Summary: In this week’s deal, we review a 16-unit apartment complex that we had under contract in Oklahoma City. Ultimately, we decided to walk away from it during the due diligence period. This post explores the issues that caused us to abandon the deal and highlight key learning points that you can use when evaluating your next deal.
This week, we’re evaluating a deal that we had under contract in Oklahoma City. In contrast to prior deals, this property is larger in terms of number of units. As we’ve talked about in previous articles, we are working up to buying larger apartment complexes so this one was a step towards that goal. (That is, if we had gone through with the deal.)
The Property
Brief description: This 16-unit complex was built in 1962.
There are twelve 1BR/1BA apartments and four 2BR/1BA apartments.
Rents for the 1 bedroom units ranged from $470 to 500.
Rents for the 2 bedroom units ranged from $575 to 595.
The asking price was $685,000 and the seller was not willing to negotiate on the price.
We ended up putting in a full price offer because our agents believed that the rents were significantly under-market. This was based on the premise that a) the units were larger than comparable units in the market, and b) the current owner was unable to get premium rents because he did not allow pets.
Issues Identified During Due Diligence
Now that we had “locked up” the property, it was time to dig in and do our due diligence.
We knew from the beginning that this 16-unit complex didn’t have much hidden value or value-add opportunities. We normally like to buy properties with several opportunities to significantly raise rents or decrease expenses. This means that you have a lot of different ways to increase your cashflow and force appreciation. (I.e., increase the value of the property by increasing the net income.)
With this property, there was really one main play: to raise what we thought were under-market rents.
Since the inspection didn’t turn up much, our focus during the due diligence period was to come up with an accurate estimate for rents.
Therefore, we asked two property managers to walk the units and give us their best estimate. We also had a friend who lives in OKC and owns over 30 doors weigh in as well. Here were the results:
- Property Manager #1 came back with significantly higher rents. She thought the 1 BR would go for $625-725 and the 2 BR for $775-825.
- Property Manager #2 told us that there was no room to raise rents. He thought the 1 BR wouldn’t rent for more than $500 and the 2 BR at $595.
- Our agent felt that Property Manager #1 was too aggressive, so he suggested rents would be $550-575 for the 1BR and $675-725 for the 2BR with $30,000 to 35,000 in rehab.
- Our friend agreed with Property Manager #2 and didn’t think the rents would go much higher than it was now, even with the upgrades to the units.
It’s interesting to note that Property Manager #2 was the one we brought in as a second opinion after Property Manager #1 came back with high estimates. Property Manager #1 was the one brought in by our agents.
One thing to point out here is that you always want to watch out for conflicts of interest when an agent and property manager are working closely together. The property manager in this case has an incentive to push the numbers higher because they want the agent who brought them in to get the sale and get future referrals. I’m not saying that’s what happened here but that’s why we always recommend getting an objective third party to weigh in (as we did in this case).
Calculating the Cash-On-Cash Return Using Two Scenarios
The COC calculator is great for comparing different scenarios. In this case, we are going to focus on one variable under the two scenarios: Monthly Gross Rental Income.
For Scenario 1, let’s use the numbers suggested by our Property Manager as well as our friend of $500 for the 1BR and $595 for the 2BR.
For Scenario 2, let’s use the numbers suggested by our agent of $550 and $675 for the 1BR and 2BR, respectively. We used the lower end of the range he gave us in order to stay conservative.
Now, let’s fill out the cash-on-cash (COC) return calculator (download this for free below), going line by line for this 16-unit complex:
Purchase Price
The seller was not willing to negotiate so we’ll enter the full asking price of $685,000.
Down Payment
We assume that you have to put down 30%, because this 16-unit complex will require a commercial loan. (Anything with 5 or more units requires a commercial loan.)
Closing Costs
Closing costs typically range from 2-5% of the purchase price. Based on previous transactions, we will assume 2% or $13,700.
Repairs/Renovation
As described above, we estimate renovation costs to total $30,000 to 35,000. We entered $35,000.
Interest Rate/Years/Payments
We assumed a 6% interest rate, amortized over 25 years with payments made monthly. These figures are based on a recent commercial loan that we obtained.
Number of Units
There are a total of 16 units in this complex. We need the number of units because there are leasing costs associated with each unit. This combined with leasing cost per unit (below) and average occupancy (below) will determine your total annual leasing cost.
Property Taxes/Year
According to the Oklahoma County website, 2018 taxes are about $5,134. It’s always best to pull the information directly from the County website as opposed to relying on the information in Redfin or Trulia.
Insurance/Year
We estimate insurance of about $5,300/year. This is based on our experience, but you should verify this with your insurance agent.
Monthly Gross Rental Income
As above, depending on who you believe, the gross monthly income is either $8,380 or $9,300.
Vacancy Rate
Based on our experience, vacancy of 5% is a fair estimate. You should verify this number with your property manager and real estate agent.
Property Management Fee
Our current property management fee is 8%.
Leasing Cost Per Unit
Our property manager charges us $300/unit for leasing.
Average Occupancy
We conservatively estimate one year but this is one that we sometimes increase to two years because in practice, you have some control over vacancy. For example, we generally raise rents every year. If we want to keep a tenant, we may choose to leave the rent the same in order to keep a tenant in for longer than a year.
Maintenance Costs
We typically use 5% as our assumption. We normally fix up our units to our high standard so our actual maintenance costs are typically lower but we like to be conservative in our estimates.
Monthly Utilities
Based on the previous 12 months, utilities and the cost of maintaining the grounds cost $1,162/month on average.
Conclusion
After entering in all of the figures above, we get an 5.8% COC return for Scenario 1 and a 9.3% COC return for Scenario 2.
Given the fact that there were no other value-add opportunities with this property, the decision to move forward or not boiled down to the rents. We had to believe that the rents would go up significantly for us to pull the trigger on this deal.
However, there were several factors that tipped the scales against buying this 16-unit complex.
The first is, having owned another multi-unit property in OKC, we experience first hand that renters appear to favor either single family homes or large apartment complexes with lots of amenities (e.g., gym, pool, gathering areas, etc.). These small multifamily complexes with no amenities don’t seem to be as popular.
Also, there was a discrepancy with the square feet of the units that we didn’t like. Our agent originally told us that the units were larger than comparable units in the market. This is one reason we thought we could raise rents. However, during inspection, we found out that the units were actually smaller than comparable units in the market.
Last, it didn’t help that there was one 1 BR unit vacant and on the market for $500 during the entire time and it wasn’t renting. This seemed to lend support to our property manager and friend’s opinions on the rent.
In the end, we went with our gut and walked away from this deal.
Have you ever walked away from a deal? Share it with us in the comments below, and be sure to join our Facebook community to connect with like minds!
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