Here is the first post in many to come on analyzing residential income properties. This is directly from my course on property valuation and analysis.
Learning Objectives of this Post on Analyzing Apartment Buildings and Residential Income Properties: Data Collection and Income & Expense Analysis
Identify sources of data
Describe the components of an income & expense sheet
Understand how to arrive at Net Operating Income (NOI) from Gross Scheduled Income (GSI)
The first step to accurately determine the market value of a real estate investment is a solid program of data collection and analysis. Each property will have its own unique considerations
All should at least begin with:
Overall condition of the improvements
Type of construction
Overall market conditions
Income and expense analysis
Legal requirements, zoning etc
Comparable property data
This list is broad in scope, but it’s a good foundation for the data collection plan. The data collected from the market on comparable type property will be used to determine the appropriate capitalization (CAP) rate and make market comparisons in a later step. Unsure of what a Cap Rate is? Check out my blog post that explains everything you need to know about this powerful valuation metric. The next step is the actual collection of the data.
The data required for the analysis is obtained from many of the same sources as the information used in residential sales.
Multiple Listing Service (MLS), Costar, Loopnet, Commercial Agents & Property Owners, Public records
Chamber of Commerce
Local Housing Authority
Local Council of Governments
Tax assessment records
This should give you an idea of a few of the possible sources of data and the steps to begin the data collection process. Once the data has been collected the next step is the analysis of the data.
The Operating Report (Profit and Loss Statement)
When analyzing a real estate investment, we begin with an existing operating statement, also known as a profit and loss statement. The operating report will consist of both income and expense items attributable to the property. In the first step of the analysis, we will only be concerned with the cash income and expense of the property. We will consider depreciation and other non-cash benefits in a subsequent calculation.
Gross Scheduled Income
The gross scheduled income is the amount of money that the property would produce on an annual basis if it were fully occupied. Included in gross scheduled income would be any income attributable to the property from non-rent sources.
What types of sources can be included for determining gross scheduled income?
These sources could include income from laundry and vending machines, parking and storage fees, as well as other owner operated concessions.
When analyzing the gross income, consideration is given not only to the existing rents being charged, called contract or current rent, but also economic or market rent, which is the rent the property would command if it were available for rent in the current market. An adjustment can be made to the gross income if the market indicates that market rent differs from the actual rent. If such an adjustment is made, that should be plainly noted on the operating statement (see loss to lease).
Vacancy & Collection Losses and Effective Gross Income
The chief component in the calculation of effective gross income is the vacancy and collection loss rate. Most properties are not expected to remain fully rented for the entire period of ownership. When a tenant vacates, often there is at least some rental income lost during the turn over period due to repair or remodeling time. In addition to this consideration, one must face the reality that there may be a situation where a tenant becomes unable or unwilling to pay rent as agreed. In this circumstance there will be some rental income lost.
The vacancy and collection loss is usually expressed as a percentage of the gross annual rental income. There are several generally accepted methods for determining the amount of the vacancy and collection loss
None of these things by themselves will probably give you a 100% complete picture but combining different resources the picture will become much clearer.
Historical data and market analysis are perhaps the most accurate, because typically published figures for the community are an average, and may not be representative of the property you are analyzing. Once the appropriate rate has been developed, the loss is subtracted from Gross Scheduled Income to derive at Effective Gross Income.
Gross Scheduled Income $12,000
Vacancy and Collection Loss (5%) (600) Effective Gross Income $11,400
Gross Operating Income
To figure the gross operating income you go through the following steps:
Gross Scheduled Income
– Vacancy & Credit Loss
= Effective Gross Income
+ All Other Income (garage rent, laundry income, vending, etc)
= Gross Operating Income
The figure derived from this process is what we will call rental income. This is the actual income received after taking into account vacancy and credit loss against potential income.
Other income can come from a variety of sources. In apartments, it is quite often laundry, but it could be rental on furniture for furnished apartments, garages, etc.
The resulting figure of gross operating income is all the income left over after subtracting out the above mentioned items. It is your actual income in hand before expenses. Therefore it is a very important number.
The next step in the analysis process is to determine the total operating expenses for the property. Like income, expenses will be analyzed on an annual basis. The investor will do a detailed analysis of the expenses of a given property, so it benefits the practitioner to have done a thorough analysis in the beginning.
It is important to carefully analyze all categories of expenses to accurately portray the financial condition of the property. There are different categories of expenses, depending upon the type of property you will be analyzing, however all expenses are segregated into two basic categories, fixed expenses and variable expenses.
