If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Phone calls this month have been less about loans and more about buying property. It’s the beginning of the year and folks are seriously considering another purchase. The questions generally revolve around three points:
- Where should I buy?
- When should I buy?
- What should I pay?
Where to Buy
The old rule of thumb was to buy where you live. The thinking was that if your rental properties were convenient you would pay closer attention to them. You could make better purchase decisions because you would know things about the area that an outside buyer would not. It’s called “local knowledge”. It’s important. You have it. It would be a shame to not capitalize on it. I used to think that way, but not so much recently. It kind of glues you to one spot, doesn’t it? I mean, if you’re in City “B”, how would you ever move to City “A”?
Sometimes great success is achieved with aspirational purchases. What’s wrong with buying not where you are, but where you would like to be? Your new purchase becomes a transitional step. It’s the move you take to bridge the gap between what you have and what you want. Say you spend most of your casual time atSouthCoastPlaza. What’s wrong with buying a property nearby?
You’ll first want to get to know the area aroundSouthCoastPlaza, the people, and the market. It’ll be pleasant for you because you like being in that area anyway. You’ll talk to local renters and ask what they would like to have in an apartment if they were to move. (See, we’re already researching the local characteristics of a “franchise” building!) Often it’s better to try open ended questions. Open ended questions cannot be answered with a “Yes” or “No”. Ask “Why did you come to live where you do?”, or “If you were going to move, where would you go?” or “What do you like best / least about where you live right now?” You’re developing local knowledge of the area you would like to be, before you buy.
A franchise building is one that rents (to varying degrees) on characteristics other than price. If you’ve discovered that renters really prefer individual garages, shouldn’t you be able to charge for a garage over and above the unit rent? If three bedroom units are hard to find, wouldn’t you expect that they are less price sensitive than those two bedroom units that are always on the market? And, speaking of three bedroom units, couldn’t you also buy in the best school district? Now you would have two “franchise” characteristics. The more franchise features the less sensitive your units might be to “market” rents. Don’t get excited – we’re not talking a doubling of rent, here – but when even a small increase is capitalized the gain can be astonishing (see below). When you’re ready to buy you’ll find something you know tenants will like because you’ve taken the time to discover their preferences. You’ve already identified local Franchise characteristics.
Just as a thought experiment, what might happen to the value of the 10 three-bedroom units in your new building if you raised the rents $50 a month ($600 annually) per unit for five years? Forget the two-bedroom units. Every landlord in your area is trying to lease his vacant two-bedrooms, so it’s real hard to raise rents on the deuces. But the three bedrooms? Stick a sign out front and the line of hopeful applicants goes around the block. So you bump the rents $50 net on your franchise units only. Cumulatively, in five years your NOI would be $30,000 more than it is right now. If cap rates at that time are, say, 6% then the value of your building has increased $500,000.
Reflect on that a moment. The “commodity” two-bedrooms, both in your building and in the other apartment buildings in the neighborhood can’t generate any rent increases at all. There are too many of them sitting vacant. But your “franchise” three-bedroom units rent for reasons other than price. The guy who bought next door at the same time you did has no appreciation. You took your time to discover the franchise characteristics preferred by the neighborhood and as a result you got a $500,000 bonus. Nice, huh?
As your new building prospers you do the traditional refinance and pull out some cash. Use that cash for the down payment on your next purchase close toSouthCoastPlaza. Pretty soon you feel comfortable enough to sell your old house and move to where you’d really like to be, right next to Nordstrom.
You started with an aspirational purchase (“Golly, I wonder if I really could move my portfolio where I’d really like to be?”) and turned it into reality. Good for you!
When to Buy
I used to think it might be better to wait until interest rates peak, but it seems the Fed keeps kicking that can down the road. If they postpone the rise in interest rates long enough it will make today’s prices look cheap just because, over time, your rents should increase.
So if you believe the Fed is going to keep interest rates low and you’ve found the right property, I’d go ahead and buy. Even if you think to yourself, “Gosh, they’re asking a lot for that!” remember that they were asking a lot when you bought your last property, too. It’s the nature of the beast. The person who offers the most gets it.
Interest rates fluctuate, but I’d be shocked if rates went down much more. The two most likely scenarios we might face are either (a) interest rates stay the same or (b) they go up.
If we can agree that the true cost of borrowing is the difference between the interest you pay and the inflation you experience, here’s how it might look in numbers:
Example 1: Inflation less than bank rate
If the bank charges you 6% and inflation is 4%, your true cost of borrowing (net of inflation) is 2% (6% – 4% = 2%). That’s manageable and the economy powers right along.
Example 2: Inflation equal to or greater than the bank rate
If the bank quotes an interest rate of 4% and inflation is 6%, you have a negative net cost of borrowing (4% – 6% = minus 2%). No matter how much money you borrow you are guaranteed to make an over-ride on the amount borrowed. The more you borrow, the more you make.
Settle down. The second example doesn’t happen very often. It tends to generate unmanageable economic bubbles that end poorly.
The takeaway here is that Example 1 is normally what happens. It is in the national interest for interest rates exceed the rate of inflation, but only modestly. This allows banks to make a profit and doesn’t seem to damage the economy as a whole. The accumulated national debt (as opposed to the annual deficit) is repaid in inflated dollars.
While interest rates change, the defining characteristic of Example 1 is that rates continue to lag behind inflation. Rates will go up, but inflation will have gone up first. Right now we have low rates and low inflation. Some people might call this the “sweet spot”. If you agree then right now could be a splendid time to buy more income property . . . just get as long a fixed rate period as you can.
What to Pay
The basic purchase format remains unchanged. We determine the largest loan that the new building can support, and then add the down payment. Currently, down payments in most areas are hovering right around 35%.
Formula: Gross Scheduled Income minus Vacancy Allowance equals Gross Effective Income minus Fixed and Variable Expenses equals Net Operating Income. NOI divided by Debt Coverage Ratio (assume 1.25) equals Funds Available for Debt Service.
Example: 20 units @ $1,200 / mo x 12 mos. = $288,000 GSI less 8% vacancy equals $265,000 GEI minus 38% estimated expenses equals $164,000 NOI. Divide by 1.25 equals $130,000 available for annual debt service. [Sidebar: NOI minus Debt Service is your Cash Flow] $130,000 divided by 12 equals maximum monthly debt service. At a hypothetical 5% that $11,000 would support a mortgage of $2,000,000. If we assume a typical down payment of 35%, the value of this example property is $3,100,000. (All numbers rounded.)
You will be earning an initial cash flow of $34,000 on an investment of $1,100,000, or 3%, and that’s probably appropriate for trophy buildings in good areas right now.
Low interest rates result in high loans. Low interest rates also mean the seller can ask for higher down payments. Initial cash flow divided by the large down payment results, mathematically, in low initial yields.
Had this been a refinance, the money you’d be able to pull out for the down payment on your next building would be your gross receipts – (ex: $2,000,000) less costs minus the existing loan that’s paid off in escrow.
On another topic . . . earlier today a reader emailed me her loan documents from when she bought her property. They make astonishing reading, especially for those who hope that today’s super low rates are permanent. Her loan docs were dated 06/18/2000 and state that the prime rate was (then) 9.50% and her loan on investment property would be at 11.24%. The highest the adjustable rate loan could go was contractually capped at 18%.
For those whose loans are adjustable, given interest rate increases of 1% every six months it might take six or eight adjustments (three or four years) to get to the 11% level. If you’re at 4% right now ($477 per $100,000 of principle) and it goes to 11% ($952 per $100,000), how will that affect you? If you’re worried, call me. We’ll put you into loan with a fixed rate period you’ll like.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].