There are many people that like the thought of owing large multi-family complexes.  These complexes have five or more units in them which in some minds, spreads out the risk of owning them.  In other minds, it compounds the risk as there are more expenses overall.  Having banked many of these in the past, I’ve seen both come true.

First the positive approach.  The most positive part of having larger complexes is the income is generally more consistent.  For instance, if you own a 20-unit complex and go through a bump in the road and two of your units are waiting to be rented.  This only accounts for ten percent of the units and if all were priced the same, ten percent of your income.  Now, if you had a quad or four unit building and had the same thing happen, the two vacancies would amount to fifty percent of your units and income.  Ouch!  There are also times when you have the normal moving families in and out of the complex.  Having more units allows you the time to remodel the vacated units while the others are still paying their rents so the financial impact is felt much less.  Depending on how much common areas there are and what’s in them, the cost of maintaining them is much less with more units.  The owners of larger complexes also have less traveling to do as they have one property to work on instead of many to make up the same number of units.  Sounds great doesn’t it!

On the negative side of the equation, financing is much more difficult with larger complexes and more expensive.  With small quad units, you can still get 30-year fixed rates at non-owner occupied levels.  The larger complexes are usually tied to short, three to five year, loans that have either fixed or variable rates.  So on one hand you finance a property once and for the next 30 years the payment doesn’t change vs. essentially qualifying the property five to eight times over the same period with the larger complexes.  Even if you’ve paid all of your payments on time, it is not a slam dunk having the property refinanced.  The lender will more than likely have the complex re-appraised at your cost, the rate will be adjusted to the current rate at that time and the payments will be adjusted to try and keep the repayment at the original amortization.  Oh and by the way, the amortization of large complexes is usually twenty to twenty-five years.  You’ll also pay a loan fee of a half to one percent of the balance each time it renews.  So financially, it is very difficult on the large complex owners as if you had an time where there have been large vacancies in the complex and your income has suffered, this may affect the ability of the complex to be refinanced.  Oh and if you want to accelerate the loan and pay more on the principal each month or at the end of a year, you may pay an additional fee called a pre-payment penalty of a percent or so depending on what you signed.

When you evaluate the size of the complex you want to pursue, you need to keep these things in mind.  What I’ve found is that the more capitalized you are, the less problems you will have on the financing or refinancing of the larger complexes.  You should also put into reserves part of the rental income you receive to pay for of the remodeling of the units as they empty.  So in looking at the complexes, be sure you really look at what deferred maintenance there is and what bigger expenditures are going to happen during the next five years, so that you will not be caught trying to figure out how to pay for the expense.  Bigger complexes take bigger management and planning so be prepared.  If you do it right, they can be cash cows but if you err, they can become money pits.

For several years, I’ve watched many people take stabs at buying Motels and wondering if they know what to look for.  Most investors will look at the gross revenues, bottom line and some of the normal statistics like vacancy rate but don’t really know what they are looking at.  What’s important to most people is, does it make money.  Well, this is a good starting point but there are other factors that are also important.

Have you ever heard of a rack rate?  Does your realtor know what it is and why it is important?  This is one of the most important items to know when considering buying a motel.  Why?  Because by understanding what the rack rate is and how it is seasonally adjusted will tell you what the vacancy rate is so you can check what you’re being told.  The rack rate is basically the standard cost for rooms in the motel.  Now usually this is seasonally adjusted so that they increase in the busy months and  are reduced during the slow months to keep the rooms being rented.  Now I’ve heard of and it’s been in the news of some motels drastically increasing the rack rate during snow storms to prey on those that can’t get home.  Some of them doubled the rate or more.  This is really important to know because if you look at the gross revenues and divide by the rack rate to find out what the occupancy was, this type of adjustment will throw off the statistics.  Plus, having a large increase because of inclement weather is not always going to happen.  What you are looking for is some way to verify what you’re being told to do your “due diligence” in evaluating the motel.  Understanding the rack rate is very important.

Another area that is hugely important is deferred maintenance and current remodels.  Deferred maintenance is a potential issue if you don’t have a good grasp on keeping one of these operating efficiently.  There’s nothing like having to replace the roof, cleaning equipment, room equipment, air conditioning units…etc a couple of years after you buy the motel.  Going along with that is scheduled remodeling of the rooms.  How many are done in a year?  At what average cost?  How long does it take?  These types of questions are important as they affect the revenues of the motel.  Most current owners are more than willing to share this type of information as it increases the value of the motel and shows why the revenues are not higher.  Modernizing an old motel will take a substantial amount of money and cost you revenues due to the room down times.     It may be better to negotiate with that in mind then just looking at the numbers.