What are three fixed expenses and 10 variable expenses?
A list of typical fixed expense categories will include
Landscaping and service contracts
Any expense that does not change from month to month
What determines a fixed expense is the fact that the expense will not vary in response to changing levels of occupancy.
Mortgages are not part of operating expenses and are categorized elsewhere.
This group of expenses is not difficult to document for your analysis, but be careful to consider the fact that these expenses may not be the same for a new owner; i.e., the building insurance may go up and most likely the real estate property tax may be reassessed upon transfer.
Real Estate taxes can be one of the largest expenses so make sure to calculate any new tax increase or decrease in your analysis.
This category of expenses is much longer, and categories to consider will vary depending on the type and size of the property under analysis. This category will include all of the expenses necessary to maintain the income stream of the property and to provide agreed upon services to the tenant. To attempt a comprehensive list of all expense categories for all types of properties might be impossible and, certainly, is beyond the scope of our study. We will discuss the more common types of expenses in some detail, remembering that each property has unique characteristics and may include its own unique expense categories.
Many properties will be managed completely by off-site personnel. The cost of off-site management is determined and subtracted as an expense of operation. It should be noted that a management expense is a valid deduction from income even if the owner is managing the property. There are many firms specializing in this field; they usually charge between 4% and 10% of the rental amount.
Payroll On-Site Personnel
Resident management is used when the day to day activities of the property require constant supervision. A resident manager is sometimes given free or reduced rent. If that is the case, you must include the managers unit rent in gross scheduled income, then enter the amount of free rent as an expense. In California, if a property has 16 or more units it is the law to have a resident manager on site.
This would be for other management costs. For instance, office and administrative expense, performance bonuses paid to an on-site manager, and any health insurance or retirement plan contributions would be listed here.
Taxes – Workers’ Compensation
Whenever there is an employee, there are various taxes the employer is responsible for. Among these are: Social security tax, unemployment tax, as well as local, state and federal income taxes. These taxes are payable by the employer, and in addition, the employer is required to withhold some amount from the employee’s pay and forward it to the IRS.
Repairs and Maintenance
This is the total amount of repairs and maintenance necessary for the year. This would not include any money spent on capital improvements. A capital improvement is any improvement which substantially increases the useful life of the property. If you find a property which has not had any maintenance expense in the recent past, you will probably find a trade off in the overall condition of the property.
This is probably the most difficult portion of the operating statement to complete accurately. This information is most easily obtained from the owner. NOTE: If the owner is paying the utility bills and is then reimbursed by the tenant, the full utility cost will be listed here and the amount reimbursed to the owner would be listed as other income (this is referred to as R.U.B.).
Accounting and Legal
This is the amount for the bookkeeping required on the property. It will include any amounts paid for payroll reporting or for monthly profit and loss statements. This should also include any legal expenses associated with evictions, drafting of leases, etc.
Advertising, Licenses and Permits
Many larger properties will have ongoing advertising expenses. At the very least there will be some cost at each vacancy. This includes the amount spent for advertising, as well as any licenses or permit charges; e.g., city business license, pool inspections, and/or housing code inspections.
This might include supplies for the vendors mentioned previously: Bug spray, batteries for smoke detectors etc.
That’s right! There should always be a category for those expenses too insignificant to warrant their own category. This would include any additional expenses which were not accounted for elsewhere in the analysis.
These are services which are supplied by outside vendors not already accounted for under fixed expense categories. These are additional services such as maintenance contracts, design services, appraisals and as many others as necessary.
Here is a list of the more common expenses in alphabetical order. Some of them we list without explanation because they are rather obvious:
Accounting and Legal expense
Licenses and permits
Miscellaneous and other expenses Property Insurance
Payroll and Workers Compensation
Real Property Taxes
Repairs and Maintenance
Utilities (Such as the electric bill)
Total Operating Expenses
This is the total of the expenses calculated. This is not to include vacancy or credit losses. Remember that what we are attempting is to give as accurate a picture as possible of the property’s financial condition. The property’s value will be dependent upon the ability to produce income, so it is important to be as accurate as possible in estimating both income and expenses.
The total operating expenses are now subtracted from the effective gross income.
Effective Gross Income $11,400
Total Operating Expenses (4,500)
Net Operating Income $ 6,900
Net Operating Income (NOI)
The net income that a property is capable of producing will be one of the first indicators of the worth of an investment. Later when we begin to apply the capitalization rate to the property, the NOI will be used to estimate total investment value.
