Ramon from Los Angeles asks,
I am in contract to purchase a 6-unit value-add multifamily property in a rapidly gentrifying area of Los Angeles. It is a rare true off-market deal that is well priced (at least pre-covid). With 5 of the 6 units vacant I can immediately renovate most of the units. I own other property in the area and posted test ads so I feel like I have a good sense of the current rents. I am projecting a pro forma 6.3 cap rate, mid-to-high single digit cash on cash return and mid teens 5-year iIRR with further upside as the area improves and if I can bring the one currently occupied unit to market rent. Pre-covid this definitely met my investment criteria. However, given all the risks around covid, I am struggling with those criteria. Rents might continue to fall if vacancy increases. Assuming, I am able to lease up at my projected rents, collection risk is much higher than usual in this weakened economy. In addition, if foreclosures start to hit the market there may be there may better deals in the next 6 to 12 months. All that being said, this deal is trading below the price of comparable properties with low-paying tenants, the ability to execute my business plan immediately as a result of the vacancies is very rare, interest rates are low and I can hopefully benefit from the growth in this sub market for years to come. One way to think about all of this is as short-term noise – that it makes sense to buy a solid deal and not try to time the market? On the other hand, should I be getting “paid” more for all of this risk? Based on other deals that are selling the market doesn’t seem to think so. I once heard a saying that if the answer isn’t “hell yes” then it’s a “no”. Maybe that is good advice in this situation.
Ramon this is a great question. Real Estate as always is hyper-local. I don’t know the specifics of the neighborhood you’re working in. We’ve seen that during the pandemic there has been migration. That has meant migration from more expensive cities to less expensive cities. It has meant migration from the most expensive areas to more affordable areas within the same metro area.
There are a couple of factors that can play in your favor.
1) If you design a product that is going to be more desirable than competing product in the market, you have a distinct advantage that will take a long time for the rest of the market to copy. That isn’t to say that the rest of the market can’t copy it, just that it takes time for the rest of the market to catch up.
The quality of the property management can be a game changer when it comes to having a better product in the market. Most of the time when people leave a property, a disagreement with property management has been a factor in the decision. Good property management can give you above average results and poor property 1) management can completely destroy your investment. These are timeless fundamentals.
What I’m going to share with you now is another test that you can apply. Congratulations on test marketing rents in the area.
What if you went to the investor community in your area and offered to sell the project to other investors, complete with your design concept, financial model? You could wholesale the deal to them. Now you don’t have to actually sell the deal, but use the process of offering the deal as a source of feedback to see what others think of the deal.
But when you offer the deal, don’t set your assignment fee in the deal. Simply show them your analysis for the finished product and ask them what they would offer you for the deal. Some may offer less than you paid for it. Others may offer you $5,000 more than you paid. Others may offer you $50,000 more than you paid for the deal. The information in that feedback is like gold. You have a choice. You might choose to wholesale the deal, or keep it for yourself.