If you’ve missed some of the basic articles, guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.
Continued from Part 35: Consumables vs. Assets, Part 2
Businesses: Generally, because of low barriers to entry consumables tend to be price sensitive. Commodities are a type of consumable that competes only on price. Everything else being the same, given identical packages of uncooked spaghetti from different producers, the cheaper purchase will sell more and quicker. But some things do not compete on price alone. That’s what makes the asset a candidate for investment: there is demand combined with barriers to entry.
Barriers to entry come in several classes:
- Intangibles (brand, patents, etc.).
- Economies of scale (Amazon, Costco)
- Switching costs (banks, medical devices)
- Network effects (Microsoft, Facebook)
- Legal, environmental, economic restrictions (garbage dumps, utilities)
- An apartment owner who does not wish to compete on price alone might choose to keep the above list of classes, but modify their contents in the following way:
- Intangibles (school system, view, proximate to houses of worship)
- Economies of scale (ownership of multiple units / buildings in same area)
- Switching costs (three-bedroom units in a good school district)
- Network effects (WalkScore, employment, public transportation)
- Legal, environmental (restrictions on further development)
Degrees of Scarcity
Things might work out better if any new apartment purchase had at least some of the features mentioned above. Even one item, however, is sometimes enough to improve the investment. As an example, would a three bedroom apartment likely earn a higher rent in a good school system or a poor system? Would a young single person likely pay a higher rent for a unit with a good WalkScore in a high employment node or for some isolated unit hours away from employment? The questions answer themselves.
Many tenants willingly pay for useful amenities, even the ones not onsite. A good school system is outside the apartment owner’s control, but the landlord nonetheless benefits: a fructiferous young mother will pay higher rent to receive better educational benefits for her children. Combine good schools with three-bedroom units and multiple local employment centers and the apartment becomes uber-desirable to more tenants.
Owning apartments is not a charitable work, or at least it shouldn’t be. In place of or in addition to higher rents, the practical benefits of the various barriers to entry could take different forms: (a) fewer vacancies; (b) quicker re-lease; (c) higher tenant quality; (d) quicker sale, or (e) lower cap rate (no free lunch: this is a sadness when purchasing, a boon when refinancing or selling).
- Popular economists explain that prices are established by the interplay of supply and demand. That definition is most useful when discussing consumables due to their elastic supply.
- Assets are priced differently than consumables. Asset prices are largely driven not by supply but by scarcity.
- Investors benefit from disproportionality. When the outcome of an investment is disproportionate, one party to the trade receives more than he paid. Somewhere in the deal there are benefits not included in the price.
- A scarce item, if it’s desirable enough, does not have to compete on price alone due to barriers to entry for new competition.
Emily knew that even a great asset with multiple barriers to entry can be a poor investment if the buyer pays too much. It’s the owner’s or agent’s job to get as much for the property as they can. Sometimes this will involve misrepresentation. When it comes to marketing an income property, one common way to generate overly high offers is for the seller (or the seller’s representative) to error when computing the capitalization rate. This might happen through capitalizing the wrong number in the income stream.
Of the four examples which follow, the proper way to capitalize is shown in Actual Rents. The other three examples – Market Rents, Fantom Income, and Forecast Rents – inflate the value of an investment based on the subject’s current net operating income.
Right! Capitalizing Actual Rents
Gross Scheduled Income: $360,000
Minus vacancy and credit losses @ 5% (18,000)
Gross Effective Income $342,000
Minus Fixed and Variable expenses @ 30% (108,000)
Net Operating Income (NOI): $234,000
If the property in this example was offered at $5,000,000, the cap rate would be NOI ($234,000) divided by purchase price ($5,000,000), or 4.68%.
If comparable properties (a) in the area (b) had recently sold (c) at a mid to high 4’s cap rate, Emily told herself, this property was probably appropriately priced. Its offering price is bracketed and supported by the sales prices of comparable properties.
Enter the seller’s nephew, who is not licensed but nonetheless acts as the seller’s agent. He is behind on his Mercedes lease payments and needs a quick sale. You can bet he knows how to misstate his uncle’s property by computing a higher cap rate than the property actually offers. He knows that in a 4.7% world, an offering at a 7% cap rate will generate a ton of interest. Even overbids are possible.