The calculation of the net operating income does not take into consideration the effect of any potential financing of the property. This may seem odd at first, but in consideration, it will not take long to realize that the property should have a value that is completely independent of any financing that an investor might use to acquire that property.
Measure NOI correctly in order to properly value property
NOI is arrived at as follows:
Gross Operating Income
– Operating Expenses
– Capital Expenditures
Net Operating Income
The sales proceeds that come from divesting yourself of a property are as follows:
– Selling Expenses
= Net Sales Proceeds
– Adjusted Basis _
= Taxable Gain
– Depreciation _
= Capital Gain / Loss
Having discussed the income and expense analysis in detail, we will concentrate on the balance of the data and other considerations. The property will be analyzed for the following:
All of these considerations will be compared to other investments available in order to determine the appropriate rate of return and measures of value for the property being analyzed.
Test Your Knowledge: Data Collection and Income & Expense Analysis Questions
1. What is the chief component in the calculation of effective gross income?
2. How do you come to Effective Gross Income?
3. Circle the following that are considered an operating expense:
Property taxes Insurance The owner’s income taxes
Mortgage debt service Payroll taxes Utilities
4. How do you arrive at NOI from Gross Operating Income
5. How do you arrive at the capital gain / loss from the sales price?
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Cap rates on properties can be misleading without proper expense reports
Many small to mid-sized multi-family buildings don’t have accurate expenses records
By only looking at cap rates can cause you to lose out on potential good deals
It is imperative to do your due diligence and analyze the expenses
Pairing yourself with proper representation (commercial broker) can make a huge difference
Learning standard expense multipliers can save you a lot of time and money
So, you’re looking to purchase your next multi-family building. You’ve selected a few perspective properties, gathered the financial reports, and are trying to decide which is the best investment. How do you know which one is the best deal? Many investors would run straight to comparing capitalization rates (AKA cap rates).
While this is a good start, I’d argue that you should be cautious when comparing cap rates. It is crucial never to take a cap rate at face value and always conduct proper due diligence and seek appropriate representation. Not only could you overpay for a property, but you could also miss out on some great deals. The answer to this dilemma lies in the expenses.
First, I will explain why cap rates can be inaccurate due to inaccurate expenses and then offer a more accurate and efficient alternative.
Be sure to make it down to the end of this post for my PowerPoint presentation on “Don’t Take Cap Rates at Face Value”. I’ve included some valuable and practical examples of the topics discussed in this post.
To understand cap rates better, it is best to take a look at a crucial component, the net operating income (NOI).
To arrive at the net operating income, we must subtract gross operating income from operating expenses; but what if the operating expenses are misreported? That can have a drastic effect on the final calculation of a cap rate.
Most small to mid-sized apartments available on the market don’t have actual expense reports or profit and loss statements from the owners.
This could happen because the owner is:
Doing repairs themselves and not factoring in things like labor costs
Miscategorizing capital expenses as maintenance expenses
Keeping incomplete expense reports or in some cases, no reports at all.
Other times it can also be the broker’s fault because they don’t ask for the expense reports from the owner.
A failure to have actual expenses can lead to you, the potential buyer, to purchase an over-priced deal or worse, walk away from a great deal.
Here are some ways it can be inaccurate
I’d like to introduce Mr. Magoo, a carpenter, and the owner of a small apartment building that has recently been put on the market. He’s seen a couple of Martha Stewart shows and thinks he’s quite the handyman, so he decides to do all maintenance and repairs himself. He’s made some questionable decisions like when he mixed several leftover paint cans to paint the exterior of the building, or when he patched a leaky roof with plywood. He’s also read online about property management and decides he can manage the building himself.
By doing this, Mr. Magoo has been able to save thousands of dollars on labor and maintenance expenses. He’s able to avoid placing these line items on his expense report, which makes his NOI appear higher than it is.
So, one day you’re on LoopNet or Costar looking for commercial property and stumble upon his building and decide to give him a call. When you speak to Mr. Magoo, he tells you it is an excellent building with little expenses. He claims that maintenance and repairs only cost him 5% of total expenses, which is drastically different from another owner who may assign 25% of their total expenses towards maintenance and repairs.
After doing some math on the given expenses, let’s say you calculate the cap rate of his property to be 6%. You think this looks like a great deal and are considering making an offer.
