surprises, understand the market in which they seek to invest in, and emphasize cash flow. If you happen to be looking for your first deal, I trust that this blog series will help place importance on some of the things my team and I, as well as other more seasoned investors, have learned on their journey of scaling a real estate portfolio. On the other hand, if you’re a seasoned real estate professional, this blog series will likely confirm what you already knew to be true. Having said that, let’s jump into this post

Plan For Surprises

Like anything in life, you can’t expect for everything to go your way. There will always be surprises and sometimes those surprises happen to be in your benefit but other times they can be costly in terms of time, money, and stress. When it comes to real estate, the four largest surprises that will arise at some point are vacancies, unexpected repairs, changes in the market, and cost overruns.

When it comes to vacancies, not all buildings are as attractive to the renter pool in a market as an investor might expect. While class A properties tend to get their vacancies filled faster due to the desirability of the units and the stability of the renter pool who looks to rent those units, lower class assets tend to experience higher vacancies. This is not to say that class A buildings will always have 100% occupancy and a line of renters wanting to rent the units in the building, but rather that we need to be conservative in our vacancy assumptions when underwriting. Each asset needs to be treated differently and a good rule of thumb when you’re purchasing an asset and seeking to increase the rents is to assume that the tenants will not respond kindly to the increase in rent and as a result you will need to factor in higher vacancy assumptions year 1. The more drastic the increase in rent that you want to implement, the higher the vacancy assumption needs to be. For example, if you’re looking to purchase a 20 unit building and want to increase rents on average by $200, you’ll likely want to assume a 10%+ vacancy factor. What makes the topic of vacancy hard to talk about is that each building is different and not all tenants pay the same rent. You will need to use your best judgement when deciding a vacancy factor. Nevertheless, an industry standard when underwriting is that once the building is stabilized you will want to assume a 5% vacancy.

As buildings age and things wear out, you will need to stay on top of repairs or risk tenants leaving due to deferred maintenance. When you’re purchasing a building and there is a lot of deferred maintenance, you can leverage the fact that there are repairs that need to be done to lower the purchase price or have the seller issue you a credit. When underwriting an asset, you need to factor in a reserve amount that makes sense based on the quality of the building in the event that things go south and you need money ready to tap into. A rule of thumb when coming up with a reserve number is anywhere between $300-350 per unit. Some people choose to factor in $200-250 per unit but I suggest being more conservative when starting out. Furthermore, you will need to factor in what is called a “deposit to replacement reserve” which is an amount of money as a portion of expenses that will go toward replenishing or adding onto the reserve balance you calculated. A good rule of thumb for the deposit to replacement reserve is anywhere between 1.9-2.5% of gross income. The last thing I’ll note in relation to repairs is that you should factor in a repairs and maintenance expense when underwriting to account for things such as broken toilets, light fixtures, doors, etc. The repairs and maintenance expenses line item in your underwriting is harder to come up with a number for and I suggest looking at what that number has been historically based off of the trailing financials the broker gives you and taking a percentage of that number. The more experience you get the better you’ll be able to judge what you should account for repairs and maintenance. Once you’ve toured the property and gone through the due diligence process when under contract, you’ll get a sense of how much repairs the property may need in the future.

As time goes on there will undoubtedly be changes in the market where you own properties. Some of those changes include average median income, development, crime, etc. If you’ve done enough research on the market prior to buying any properties, hopefully, the changes that take place will be positive. After buying a property, you’ll want to keep note of the changes that occur. You’ll want to ask yourself questions such as what developments are happening? Are there any large employers that have entered or left the market? Has there been a pick-up in small business activity? The answers to those questions in addition to others will give you an indicator as to what you should do with your property. Perhaps it makes sense to renovate the units of your property to stay up to date with the changing times. Maybe you’ll start to see some indicators that point to a decrease in the quality of the residents in an area and want to sell your property to stay ahead of the curve. Whatever the case may be, you’ll need to be on top of what is occurring in the market which you’re looking to purchase property in or the market you already own property in.

If you’re the type of investor that looks for properties in need of heavy repairs, you should expect there to be cost overruns. Whether you’re looking to do a gut rehab or renovate multiple units you’ll want to find a competent general contractor (GC) with experience that you can trust. If you’re going to be doing the repairs yourself, hopefully, you have experience so that you don’t stumble upon any unexpected increase in the prices of materials. The author and developer John McNellis in his book titled “Making it in Real Estate” said that there are one of three ways to handle general contractors. Either you could bid out every project, work with one GC that you have a history with, or act as your own contractor. Over time McNellis found that working with a few contractors that he built trust with has been the best method of getting a project done and while it takes time to build those relationships, it’s well worth it. Nevertheless, it’s vital to have very conservative numbers when assuming a renovation budget and the general contractor you’re working with will help you pencil in a margin of safety in construction costs so as to not get burned.