There are other items that you should look at but this is just a short blog so the last part is about borrowing money to buy a motel.  Be sure you can get at least three years and year-to-date financial information on the motel.  This is the basic information that you and your lender should have.  Find out the information above plus if they are under contract from a larger chain and what the requirements are.  Understand what the potential financing terms are and remember to figure out what the debt service coverage ratio is and does it meet what the lender wants.  To find out what the cap rate is to determine the value of the motel, your realtor should know a commercial appraiser that you can ask.  The more work you do now the less work you’ll do later.  If you don’t know what these terms are and how they affect you, you can read my other blogs on those subjects.

Good hunting!

Recently there has been more commentaries on who’s to blame for the housing decline and subsequent recovery.  If there is a blame it is way too easy to make the banks the fall guys.  Now “banks” is really a misunderstood term as there were some huge non-traditional brick and mortar banks that made a huge amount of mortgage loans, Countrywide, for one.  They were bailed out by Bank of America but that bank was not responsible for the mortgages that were made by them.  That is not to say that they didn’t make their own loose mortgages but they are not alone.  So who’s to blame for the housing decline?  It really starts with greed and ends with greed on both the buyers and sellers of houses.  During “good” times, which really is when there are many transactions for houses and the values are steadily increasing, both buyers and sellers are looking to maximize what they get out of a home.  Is this safe?  Well, I think recent history show’s us that it is okay during those times but heaven help us if the rise is stopped for any reason.

An example of this is a group that I know, who had experience generating mortgages and also been a part of selling homes.  Think they knew what not to do?  Think again.  Caught up in the same stargazing mentality, they maximized their capital and bought many houses that they really couldn’t afford and hoped to get out of it unscathed.  Well that didn’t happen as most of the homes are no longer theirs and financially it was a disaster.  Well, who do they point to as being to blame…ah yes, the banks.  The lending institutions did in fact loosely lend to many people but are they to blame for the housing decline?  No one can force anyone to spend hundreds of thousands of dollars on a home or anything else.

Consumers are still looking to utilize Adjustable Rate Mortgages (ARMs) in a current market where the 30-year mortgage rate is very low, which will be the subject of another blog.  Why do this?  Well, the reasoning is that they are flipping houses and will sell the home before the ARM has matured.  Where have we heard that before?  All I can tell you is that if that doesn’t occur, you will pay increasing rates and for the honor of renewing the loan if you can, you’ll pay more fees.

In reality, all parties were to blame for the housing decline.  Sellers got greedy but after all, who can blame them for wanting to maximize their profit?  The reality is that buyers were to blame for wanting something that they couldn’t flip in time or couldn’t afford.  That being said, there were many people that lost jobs, and lost their homes because of that.  They weren’t the issue but that situation compounded what happened.  And yes, the lending institutions were to blame for the crazy loans that were being approved.  So how do we move on?  We take a lesson from the problems that have happened in the past and do what everyone should do.  Make sure you buy what you can afford to pay for.  Why does that help?  Because as long as you can pay for it, you’ll keep it.  Sounds simple and it really is.

Oh and by the way, investors are out there right now trying to do the same thing all over again.  The one difference is hopefully, they have the cash to invest and won’t rely on credit.

Dave Sato
Real Estate Professional
eXp Realty-Seattle
425-213-6411
dave@seattlepowersearch.com
www.seattlecentric.com

This is a brief video of the upcoming headquarters project as its coming along in 2010 – I pass by this corner (5th & Mercer in Uptown Queen Anne) no less than 10 times a week – it’s about time I parked the surfmobile and took a closer look!  The design of this complex, in my small opinion, is the epitome of organic / futuristic /environmental thinking and symbolic of Seattle at large.  Living in this region, I’m reminded every day of the quality of people who live here and of our collective desire to improve…one thing or another!  The Bill & Melinda Gates Foundation and Creative Capitalism – it’s an interesting time in history to watch the major shifts taking place, and what a thrill that the home of this foundation is right here in Seattle. The future Bill & Melinda Gates Foundation offices are located across 5th Ave. from the Seattle Center & KCTS 9.

[youtube]http://www.youtube.com/watch?v=L-bUAJnfeRw[/youtube]

For real estate in this area:  The 500 Mercer Lofts (along 5th across Mercer St.) went to auction this year (unfortunately) – great, great, great location!  Poor concept & design – a bit too cold for NW residents.  The downtown Seattle condo market is ripe with opportunities anywhere from $175,000 into the millions.  Uptown Queen Anne, Belltown, South Lake Union and Denny Triangle are neighborhoods surrounding the future offices of Bill & Melinda Gates Foundation and the Seattle Center and primarily Condo markets.