This can pose a severe problem if you, the potential buyer, take his expenses at face value without conducting any due diligence.
If you were to look into the expenses on Mr. Magoo’s property, you would find his cap rate is inaccurate unless you plan to hire yourself to be the painter and the property manager. The reason his cap rate appears to be high is that he was not accounting for the labor or market costs of maintenance. Unless you’re making less money than a property manager or painter at your current job, you should hire professionals. You’re going to save more money by paying them to do these services, and a lender will always add these expenses to their underwriting criteria. Your job should be running the operations, finding more properties, or continuing your career that pays you more than painting or managing your property. So, in this scenario, the cap rate is useless because Mr. Magoo’s expenses do not represent what you, the new owner, would be paying.
Without digging into his expenses, you might end up paying far more for a property that doesn’t produce anywhere near the stated NOI.
Now I’d like to demonstrate how over-reporting maintenance expenses can drive you away from potential deals.
Let’s say you stumble upon a 6-unit apartment building that has everything you are looking for in a multi-family property. The only issue is that it has an alarmingly low cap rate of 3.5% and very high expenses. Many inexperienced investors or brokers may walk away from this deal without even digging into the expenses.
Upon further investigation, you discover the current owner has been overstating expenses because they don’t know how to accurately spread out repair costs over the life of the repair. When looking at the report, you see that there were two consecutive years of significant electrical upgrades that cost about $30,000 per year. This adds up to $60,000 in total expenses for new electrical that was meant to last 50 years. The owner should have spread out that $60,000 expenses over the life of the electrical rather than doing it up front. An experienced broker would be able to spot this and reallocate the expenses to the property area. After correcting the error, you will see that the cap rate will go up and expenses will go down.
As you can see, by the owner not understanding how to report expenses accurately, the property seems to be a bad deal. You may have walked away from a great opportunity had you not conducted a little due diligence.
Another way cap rates can be misreported is through property taxes. The property taxes for multi-family apartment buildings in San Diego is 1.2% of the purchase price of the building. Where many inexperienced brokers can make mistakes is by basing their cap rate calculation off the old property taxes which is not accurate of what the new owner will be paying. Here’s an example:
Let’s say you have a property that the current owner bought for $1,000,000 over ten years ago.
Currently, the owner would be paying $12,000 a year in property taxes. The property is then listed on the market for $2,000,000. Instead of calculating the new property taxes, which would be $24,000 per year, the broker decides to use the same $12,000 that the current owner is paying.
What results is that the expenses will be reported at less than what they actually will be. This has the unfavorable result of artificially increasing the cap rate. When the new owner acquires the property, they will not be receiving that same income as their property taxes will be based on the new purchase price.
Furthermore, this could cause you to pay more for the property than it’s worth. Take a look at the following spreadsheets.
The difference between the old and new property taxes comes out to be $12,000. If we value the $12,000 difference at 5% cap rate ($12,000/.05) we get a value of $240,000. Now, let’s say the property requires a 25% down payment. If you were to pay the original asking price of $2,000,000 assuming the old property taxes, your down payment would be $500,000 ($200,000 * .25). If, however, you took into consideration the reduced value given the updated property taxes, you would see the offer price comes down to $1,760,000 ($2,000,000 – 240,000). This makes your 25% down payment $440,000. That’s a $60,000 savings by accurately accounting the property taxes.
This is why it is crucial to pair yourself up with proper representation. An experienced commercial broker would realize this and account for it in the offer.
The pay between experienced commercial brokers and new ones is not far off, so why not pair up with one who is experienced?
So now that I’ve demonstrated some ways that cap rates can be inaccurate let’s look at a better alternative.
Standard Expense Multipliers
With properties that may not have accurate expense reports (especially small to mid-sized apartment buildings), I recommend that you use standard expense multipliers to learn the price per square foot. This puts you in a much better position to understand a properties performance and overall value. I have found the Institute of Real Estate Management (IREM) Apartment Expense Multiplier sheet to be extremely valuable when determining baseline expenses.
When used appropriately, this will allow you put a better estimate on what your actual expenses may look like on a price per square foot basis.
This will allow you to compare the owner’s expense report versus your estimate. Any significant discrepancies could be a red flag that requires further investigating. These calculations will save you a lot of time and potential money spent.
