This is where my philosophy regarding multi-family ownership begins to diverge with probably everything else you have ever heard on the subject up to this point. I make no apologies for my difference of opinion. On the contrary, this mindset has come about as a result of the shortcomings in my real estate education and my knowledge of running other types of businesses. I firmly believe that if you grasp the concepts in this one chapter, you will totally understand the multi-family real estate business and anything that is thrown at you, you will be able to solve very easily.
What’s the difference between single-family and multi-family investing?
Suppose there is a single-family house on a street in Idaho that is currently owned by a rather unique family who also just so happens to reside there. This isn’t just any house. This is the house of a famous movie star.
Can you name that movie star?
Directly across the street, there is another house, identical in every way; same builder, built at the same time, with the same building materials. But for the fact that it is not on the same lot, it is identical in every way except for one; this house is currently vacant. No one is currently living in this house.
Here’s the million dollar question. Which house is more valuable? If you said neither, they are both worth the same. You would be correct. The properties are valued based upon their market values. An appraiser would look at a myriad of factors to determine the market value of that particular house. The fact that one is occupied and another is vacant has absolutely no bearing on the factors that are used to value that property.
Now let’s use the same example but this time with two 100-unit apartment complexes.
They are identical in every way, built the same time, same appliances, same wear and tear but one major difference; the property on the left is 100% occupied and the property on the right is 100% vacant. Which one is more valuable?
Of course the answer is going to be the property that is 100% occupied. But it’s important to understand why. If the real estate is absolutely identical, then it is not the property that is altering the value. In this case, the real estate is “meaningless” to the valuation (sort of). So what is it exactly that distinguishes these two properties? If you said – income, you would be correct, but to truly grasp the issue here, you need to be even more specific.
The real difference is this – contracts. More specifically, lease contracts. The leases create the income that creates the value. Understand the business behind the leases and you understand the multi-family business.
This is why this is not your typical real estate business. You are entering a business with living, breathing customers. These customers pay you big money every month as long as you take care of them. Leases are the product that you sell to these customers. The real estate, or in this case, the apartment complex, is the business or factory that produces the leases. As you recall from the Most Important Formula, the more valuable the leases are the more valuable the business. Note that I did not say the more valuable the leases, the more valuable the real estate. In the multi-family business, you could have very valuable leases but your expenses are going through the roof and therefore, the business isn’t worth anything.
The biggest mistake a new investor makes in the due diligence process
This is where many new investors start to go astray. They find a deal, make offers, get an offer accepted, put it under contract and then start the due diligence process. During the due diligence process their entire focus is centered on the real estate. They interview and negotiate rates with property inspectors. They set up a date and time that they will go through each and every unit looking for the most egregious example of poor management so that they can go back to the seller and negotiate a repair allowance.
The owner of a bad property will see this coming a mile away and be prepared for it. They will inflate their purchase price to pay you the repair allowance WITH YOUR OWN MONEY. They will play hardball with you and structure the terms of the repair allowance such that the dollars come out of the deal in an in-kind transfer and not in cash. You, at the end of the day, end up with a property that has a list of needed repairs and no cash to fix it.
But that is not where your focus needs to be. Here’s where the new investor goes astray. After the property inspector has completed his task and submits his beautiful 100-page report that you pay for, you will review it and look at the last page that gives a dollar amount as to the needed repairs. You then go back to the broker and open the negotiations all over again and I can assure you, they are lying in wait for you to return.
But the problem with this overdependence upon the inspection report is that, no matter what the inspector finds, it can be fixed with one thing – Money. Just name your price and the roof is fixed. Get three bids and the foundation is fixed. You see, his focus, along with yours and everyone else is on the real estate. I am here to tell you that this is exactly where you should not be focused.
What business are you in? Real estate or multi-family? You are in the multi-family business. What generates revenue in the multi-family business? The factory or the product? The product, or in our case, the leases, is what generates revenue. How much time and money have you spent up to this point in the due diligence process analyzing the value of the leases?
See, when you show up with your inspector and you walk the property with your clipboard and flashlight, the real deal is not going to be found in the units. The real deal is going to be found in the filing cabinets in the manager’s office. That is where you should be spending the majority of your time. Now don’t get me wrong, you will still need to do a complete and thorough physical inspection. But that should be secondary to your “product” analysis.
Why is this so important? It is important for a whole host of reasons, the least of which is the fact that you need to understand the types of things that can destroy your business overnight. Hurricanes, tornados, floods? Nope, you can buy insurance to protect you for those events and in some cases, you might end up better off. Leaky roofs, broken pipes, appliances that don’t work? Nope, those happen all the time and it just takes money to fix.
What can destroy a property faster that a property inspector never finds?
So what can destroy your business overnight and that can’t be fixed with money? The answer, just so we can keep it in the business realm, is bad customers. More specifically, felons, child rapists, drug dealers, gang bangers. Nothing can clear out a nice apartment complex faster than the news that a sex offender has just moved in. Not only will you lose existing customers, your property will quickly get the reputation as being the place where felons can go and live. That is the kiss of death for any property.
Let’s go back to the discussion of the repair allowance. What do successful people do? Successful people do those things that the rest of the world won’t do. In this case, the seller is expecting you to come back with a list of items that shows all the things wrong with the property. He is seeing you coming a mile away because he played the same game when he bought the property. In addition, his broker is preparing him for it and they have already strategized with a response.
But you are not like all the other investors. You look at this business as a business. You look at the strength of the customers as the strength of the asset and you will negotiate accordingly. When you complete the inspection and set up a meeting with the broker to review, you will have two sets of reports. The first one will be the property inspection report. That will have a dollar figure at the bottom. The broker will nod his head, let you know that he will present this to the seller and then ask the waiter for the check.
This is where you distinguish yourself from every other investor. “Not so fast, Mr. Broker, there is one more thing,” you say in your best Columbo imitation. This is when you bring out your analysis of the leases. This is where you show the broker that fifty percent of the files were lacking criminal background checks. This is where you show the broker that there is no income analysis done on any of the residents and therefore the sales pitch that the rents are below market and can be increased is meaningless because there is no way to tell if the current crop of residents could even afford an increase in the rent.
I will guarantee to you that the broker will do one thing; stare at you with the blankest look you have ever seen and wonder what comeback he could possibly muster. He has done absolutely no analysis in this department so he will not have any facts on the table to respond back to you. You will be in complete control of the deal.
Let’s say just the opposite is true. After your analysis, you cannot find anything wrong with the resident files. They are completely up to date and accurate. If that is the case, start getting serious about buying that property. It might be as good as you think. I do reviews on my properties to make sure that the files are up to date. I review credit and criminal background checks all the time and make sure that if I had to sell my properties tomorrow, everything is in order. That’s the type of business you want to buy. (This is not a sales pitch for my properties. This is to give you a vision of what your businesses should be like).