Emily chose to start by determining what the example property’s actual cap rate is. Following that are some ways the property might be fraudulently advertised at an exaggerated capitalization rate.
Wrong! Capitalizing “Market” Rents
There are 20 units in the building, and not all of them are at full market rents. The units run from $176 a month to $2,150. The higher number reflects recent move-ins. The lower number is the old woman in unit 11, the one with cats, whose tenancy pre-dates rent control. She’s never going to move. But if the rents for each of the 20 units could be immediately raised to $2,150 each, the new GSI would be $516,000 and the new NOI would be $335,000. Emily penciled out how using “market rents” would affect the advertised cap rate.
Gross Scheduled Income at “Market”: $516,000
Minus vacancy and credit losses @ 5% (26,000)
Gross Effective Income $490,000
Minus Fixed and Variable expenses @ 30% (155,000)
Net Operating Income (NOI): $335,000
If the property in this example was offered at $5,000,000, the cap rate would be NOI ($335,000) divided by purchase price ($5,000,000), or 6.7%.
Wrong! Capitalizing “Fantom Income”
That’s still not quite the full 7% advertised so the agent says, “You can charge $65 for parking! That’ll bring in over $15,000 a year (conveniently forgetting rent controls) and there’s your 7%! ($335,000 plus $15,000 = $350,000 NOI divided by $5,000,000 = 7.0%)
Wrong! Capitalizing “Forecast” Rents
It is not absolutely necessary for Forecast Rents to reflect the current state of affairs. After all, they’re “forecast” to exist sometime in the indefinite future under the hypothetical conditions stipulated by the seller’s representative, so almost anything qualifies.
Emily imagined she eavesdropped on the conversation:
“Well, I don’t know. We might or might not be able to get all the rents up to market”, the buyer’s wife said.
The agent was not to be undone. “True, but that’s not the only special benefit of this building. See those tuck-under parking spaces? What would it take to box them in and make little ‘bachelor’ units? There are 20 of them. That’s 20 new units! Nobody has to know! Even at a forecast $500 a month, that’s $10,000 a month to you . . . cash.”
“I heard it was hard to get permits?”
“That’s what’s special! You’ve heard the term, bootleg units? These will be those highly desirable bootleg units you’ve heard about. Nobody bothers with permits for bootleg units. If they were permitted, they would not be bootlegged. Those are unpermitted units that bring you cash each month that nobody knows about! Every buyer wants bootleg units! If it were possible to buy an empty lot and fill it with nothing but bootleg units, it would make a fortune!”
“And we’d be able to get $500 a month for each of them?” “Maybe more! Four guys on one unit the size of a one-car garage, say 200 sq. f.t, could pay $150 each. That’d be $600 and they’d still be getting a huge bargain – where are you going to find an apartment for that price – and you’d get $600 for each bootleg unit!” Emily, who was still eavesdropping, noticed that this guy seemed to use a lot of exclamation points when he talked.
“But wouldn’t it be expensive to turn those tuck-under’s into units?” “Not a bit! Throw some sheetrock between the parking spaces and run a water tap and a bit of electricity to each, and there you are!
“Where do they go to the bathroom?” “A porta-potty! Just stick a porta-potty out back and let them all use it! It’ll be fine!”
“Well, we still don’t know.”
“Let’s put the numbers together. You’re buying the units for $5,000,000. Your income will come from market rents netting you $335,000 a year PLUS the special bootleg units. Twenty new units at $600 a month comes to $144,000 a year. Add the market rents of $335,000 (“Market” rents? “Bootleg” units? Emily saw what he did there) and you’ll be getting $479,000 a year . . . after expenses! That’s over a 9% cap rate. Where can you beat that in the current market?”
Several years ago, Emily’s loan broker had taught her some of the different ways conniving people misrepresent the cap rate, and she also showed Emily some easy value checks that did not include capitalization. Emily still had her notes from those conversations and resolved to review them later that afternoon.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].