Marybeth Cicirello * 206.214.6556 * marybeth.cicirello@exprealty.com * Downtown Seattle Real Estate

Sorry it’s been so long since the discussion about debt service coverage ratios, but it’s now time for the next part. In determining how you evaluate potential commercial projects/acquisitions, there are many factors including but not limited to: the capitalization rate aka cap rate; debt service coverage rates; cash flows; expenses; and deferred maintenance. Each one of these are important to the evaluation of not only the merits of purchasing but also whether or not it is a good short and long term investment. Since the criteria will vary depending on the project type (i.e. multi-family under or over 4 units, retail commercial, warehouse, mixed-use) specific criteria and how to evaluate them will be more thoroughly covered in the 201 series.

In a previous blog, I related how easy it is to alter the value of properties by a more liberal cap rate than will be utilized in the appraisal. This means the cap rate is lower than it should be, with the result being a higher value than what may be used by the appraiser. Another way to alter the value is to not show the vacancy rate or all of the expenses. This has the effect of showing an artificially high net operating income and distorts the value. Don’t be surprised when the lender finds the discepancy, because they’re taught to. Be diligent in your examination of the income and expenses, it can save you money. I know this from many years of experience as a commercial banker.

Debt service coverage ratios cannot be faked. In most cases, the lender will look to the prior tax returns on the property from the current owner. If the information is not available, the lender will estimate the expenses high and the income low to be on the conservative side. All that said, they will look for the debt service coverage ratio to be at least 1.20 – 1.25:1. That means the net operating income divided by the potential debt payment will meet that ratio. If it doesn’t and there is no reasonable way to get it there through remodeling, rent increases, or expansion, be prepared to put more of your own money into the project. Especially in this economic climate, the lenders do not need to have any additional real estate problems on the horizon, so expect them to be very diligent in their analysis of the project and your own financial capacity. You may also be introduced to the concept of “Global Cash Flow.” All this does is to account for all of your current investments and their impact on your cash flow. If you have a business that needs to have cash contributed to it then make sure you have sufficient capacity to handle that also besides the new project.

Speaking of your financial capacity, when you invest in commercial real estate, you need to be sure and have enough cash reserves to cover 3-6 months of expenses. In multi-family, this may be more considering the vacancy rates for the area and the remodeling or updating of the units or the cost and time it takes to make the unit rentable. This also occurs in commercial space, as there are often tenant improvements or other adjustments to the rent and clean-up after a tenant leaves, in order to obtain a new tenant. In this climate, there are way more spaces available then there are tenants so the rents are very competitive and bargains are out there for those that are willing to look. All you have to do is drive the area that you want to invest in and look at what is available. If there are lots of open spaces, the rents should be adjusting downward. When evaluating property to invest in, make sure you’re looking at good hard numbers and not fluff. Take into account the fact that rents are adjusting downward so even numbers that are from the past year may be too high on the income side. Use those numbers only if there are leases that would run past the purchase date and hopefully for at least the next year. Also try and get an accounting from the owner on whose rent payments are slow. Many will not disclose this as it is a forewarning of potential foreclosures or tenant evictions.

One of the things I coach my investor clients on is how to sucessfully interact with lenders to get their project approved. When approaching lenders, just be aware that if you don’t have all of the information that they need you will be going back and forth with them several times to get the property’s basic financial profile established. Don’t get frustrated as this may take some time. Just know that they want to make good loans that make YOU money. This is to their benefit and yours. Good Hunting!

There are many ways to look at certain types of investment such as: large multi-family; motels; mixed-use; retail; wholesale; custom investments (real estate developed for a certain use and client); and many more.  I will always be available to discuss and consult on these other types so feel free to contact me.

Dave Sato, Realtor
dave@seattlepowersearch.com
(425) 213-6411

In the course of purchasing commercial property or large multi-family properties, investors will run into the “Debt Service Coverage Ratio” (DSCR) and wonder what exactly does it do and why is it so important to the lending institutions.  First of all, the DSCR is a quick measure of how many times the Net Operating Income(NOI) covers the debt payment.  Normally, most lending institutions want the coverage to be between 1.20:1 – 1.25:1 or in other words the NOI must be high enough to cover the debt payment on either an annual level or monthly level by 20%-25% more than the payment.  This is to ensure that the property makes enough money to pay the debt with some leeway for one-time expenses.  If you have a variable rate, the lending institutions will also “stress test” the calculation to see at what point changes to the  interest rate will cause the ratio will fall below what is acceptable for them.  Since most banks do not have a long term commercial real estate loan product, this is important for them to know as the loan terms may change every 3 – 5 years.

