This is the start of a series of articles for those who are interested in obtaining real estate for investment purposes. These posts will give you a good understanding of the realities of real estate investing. As always, I welcome your feedback.
Let us begin.
Someone is always seeking a way to finance 100% of the acquisition cost for an income property. This is fueled by late-night infomercials touting “no money down” deals. The way it comes across, one would believe that all you have to do to become a millionaire in real estate is to acquire the properties with “OPM”, meaning Other People’s Money, and then just sit back and collect the big fat checks they like to flash on the screen. Television is a wonderful thing. After the story is told and the product is sold, no one in the TV cast has to stick around and collect rent.
The quest for 100% financing in real estate reminds me of that joke about a dog chasing a car; what’s he going to do when he catches it? An investor high on the “desire to acquire” – that’s the peculiar state of mind that surfaces when the target of our desires looks so good that we’ll do anything to get it regardless of the consequences.
The Desire to Acquire
In real estate, the “desire to acquire” is present when the investor is willing to do anything to get a deal, any deal. Convinced that once you own real estate you’re on your way to the good life, an investor taps home equity, or finds a seller that will owner finance, and gets a bank loan on the bank’s terms. Now, he’s in a deal, but has he thought it through? Let’s take a look at what happens when you “catch” the 100% leveraged deal.
The infomercial gurus teach that if you find the right seller, you can structure the deal so that there is no money out of your pocket. They leave the impression that there will be plenty of money in your pocket after you do the deal. More often than not, that’s not the result. Let’s say that you do find a lender that will loan 80% and a seller that will carry 20%. In all but the rarest of cases, the combined debt payments are going to eat up all but the tiniest portion of the cash flow. It has to be this way, and I can show you why. Instead of projecting how much you’re going to make from the deal, think about it terms of the occupancy level it takes to break even. Then consider the difference between economic occupancy and physical occupancy.
Economic Occupancy vs. Physical Occupancy
Let’s face it, the deals that we look at with decent prices, motivated sellers, and opportunities for turnaround or upside are usually not the cream of the crop. If it were an “A” property with well-screened tenants, it probably wouldn’t be on the market at a price that would interest us anyway. So, it’s pretty likely you’re going to inherit a less-than-stellar group of tenants. The first advice here is to factor delinquency into your projections to avoid a rude awakening later. Comparing the economic occupancy to the physical occupancy can be an eye-opening exercise. Economic occupancy differs from physical occupancy, sometimes widely so. Economic occupancy is calculated as the actual cash collected divided by the total potential rents. The answer will be a percentage and that is important, as we will see in a moment. Delinquency in apartment rent is a fact of life.
You are not going to collect 100% of the money due, on time, 100% of the time. It is not uncommon for even well-run apartment buildings to run a 5% delinquency rate, and poorly operated projects may have a 30% or higher rate. For calculation purposes, if the rent is past due beyond the due date, it is not included in rent received. In the same way, vacant apartments also are facts of life in the apartment business. Vacancies are actually phantom expenses that only show up in an economic occupancy analysis. Together, vacancy and collection losses typically are projected to run 5% of gross income. A more realistic figure is 5% for vacancy loss and 5% for delinquency and collection loss. In a twenty-unit complex with average rents of $416 per month, that’s equivalent to one apartment vacant for one year. Every investor quickly finds how easy it is to “tweak” these numbers on paper to make the bottom line more attractive. I prefer to err on the side of reality and would advise that you to “tweak at your own peril”. But, we’ll use the 5% figure for this discussion, just to save the argument and to prove the point that even using optimistic numbers a 100% leveraged deal is tough to structure.
Always Run the Numbers
Let’s use an example of a twenty-unit apartment building with potential gross income of $100,000. That works out to average rents of $416 per month. If it is a normal building, there will be about 40% expenses ($40,000), including management but not including vacancy and collection (delinquency) loss. Included in the expense estimate is a “reserve for replacement” deduction. This is an annual estimate of funds needed to perform capital improvements. An average figure is between $200 and $250 per unit per year. While many owners do not actually reserve the funds, some lenders will deduct the amount from the cash flow before calculating the debt coverage ratio. Others won’t, but that doesn’t mean the improvements won’t be required. If you use the standard projection of about 5% ($5,000) for vacancy and collection loss, the building must have an economic occupancy of 45% just to operate (40% operating expense + 5% vacancy and collection expense = 45%). That leaves a Net Operating Income (NOI) of 55% or $55,000. We call it NOI but lenders call it “funds available for debt service”.
Most lenders require a minimum 1.25:1 debt service coverage ratio (DSCR) to fund a deal. Some are higher, very few are lower. There’s a good reason for that. At a 1.25:1 DSCR, 80% of the NOI is used for debt service (1/1.25=.80). In our example, the maximum debt service would be $44,000 ($55,000 x 80%) or 44% of the gross potential rent. Add the 45% of expenses to the 44% of the debt service and you need 89% economic occupancy to break even. That leaves 11% or $11,000 for profit, pre-tax. That’s with normal deal structure and 20% to 25% cash equity. At $416 average rent, the profit margin is equal to just over the annual rent on two of the twenty apartments. Or, looked at another way, if there are two vacant apartments for twelve months, and the rest of the complex operates normally, the project is going to lose money for the owner. The lender will get paid (in theory!) but the owner won’t. And that doesn’t take into account any increases in utility costs, insurance costs, property taxes, fix-up costs for a trashed apartment, or any other of a hundred things that can and do change during the year.
Now, can you see why the lenders are so tough on debt coverage ratios?