If you’re trying to look through 180 listings, you can’t underwrite every deal promptly. Instead, what you can do is quickly look at each deal and say, “okay, this is a $170,000 unit. It’s a 14 times GRM. If you put about a 40% expense on it, it is going to be in the 4% cap range”. Using this approach is going to make it much quicker for you to go down the line of properties. Also, sometimes you’re going to find very similar buildings. If you saw something that sold for a particular gross rate multiplier, that may be a better way to sort through properties quickly. It will become easier to make apples to apple comparisons because those rents that they listed are usually accurate as long as they’re not pro forma rents.
So, when do you use Cap Rates?
Well, the larger the property or, the more organized an owner is, the more likely it’s going to be accurate. Also, the more respectable and experienced the broker is, the more likely it’s going to be a precise number. If the pay difference between an experienced and new broker isn’t far off, why not pair yourself with an experienced broker?
Rarely, when you get down to it, will expenses be precisely what any owner says. The question becomes; how far off is it? So, my first piece of advice is to try to deal with people who are reputable and looking at the numbers. If everything you see in the market is at a 5% cap rate, and all of a sudden you find a property with a 7% cap rate – you should think to yourself, “that’s suspicious, why is it still on the market?”. Another example is if you see two comparable buildings with similar rents but drastically different cap rates; this could indicate something is off.
If you’re looking at larger properties or ones run by management companies, the numbers are more likely to be accurate because the owner is going to be able to print out a profit and loss statement. However, another problem arises.
What you could find is that the owner wants to write off as much money as they can on the property. Besides depreciation, they can achieve write-offs through two main ways.
First is by doing maintenance and writing it off the in the year you did the work. This could be things like fixing your toilet or patching the roof.
The second is capital improvements. Capital improvements typically have a long life but can range from one year to several years. A roof, for example, is a capital improvement because even though I paid $10,000 for it today, that write-off might be over the ten-year life of the roof. Because of this, I’m only able to write off $1000 per year against my income. Although this is the case, a seller may say, “no, that’s still maintenance, so I’m going to write off the entire $10,000 this year”, even though it’s very questionable if not outright fraudulent to do so – but it still happens more than you’d think. A good broker would be able to spot this right away and reallocate it to the proper area of the financial statement. This would change your overall NOI.
So, when working with cap rates where you get income/expense reports, it is imperative to take a look and identify which numbers are actual maintenance and which ones are capital improvements. You also need to see if they’re moving their maintenance into capital improvements. Sellers often do this so they can report more income in the year that they sell, which gives them a higher sale value. Doing your due diligence here can save you a lot of time and money.
Here’s a great example of a multi-family apartment building in San Diego that I bought a while back. The property had a very low cap rate, which typically means that it’s not producing a lot of income. Many investors would walk away right there without digging into the financials. However, after we got into the property, we realized the expenses were misallocated, and the CAP rate turned out to be higher than it was initially stated. We were able to turn a healthy profit on the building by not taking the CAP rate at face value right away.
The moral of the story is be careful when you rely on the CAP rates of small to mid-sized properties.
Learn your expenses
Learn the price per square foot
Learn the market rents in the area so you can apply those metrics to buildings you are analyzing
Take a look at who is listing the property. Is it somebody who has experience? Are they missing a lot of financial numbers?
Do they have expenses listed out, or do they just give you a bottom line number?
Do they have a marketing package? Are they seeming overly aggressive with what they’re proposing?
Sometimes the best deal you buy are the properties that were not marketed correctly. These can often be opportunities for you get a lower price if you conduct the necessary due diligence.
Please leave in the comments below any thoughts you have on cap rates and valuing a property or any stories you may have run into…
Disclaimer: I’d like to point out that none of the content in this article is absolute. It’s just food for thought and is based on my numerous years of experience dealing with commercial real estate.
These are just some things you may want to think about when analyzing commercial properties. It isn’t always advantageous to rely heavily on CAP rates when looking at properties where you don’t know their actual expenses. This post was designed to offer an alternative for when you’re looking at dozens of properties and trying to find the best deal available.
Please take a look at my PowerPoint Presentation from my recent class on “Don’t Take Cap Rates at Face Value”. I teach monthly commercial real estate classes on a variety of topics from due diligence to getting started in commercial real estate and everything in between. If you’re interested in finding out more about my classes, please visit my Eventbrite Page where you can find the complete list of upcoming classes.
Here is a quick recap of some things I look for when doing a quick inspection of an apartment building or even a single family home and common issues I come across.
I like to do a quick review to the outside condition of the property in order to gain insight as to whether it warrants further consideration for purchase or investment.
