Rehab Project

3 Rules of Real Estate Investing

Three rules of investing from the wise old heads of the Washington REIA:

1. If you aren’t embarrassed to make your offer, you are offering too much.

2. If they take your first offer, you offered too much.

3. If you need a calculator to figure out a deal, it is no deal.

More of interest for investors at WashingtonPowerSearch.com.

An Aberdeen Fixer

Q: Where can Seattle investors buy a 3 bedroom, 1.75 bathroom, 1,895 square foot house for $27,500?

A: Aberdeen!

Don’t turn your nose up at Aberdeen.  Aberdeen has a lot going for it:

• The Port of Grays Harbor is growing through trade with China
• The new 520 bridge pontoons are being built in Aberdeen. Watch the pontoon project.
• A new specialty fiber mill in nearby Cosmopolis has just opened
• The renovated D&R Theatre attracts national acts

Grays Harbor county offers tremendous natural beauty with its ocean beaches and rain forests at Lake Quinault.

Every community has teachers, firefighters, and policemen who need affordable housing.  Would you drive 2 hours to earn $26,500 on a flip?

Track the progress of our Aberdeen flip.

Original 1910 wallpaper

The National Association of Realtors (NAR) reports that nearly one million homes were purchased by investors in 2010.

CNN Money reports that flippers are active in the current market (“It’s absolutely viable“).  Flippers get a bad rap as “vultures” feeding off of the misfortune of families who lost their homes.  But there are other ways of looking at it.  Flipping homes is the ultimate green industry, recycling homes that are otherwise falling into disrepair and beyond use.  CNN Money quotes an investor as saying: “We buy the biggest eyesore on the block and turn it into the best looking house there. We’re helping pull up values in the neighborhood.”

Bare bones kitchen

Today I did some market research for a client on where he should be buying houses to flip in the local market.  I searched for “LLC”, “Corp”, and “Inc” in the owner name and “remodel” in the marketing remarks for properties that had sold in the last 30 days.  This search identified a couple dozen flippers, and then I searched further on each of these to see how many properties they were each involved with.  Most had flipped 1 to 3 properties over three years, but I narrowed down on a list of 6 active investors who had flipped 6 to 20 properties each over that time.  These active – and presumably successful (since they have kept at it) – flippers were mostly buying properties with the following characteristics:

• Location: South King county (Auburn, Burien), Pierce county (Tacoma), and Whatcom county (Lynden/Everson – the specialty of one flipper).
• Inventory: Among these six investors, their inventory over the last 180 days consisted of: 4 active listings, 16 pending, 11 sold.
• Price: Mostly $189K to $299K and usually under $250K.
• Size: 1,500 to 2,200sf. 3-4 bedrooms.

The quickest sales took place in University Place, Burien, Tacoma, Stanwood, Lynden, North Bend, and Auburn.

I’ve heard from two foreign (Australian/Canadian and Chinese/Canadian) investors in the past week that they are selling property in Shanghai, which they regard as a bubble, and are looking to invest in Washington state.

Follow the progress of our North Tacoma flip.

Learn more about Bob Kelly, the Investor-Friendly Real Estate Agent.

As seen above chart, Residential active listings units dropped 20.55% from 8707 units in 2008 to 6918 units in December 2009 while Pending Residential units increased 55.10%, as Dec 09 pending listings were 1413 units compare to 911 units in December 2008.  There is a huge increase in sold units at 57.37%, 1462 units closed in 2009 vs 929 units in 2008.  Snohomish County Sold Residential unit increase is at 89.02% when compared to 2008.

As seen above chart, Median Price declined all across for Active, Pending and Sold Listings.  For December 09 sold median price was $380,000, dropped 6% compare to Dec 2008 while year to date Median price dropped further to 11.62%.

As seen above chart, the other important indicator to watch is “Days on the market” (DOM). There isn’t a significant difference, as little as 1.19% for Dec 09 and 6.85% for the year.

Over all, Inventory of homes dropping while sold home units are increasing. December 2009 Market Trend is showing a promising future for buyers and sellers. Yes, values are declining as there is activity out there…..

If you would like more personalized information for your area, please contact me via emailSebnem.oden@exprealty.com or visiting my website www.ProKeyRE.com

Wishing you a prosperous real estate future….

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

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

Single family residences, including condominiums and 1-4 multi-family,  are good buys as you are buying at the low end.  Especially when you throw in the foreclosures.  They can still be financed with lower down payments, usually 10%-15%, with a 30-year fixed rate at historically low rates.  Add to that a soft economy where people can’t purchase a house for a variety of reasons and need to rent.  Therefore, you are paying at the low end of the market, financing at the low end of the investment rate scale, and  in a market where people need to rent rather than purchase.  Where’s the downside?  Really it’s not having enough cash to purchase the houses in the market. 

Conversely, the larger 5+ multi-family complexes are not a good buy at this time.  Not because they haven’t seen a drop in value, but because they are evaluated differently and the loans are extremely difficult for a variety of reasons that I’ll cover later.  Larger complexes are considered commercial and their values are determined by a complex calculation / manipulation of the net operating income.  Since people are renting more now, the net operating incomes are higher, therefore the value of the larger complexes have been generally stable if not increasing.  That being said, the financing of these are “horrible”.  As you are aware, banks are in extremely poor financial condition and the federal government has and is forcing them to shed their real estate loans, even the good ones, to lessen the chance of the banks going under.  So if you can find them, the down payments are running in the 25%-30% level and the incomes have to provide a debt service coverage ratio of at least 1.25 : 1.  Loan terms are also prohibitive as they are running at a maximum of 5 years with a fixed rate but more than likely the banks will want to use a 3 year term with a fixed rate or better yet a fully variable rate.  Sound good?  Not in this market. 

So investors should look to the single family or small multi-family to invest in during the next couple of years.  They will be able to more fully utilize their liquid assets to purchase more properties at better interest rates.  With the upside being, every property the investors are purchasing decreases the inventory of houses for sale and over time will bring the market back into stability.  What happens then is, the real estate market begins to increase in value, so the investors are actually creating the change in the market that benefits themselves.  Pretty good, isn’t it?  For those people that have liquidity, this may be your time to increase the eventual value of your holdings for the least cost.  Good hunting!

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