The key to successfully investing in today’s multifamily market is not to focus on the record low cap rate you are buying at now, but rather, to come in with a strategy for raising that cap rate within the first year of ownership. Granted, not all properties will work within that framework, but if you seek them out and you identify the loan programs that will support this type of value-add strategy, you can effectively raise cap rates by 200 basis points or more over a very short period of time.
One astute investor I worked with did just that with the purchase of a 10-unit building in South Glendale, a suburb of Los Angeles, for $3,500,000. The property, built in 1986, had a great mix of nine 2-bedroom, 2 bath apartments and one three-bedroom, 3-bath townhouse all with laminate flooring, brand new kitchen cabinets, granite countertops, washer/dryers, dishwashers, stoves and microwaves. Half of the units have private balconies and the building offered subterranean parking with two parking spots for each unit.
A cream puff like this was not going to go unnoticed, and there were no less than 20 offers on the property, including six or seven all-cash offers eliminating our all-cash position as a negotiating tool. It was clear the successful buyer would have to go over asking price.
That’s not an easy pill to swallow, and as you might imagine, my client sweated that idea. But instead of walking away, we conducted a rent survey and we went to inspection. With a solid belief that he could raise rents sufficiently, my buyer offered $250,000 above asking paying $3,500,000 – a 3.17% cap rate.
Ouch, you say?
Here’s why we did it and how we succeeded.
At close of escrow, the 2 + 2 units were renting for an average of $1,444 per month and the 3 + 3 was renting for $2,000 per month for a monthly rental income of $14,996. Our research told us that we could raise the 2 +2’s to $1,850 and the 3 + 3 to $2,850.
We had a relationship with a boutique bank that agreed to lend an initial 44% of the purchase price and leave the remainder in escrow for nine months. The bank’s commitment was if the buyer raised rental income to $19,425 or more stabilized for two months within the first nine months of owning the asset, it would fund an additional $725,000 bringing the LTV for the financing to 65%.
This investor had experienced property managers who quickly went to work and turned over six out of the 10 units and filled the vacancies within days. Eight months later, we were able to achieve rental increases that brought the building’s monthly rental income not to $19,425 but $20,424, and he secured the remaining financing.
Nine months after the purchase, this investor owns the property at a 5.3% cap rate, and just as important, he has the cash flow to finance further improvements such as new central air conditioning, a roof and others to further enhance the building value.
Is this strategy for every investor? Obviously not. If your relationships are with traditional banks, those institutions will only lend based on current rents and they will apply a pre-payment penalty preventing you from refinancing once you’ve raised rents.
If the building were rent controlled, it goes without saying that this strategy wouldn’t work. And if you don’t have a property management team supporting you, it would be far more risky to depend on such a short term strategy of increasing rents, even for a building where rents are below market as was this one.
But if you’ve got the right pieces in place, and if you find the right property, this is a key strategy for operating in today’s multifamily market.
George Yessaie CCIM is a principal of Lee & Associates-LA North/Ventura specializing in multifamily sales. He takes great pleasure in sharing the experience and know-how that helped him to build his own personal real estate portfolio with his clients.