Now, before getting into the details, let me summarize the most important factors regarding the physical condition of a property.
Some of the important visible considerations are:
Reviewing the foundation and cement
Checking the siding
Reviewing the sprinkler systems
Analyzing the quality of the landscaping
Looking at the windows
Looking at the roof
Inspecting at the front door
Looking at the gas meters
Looking at the train gutters
Reviewing the quality of the paint
Looking at the overall neighborhood
When buying a property, whether it’s an apartment building or single-family house that you may plan on flipping, some of the concepts are going to be very similar, if not identical. With many investment properties, you will find an inside inspection is subject to an accepted offer. This means you will need to make some assumptions about the property before you submit your offer. This can prove difficult, especially when you’re not able to view the inside.
I’ll look from the ground up – I’ll start by looking at the ground and taking an overall look at the condition of the property to see what level of care has been maintained. As a general rule, if it’s a piece of shit on the outside, it’s probably a piece of shit on the inside. There have been a few exceptions where I’ve been pleasantly surprised when I got inside a property, but that’s exactly what they are – exceptions. I’d use this analogy as a general rule of thumb – if you see a car that looks junky on the outside, it probably just as junky on the inside.
Foundation – I’ll look at the foundation,all the cement on the ground near the foundation, and all landscaping near the foundation. I’m looking for things like sprinklers spraying on the building. I’ll then check if there is stucco peeling off the building,which can sometimes indicate moisture intrusion into the building. I’ll also check if the ground is sloping towards or away from the building; it should be sloping away from the building.If it’s sloping towards the building, it may indicate that a possibility of having a foundation or other problem that relates to water. If there’s cement, I’ll look for big cracks in the cement, which sometimes can indicate unstable soil or cracks in the foundation.
This could indicate further foundation issues
Landscaping – what is it going to cost me to improve the landscaping, what do I need to do to it, are there sprinkler systems, and are they automatic or non-automatic?
Building – what kind of siding is there? Is it stucco, brick, vinyl, wood? I pay close attention to the condition that it is in. If it’s wood, I will check for visible water or termite damage.
Eaves – Does the wood going into the eaves have damage? If there’s a lot of damage in the eaves, it very well could go into the attic rafters, which could be a lot more expensive. If it’s on the siding, what kind of siding is it? If it’s an old building, a lot of times replacing siding can get very expensive for two reasons:
the eaves is the part of the roof that meets or overhangs the walls of the building
First is the fact that you may not be able to find that particular kind of siding anymore without having it specially milled.
Second is anytime you pull something off an old building, you’re very likely to find unforeseen surprises. Because you can’t be certain of the magnitude of these surprises, it is safe to assume everything is going to cost you a little more than you think. Whatever you think the price is, assume it probably cost more than you originally estimated.
Windows- Are they new or old? If it’s an old building, are they wood sash or aluminum windows? Is that something that’s going to need to be replaced? Typically, the double-wood-hung windows that you see in houses or old apartment buildings are not in very good condition. With aluminum windows, I essentially just look at them and decide if I’m going to replace them or not. What you need to be aware of is in many areas where you replace these windows, there may be architecture review committees that require you to replace them with historical windows. This could prove to be very costly, especially if they are wood sash.
wood sash window
Building Corners – Does everything appear straight? If there’s siding, are the lines of the siding vertical or are they all straight? On the corners of the building, what does the wood look like? Is there stucco coming off?
Roof – Does the roof have something called a drip edge? This is a little metal edge that goes into the lip of the shingle roof. Are there rain gutters? If there are no rain gutters, water may not have been running away from the building. Because of this, I will spend more time thoroughly inspecting the foundation.
I look at the shingles of the roof; if there are many noticeable curved edges, it is likely on its last leg. Then, if I think I may need to replace the roof, I will look at how many layers of roofing there are. Typically, you don’t want to go past two or three layers of roofing. What that means is that if you replace a roof that has two or three layers, you need to put in your budget funds to tear off that existing roof before replacing it. You also will need reserves for unexpected issues when you pull of the old roof because you may need to repair the plywood underneath. Depending on how much work you do around the roof, you may have to re-sheet it.
re-sheeting a roof
Fence –Do I need to replace or paint it?Is the fence wood? Is it leaning, does it look like it’s on my property line, does it look I could add private yards for apartment units? Many times, you will find large open areas in the back of apartments that are shared. What we can do is put up a fence around the units and now each unit has their own backyard – a very inexpensive fix that not only can help you get higher rent but can reduce costs because you may not have as much landscaping to maintain
Paint (for older buildings) – If it’s pre-1978 and you have peeling paint, you’re probably going to want to get a lead-based paint test conducted. That’s going to tell you whether you’re going to need to do any kind of abatement or work on the property. If work is needed, you may need to use lead-based paint best practices, which can prove very costly. I usually recommend getting a test. Paint used in older buildings in San Diego is less likely to have lead in it compared to the east coast, where the weather is harsh and requires more durable paint. Most of the properties I have tested did not contain lead, but it is still important to get it tested.