Now the calculation is critical to whether or not the property can be financed.  This is where you have to be the most careful of what you get for information.  The lending institutions when analyzing the property will try to obtain the past three years of operating statements from tax returns as they are the most conservative.  This is also a good practice for the investor as the information on the income tax returns will show the most conservative income and largest expenses to create the smallest profit to pay taxes on.  This can also be the closest you get to the truth.  There are some sellers that will give you the actual figures but with some you have to ask questions and potentially see leases and rent rolls for the income to make sense and analyze the expenses very closely.  For example, when looking at a multi-unit building whether it’s residential or commercial the electrical expense is sometimes lower than you think but people don’t ask why.  Think of your own home and how much you pay for utilities.  If the real estate that you’re considering buying has less in utility costs than you do but is significantly larger than your home, the question of why needs to be asked.  There are many reasons why it’s ok but you still need to ask.   Why is this important?  Because the lower the expenses the higher the NOI and if you saw my last blog on CAP Rates, you’ll remember this is a way that the value of the property is manipulated.  So watch the expenses and make sure that if there has been vacancies in the building that the income reflects it.

No matter whether or not you see the issues or questionable accounting, the lending institutions will ask you the questions, so you might as well understand as much about the property as possible.  The appraisal will also show what is happening and what effect it has on the sales value.  But most of all, you want investment property to pay for itself and the DSCR will show you that it can.  That’s why it’s important.

As always, I’m always happy to discuss this further if you have any questions.

Next, putting it all together.

Dave Sato

Real Estate Professional

dave@seattlepowersearch.com

425-213-6411

Since initially writing this blog, there has been many new articles by many authors about the definition of “Cap Rates” and what they mean.  Most of the articles are pure definitions that most people have difficulty understanding how it may affect them.  Other articles are specific to particular types of real estate.  What you’ll find is that “Cap Rates” are not utilized differently by type but the rates are adjusted by the type of real estate that you are looking at.  The basic math and how it is used does not differ.  If you read on you’ll get a basic understanding of how they are determined and why it is important to know.

After spending many years in the commercial banking industry and making the jump to real estate, it was very interesting to me that many people do not know what a “Cap rate” is.  First and foremost, it is NOT an indication of or a fixed rate of return.  “Cap Rate” is short for capitalization rate or a mathematical rate that is assigned to a property based on the risk of the investment.  The higher the risk, the higher the rate.  For instance,  let’s say you’d put money into a 30-year investment that is yielding 5.6% annually and is federally insured so there is no risk.  That would be the base rate so anything higher in risk, would be a higher rate because why would you take more risk with your money and not get more in return..the answer is you wouldn’t!  Now let’s say a property has one tenant that pays income to the property owner and has been in the property for many years, has always paid on time and has no wish to move.  The income received from the rent is sufficient to make the mortgage loan and return’s a substantial amount to the owner.  This is more than likely to have a low cap rate as there is very little risk probably somewhere in the 6.5% rate, as there is always some risk.

Now, if you have a commercial building where there are multiple tenants and you average 10% vacancy and barely can make the mortgage payment, this is a higher risk than the other example and would have a much higher cap rate, let’s say 8%.  What the cap rate tries to do is adjust the value of the property to what the income can afford.  Using the previously mentioned cap rates and a annual net operating income of $100,000 for round figures, the value of the commercial building would be $1,538,462 using a 6.5% cap rate and $1,250,000 using a 8% cap rate.  That means the higher risk and thus higher cap rate would cause the property to be worth $288,462 or 18.75% less, in this example.

Cap rates are one of the basic tools used by appraisers and smart bankers in evaluating the potential value of commercial buildings.  Lenders typically would like higher cap rates as it lessens the value, makes loaning money on the building a better risk and is a more conservative approach.  Conversely, if you are a savvy commercial property owner, you’d use a low cap rate to increase the value of the building you have for sale.  And yes, over the years, this has been done frequently.  Normally it doesn’t work because the lenders and appraisers come to their independent judgement on what the cap rate should be and adjust it to a realistic value.  What then happens is the seller either comes down in price or you have to put down the difference between what the seller wants and the lenders would approve.  In other words, you lose out!

Remember, investing in commercial property is risky even if you know the potential tenant(s).  You need to evaluate the income and expenses over a multiple years and also look at the tenant leases.  Until then, if you want to know whether or not your real estate adviser really knows about commercial properties you might start by finding out if they understand cap rates, I guarantee you the lenders will and who do you think controls the money?  Good hunting.

Additional Investor blogs:

Buying Multi-Family Complexes

Buying Motels

Real Estate Investing in Today’s Market

If you have questions about utilizing this type of valuation, please let me know.

Dave Sato

Real Estate Professional

dave@seattlepowersearch

425-213-6411