When A Bad Deal Crosses Your Desk

The Real Estate Espresso Podcast

When A Bad Deal Crosses Your Desk

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When A Bad Deal Crosses Your Desk

Welcome to the Real Estate Espresso Podcast, your morning shot on what’s new in the world of real estate investing. I’m your host, Victor Menasce.

On today’s show, we’re doing a walkthrough of a property offering memorandum in Arizona. Let me be clear, I’m not here to disparage any property, I’m simply going to share our perspective on how we would look at this type of property.

The property in question is a conversion of a 1960s vintage motel in Tempe, Arizona. The original property had 140 motel rooms with a 2-story structure. The center courtyard has amenities including a swimming pool. All of the parking is surface parking around the perimeter of the property.

When we look at a property, we’re looking at the sub-market and the specifics of the deal. Maricopa County consists of 33 separate municipalities. It encompasses a massive population of over 4 million people. Some of the larger communities include Phoenix, Scottsdale. In the middle you’ve got smaller cities, including Mesa, Chandler, Gilbert, Glendale, Paradise Valley, El Mirage, Tempe. I’m not going to name all of them.

This particular property is in an area that I would consider to be a lower-income area. The multifamily apartment market segments into a lot of brand new Class A properties. These are often built into golf course communities, or they have some other form of amenities, or just a great location. There’s also quite a few properties in the A- and B+ category. Again, these target people with strong employment incomes.

And there’s a large amount of C- and D-class properties in the valley as well. These properties often have large numbers of visible minorities. Local rumors suggest large numbers of undocumented aliens. I truly sympathize with those refugees who are fleeing persecution from elsewhere in the world. My wife works directly with the refugee population, and I’ve met many outstanding people.

Now, apartments in these neighborhoods have been the subject of ICE raids resulting in deportations. If residents fear being discovered, they will often leave, and then the question becomes: who will rent these apartments?

We saw the same phenomenon happen in Maricopa County when Sheriff Joe Arpaio took action against illegal aliens back in 2010. This was also at the height of the financial crisis. There were hundreds of thousands of foreclosures in Maricopa County at that time. And at the same time, about 200,000 people, mostly Hispanics, left the city. Many relocated to Texas, New Mexico, and elsewhere.

That exodus created a surge in vacancy. In those days, I remember seeing $99 move-in specials advertised on many street corners. There was literally nobody to move into those vacant apartments.

This particular property is being advertised as newly renovated, but the truth is, the physical layout of the units means the bedrooms do not have windows. They’re tucked at the back of an old motel design. If they were built today, they would not pass the building code as a legal bedroom.

The financial model that accompanies the glossy package shows some stellar returns, but unfortunately some of the financial metrics did not seem credible when we view it through our lens. There is no way, in our opinion, that a 70-year-old motel converted to apartments would value at over $500 per square foot in the open market.

This analysis was clearly the result of some financial engineering that used an aggressive 5% cap rate, high rents based on brand new apartments built in the past year in the area, and fairly low expense ratio. The valuation is well above replacement costs. If you were to build new, you’d have a brand new modern asset that might attract those rents.

When you search the site using Google Street View, you see that most of the cars in the parking lot are very old and dilapidated. This is yet another indication that the tenants on the property have very few financial resources. I sincerely doubt that people driving rusty, 15-year-old cars are going to be paying top dollar in rent.

You have to remember the ALN report from last week, which showed the market occupancy rates for all of the major centers across the United States. Average occupancy in Phoenix and surrounding areas at the end of November this year is sitting at 86.9%.

In times of oversupply, the vacancy has a tendency to shift to the oldest and poorest quality product in the market. Yes, this property has a brand new paint job. But it’s a little bit like putting a paint job on a car from the 1960s. It’s still a car from the 1960s.

I’m shocked that any broker would even accept a listing for a property with so many obvious red flags. These types of offerings don’t even get five minutes of consideration from our due diligence team. My big worry is not that the property doesn’t sell. My largest worry is that someone actually does buy it. That would be a tragedy.

Needless to say, we didn’t spend a lot of effort on the property. It simply didn’t meet our investment criteria. The sad part is that these types of property listings are out there. I never want to see an investor lose money. I certainly don’t want to see a property fall into disrepair and become blight in the community.

But things do get old, and once they’re functionally obsolete, the right solution is to demolish and rebuild. Extending the life beyond the useful life is rarely the right answer. I’ve had to demolish properties in Philadelphia, and it’s sad when that happens. But then, I don’t feel bad because I only paid an average of $13,000 for those properties that were demolished and then redeveloped.

Today, those same properties are brand new townhouses that sold for an average of $450,000 a piece. There’s nothing wrong with affordable housing. Sometimes that means redeveloping older product. If that’s the case, the financial model better show that that’s indeed what you are doing. Asserting that a functionally obsolete building is going to attract top rents simply isn’t credible in our eyes.

As you think about that, have an awesome rest of your day. Go make some great things happen. And we’ll talk to you again tomorrow.

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