Understand the Market

I touched on understanding a market in the previous section but want to build upon what I wrote there. As we already know, markets change over time and it would be foolish to assume that a market will stay the same indefinitely. Below I’ve listed a set of questions that you’ll want to know the answers to so as to help with market research. As noted previously, understanding a market is an ongoing task, and getting lazy with market research, especially when not buying in your area, can prove to be costly. Some questions you’ll want to know the answers to are the following:

1. Is the population and number of jobs growing?
2. What are the major employers in the area and do they have a disproportional presence?
3. Are there a lot of transactions that are happening in the market?
4. What is the quality of life?
5. What is the crime rate?
6. What is the unemployment rate?
7. Have home prices been increasing?
8. Is there an over-supply or under-supply of housing?
9. What developments are happening and when are those projects going to be completed?

If the answers to the questions above point to a market getting better and experiencing growth, then it’s safe to assume that the rate of organic rent growth that you can expect will be higher than the industry standard of 2%. Savvy Individual investors and investment groups are by no means ignorant of market factors and that’s why you see property prices in certain areas get bid up (i.e. cap rates are low). There are certain markets such as Dallas, Phoenix, Charlotte, etc. that everyone knows are hot and it’s because the market factors point to growing demand in those areas. The beauty of doing market research in today’s age is that we have so much information available to us via the internet. On the flip side, as a result of all the information available, it’s harder to find markets in which other investors haven’t already established a presence in.

All this isn’t to say that just because a market is experiencing a slight population decline, stagnating median household income, etc. that you shouldn’t invest there. Our company operates in the Chicago market, although we are considering other markets, which is growing very slowly but it’s because we have the luxury of living here that we know which submarkets are worthy of investing in. Some investors specifically choose to invest in more impoverished areas because they know the market like the back of their hand. It’s due to the information asymmetry that allows those players so to speak to outbid others because of their insights. Finally, I want to mention that as a market gets more mature and becomes saturated, you’ll slowly see people moving to more tertiary markets. For example, if you look into the Chicago market closely enough you’ll see that some people are slowly preferring to live in the suburbs so as to avoid some of the negative idiosyncrasies of Chicago. You can pivot knowing that people may be starting to prefer tertiary markets in a given area by doing research and staying ahead of the trend. Nevertheless, I think you get the point that market research is critical to finding worthwhile investments.

Emphasize Cash Flow

In previous posts (specifically this one), I’ve mentioned how someone can invest in a property with a focus on cash flow or appreciation. When underwriting we have to make many assumptions but if you think about it, appreciation is never guaranteed and is the harder assumption to make. As you look into the numbers of a deal you can tell relatively easily if a property will cash flow, however, appreciation is a factor of the exit cap rate that you assume when underwriting. Many things are outside of our control such as interest rates, market factors, etc. and can sway an investors exit cap rate assumption and as a result, can throw off the economics of a deal. Knowing that appreciation is a hard assumption to make, I want to stress that focusing on cash flow is more important than focusing on the appreciation of an asset. Cash flow and cash-out refinances are far more controllable and because of that an investor should primarily seek to achieve their return as a result of those. At the end of the day, it’s the revenue that is generated off of rents minus expenses (i.e. cash flow) that comprises a multifamily asset’s price. One of the aspects that makes multifamily real estate so attractive is the control aspect. Through renovations, raising rents, or both you can force the appreciation of an asset. Why put faith in the assumption that a property will be worth way more simply because of appreciation as opposed to what you can control? The economic environment of increasing interest rates we find ourselves in today helps prove my point. Investors who purchased an an asset with little cash flow let’s say 5 years ago with the assumption of selling today hoping that interest rates stayed low have been disappointed. Those people or investment groups now find themselves in a position where they will have to wait out the Fed’s hiking cycle in the hopes that we can return to where we were once before. Over the past 12 months interest rates have risen the fastest ever in history and who could’ve predicted that? Another question to ask ourselves is that even when interest rates do go back down where will they stabilize? I assume that we will not see interest rates near 0% anytime soon. More so, think of all the investors who had adjustable rate mortgages who have gotten hurt as they saw their debt payments sky rocket. Thus, I stress this simple point that cash flow is king and investors should focus on what they can control (rent increases, cash-out refinances, depreciation benefits through cost segregation studies, etc.) as opposed to what they cannot.

Conclusion

We now find ourselves at the end of part 2 of the 3 Real Estate “Cheat Codes” blog series and we’ve learned a multitude of things. Firstly, when investing in real estate we need to plan for surprises such as vacancies, unexpected repairs, changes in the market, and cost overruns. Secondly, understanding the market in which you’re invested or want to invest in is critical to ensuring your targeted return. Finally, we learned that cash flow is king and an investor is better off focusing on what they can control as opposed to hoping the appreciation of their asset will yield their targeted returns.

If you have any questions regarding the terms and concepts in this post or previous ones, don’t hesitate to reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain what is causing the confusion. If you’re interested in investing with us at JP Acquisitions, you can contact us via email (contact@jpacq.com), LinkedIn, Instagram, or our investor portal to set up a meeting.

As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!

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About the Author

Make sure to always do your own research before making any final decisions on buying/investing real estate, stocks, or other securities. I am not a CPA, attorney, insurance, or financial adviser and the information in this blog post shall not be construed as tax, legal, insurance, construction, engineering, health and safety, electrical or financial advice. If stocks or companies are mentioned, I sometimes have an ownership interest in them – DO NOT make buying or selling decisions based on my posts alone. If you need such advice, please contact a qualified CPA, attorney, insurance agent, contractor/electrician/engineer/etc. or financial adviser.