If it is tested and comes back negative you do not need to follow lead based paint best practices. If you have a pre-1978 property and decide not get it tested, you still must work on it like it contains lead based paint – which is a good reason to get it tested in the first place.
Front Doors – Aesthetically, are they looking good? Are there any gaps? If I look at top of door, I will look for a little pie-shaped gap at the top. If this is present, it indicates there may be some settling in the property.
Meters– Is it gas or electric? Are there gas meters for all units? If the property runs on gas and there is one water heater, there should be gas meters for each unit and also for the building.If it’s a multi-unit building, I count how many individual meters there are. There should be as many individual meters as there are units, plus one additional one, which would be for the common area. If you’re missing a meter, you may have something called a bootleg property, which means one of the units may have been put in unpermitted(just something to look at). These are important things to note because in San Diego the tax assessor will charge for all the units, and state on the public website that it is X units, but that does not necessarily mean they are legal units.
Electrical –As far as electric meters go, I’m looking at what kind of panel it is. If it’s old, it could be something called knob and tube, which could indicate that I’m going to have to put a lot of money into upgrading the electrical. This will likely increase the interior costs as well. I then look at the circuit panel – is it updated? Then, I’m looking at how many amps each unit has. Ideally, you want 100 amps, but for many apartments, you’ll have between 30-50. Newer apartments should have 100.
Knob & Tube Wiring
I’m also looking at the type of panel; Murray Lampert typically have problems, so I want to check what kind of panel there is. Are there circuits in the units? Is there any room to add additional circuits if you want to add appliances or anything else inside the property? Is the inside of the panel painted? If so, it could indicate that the previous people who worked on the property weren’t doing things the proper way. This would lead me to believe other things were not done the proper way.
This is quite the mess!
I’m looking for bunches of electrical or cable lines running all over the place. We’ve bought properties where it looks like spaghetti running all over the building, and we’ve ended up having to rip it all off and start from scratch simply because it’s easier to do instead of trying to sort it all out.
Staircases –When I walk on the stairs, I make sure to walk very heavy.I’m looking to see if it seems squishy. Is termite damage visible, are the railings stable? In compliance with code, railing spacing should be about three and a half inches. For me, if I can make a fist or place my hand through the pickets of the railing, it is most likely not up to code and I’ll have to replace it depending on my insurance company and how bad it is. I look at the stairs to see if the tread rise and depth are consistent. It should be around 7” of rise and 11” of depth. If they are not to code they may need to be replaced.
Inconsistent stair depth
After An Inspection– Once the inspector gets into the property and finds things that I may not have found, do I decide not to buy the property? No, not at all. It just helps me to figure out what it’s going to cost to fix or if I even want to fix it, and what exactly I’m getting myself into. That’s what is critical about the inspection. You can make a well-informed decision on the property rather than going in blindly and being surprised later.
It is naïve to think you can figure out how to hit a certain number or certain profit, or how to stay within a tight budget, without being informed of all the problems. This is valuable while I’m negotiating in the beginning. If I’m coming in lower than the initial offer, I can right away talk to them about some of these problems, which, most likely, the owners already know about but haven’t disclosed yet or many times they had no idea there were these problems which make it easier to negotiate.
Keep in mind, none of this is 100%. These are just good rules of thumb when looking at a property. They have served me well to establish if an investment property warrants further investigating and analysis, and if so, what kind of offer to submit. This obviously isn’t everything. I depend on inspection in most cases. I will be posting an interior walk through an article in the weeks that follow. I’m interested to hear your story and what else you may look at when walking a property. Please share your take in the comments below.
**Disclaimer** – make sure you are walking the property with the consent of the current owner. Please keep in mind we are in the San Diego market and practices in your area may be different. I highly reccommend you get a building inspector to look at the property unless you are highly confident in your ability.
Curtis Gabhart, CCIM President Gabhart Investments, Inc.
Edited By Blake Imperl, our newest intern at Gabhart Investments. Check out his Linkedin page by clicking here.
Gabhart Investments, INC. (GII) is a privately held real-estate investment firm based in San Diego, California. We operate in a rapid paced project driven environment. The employees at Gabhart Investments, INC. (GII) are close-knit, highly qualified professionals, possessing the necessary competence to meet our clients’ goals. GII promotes ethical balance for continuous training, leadership, and teamwork. Since 2000, GII has acquired and converted multi-family properties into condominiums throughout San Diego County. The new real-estate market has presented us with many opportunities to take advantage of. Along with our equity partners, Gabhart began to grow its portfolio in, arguably, the strongest housing market in the country. Thus, we consistently generate superb risk-adjusted rates of return for our investors. In 2005, Gabhart’s private investment portfolio had transactions in excess of 40 million dollars. We intend to accelerate our business model by maintaining our focus within the purchasing and rehabilitation of bank owned real-estate property. Our additional services include consulting, brokerage, venture funding, development, construction management as well as property and asset management.
Curtis Gabhart will be presenting this course November 11th, 2015 in San Diego for the National Association of Realtors.
This 3-hour course offers a broad overview of the basics of commercial real estate and how it differs from residential real estate. Students will be able to
Understand the broker’s role.
The basics of commercial real estate.
Discover the different types of commercial properties, terms, valuation methods, marketing and resources for further education.
Learn how commercial real estate impacts residential sales.
How to make a successful career in commercial real estate.
While it will not equip an agent with the needed tools to practice commercial realestate, it will explain the business and introduce many of the resources needed to pursue a commercial transaction or a career in commercial real estate. This is an ideal introductory course for those who are newly licensed and/or residential agents who want to learn more about commercial real estate.
Curtis Gabhart is President of Gabhart Investments, A Real Estate development & advisory services company based out of San Diego California.
Curtis is the President of Gabhart Investments Inc. which is a privately held real estate firm specializing in acquiring, renovating and upgrading Single & Multi-Family properties. His firm provides expert services in property and asset management, acquisitions and dispositions, zoning and entitlements, real estate development, construction management, venture funding and related financial analysis as well as sales training and property investment consulting. Through years of coaching and mentoring the organization clearly exhibits dedication, diligence, purpose integrity and value. Come and learn from one of San Diego’s Top Real Estate Advisors of Commercial and Luxury Residential estates.
Curtis is one of only 29 instructors throughout the country approved to teach this course.
Here is a list to use that should help you with your due diligence when buying apartment buildings. Below are some of the things to request from the seller of a multifamily property.
I decided to post this list because of a comment I received on a previous posting. I did named data collection and income & expense analysis of apartment buildings (click here to read that post).
Here is an excerpt from his comment
Remember that the SELLER always LIES so NEVER ever rely on the seller to give you accurate numbers. Do your own research that way you only have your self to pat on the back!!!
Below is a list of items I use (in San Diego) that you will want to request from the apartment buildings seller and/or broker listing the property.
Due Diligence Request List
1. Annual profit and loss statements (P&Ls) past 3 years; one year of monthly P&Ls
2. Rent roll and leases including term, deposit, and payment history, Section-8 housing documents, if any
3. Tax returns (last 2 years)
4. Receipts of utility bills (water, gas, trash, sewer, electric, etc for last 12 months) or recap report from provider showing usage and cost
5. Any service or advertising contracts: (Trash, extermination, maintenance, management, commission agreements, union agreements, vending, billboard, pay telephone, etc. and any instrument or contract to be assumed by Purchaser)
6. Copies of all appraisals, engineering reports, termite reports, environmental reports
7. Insurance claims history for last 5 years (can be obtained from insurance agent)
8. List and receipts of any major repairs done in the last 5 years (paint, fence, remodel, roof, water heater, etc)
9. Insurance policy including all riders, risk assessments, and disclosure affidavit for carrier
10. Architectural and engineering plans and specifications (if available)
11. Payroll register: List of employees including name, position, wage rate, and entitled benefits
12. Business license
13. Litigation History: details of any past or pending litigation (if none, then an affidavit from the owner)
14. Environmental Inspection and Survey, if readily available: Key Issues: Asbestos, Lead Paint, underground tanks, wetlands
15. Warranties: existing warranties from roofers, contractors, etc. (passed to the new owner if possible).