Real Estate Ride Along: Buying, Renovating, & Selling a 6-Unit Multifamily Property
June 19, 2020
In this episode of “Real Estate Ride Along,” Chris Lopez and I walk a six-unit multifamily building that is just five minutes outside of downtown Denver in the West Colfax neighborhood. We really like this area for several reasons.
- There’s a lot of new development here. Watch the drone footage in the video, and you’ll see lots of development going on.
- It’s close to downtown and has easy access to everything the city has to offer. The light rail stop is within walking distance.
- It’s located in between two Opportunity Zones. These are areas the government is incentivizing investors and developers to revitalize.
How We Found the Property
We found this deal not through cold calls or knocking on doors but through a broker relationship that we’ve built up over the past two years. What’s great about building these relationships is that they know our “box” or niche and the types of buildings we like to take on. If one of them comes across the table, we are their first call.
On our side, we know that when we get a call from that broker, it’s usually going to be a good fit! So not only is it more efficient to go this route, but we also don’t have to spend thousands of dollars monthly in marketing to create opportunities.
We were first approached about this deal in June 2019 and walked the property shortly thereafter. We officially made an offer in July and negotiated with the seller back and forth until October, when our offer was finally accepted.
The seller was originally asking $950K for the building. But with all the work that needed to be done, our offer was $825K. We eventually settled on $852K and closed on the unit in December 2019.
Our Rehab Plan
Dealing with Tenants
The first step is to help relocate the tenants who are currently in the old units and did not want to live amid construction during the redevelopment. This allows us to demo and renovate at a quicker speed. Also, by moving the tenants, we are able to avoid conflicts with angry tenants, complaining about living in “construction zones.” We’re keeping everyone safe, too.
Ideally, however, we’d renovate in phases or sections of the building, so we can keep some renters in the building and keep some rental income flowing in.
Demoing
We plan to take out everything in all the units, as it’s all outdated and disgusting from being vacant for many years.
Renovating
We will renovate all the units and use “higher-end” finishes to compete with comparable properties in the area. It is very important to always remember who your end-user is going to be before starting construction. In other parts of the city, these kinds of finishes would not make sense and would actually hurt our return.
But in this particular part of Denver, it makes sense to do a high-end remodel based on the class of tenant who will be living here. This usually means spending more money on tile, flooring, and custom light fixtures; adding bedrooms where able; and adding a more functional and higher-end laundry room for tenant use.
Filling Units
The next step is to fill the building with tenants for market rent. The previous tenants were paying under market rent because the units were outdated. Once all the units are brand new, we can demand higher rents.
Selling
The final step is to sell to another investor who is looking for a turnkey property. Investors love that we’ve done the hard work by renovating and renting out the building. It will be performing well at that point and will be an easy place to park their money..
Funding the Project
For this project, we were able to use a single private money lender (one wealthy individual) to fund the entire $852K. This means that we didn’t have to bring anything to the closing table. However, we were responsible for all construction costs, which were about $160K, as well as all interest payments, or about $5,700 per month—an 8% annualized interest rate.
We get asked a lot why we would use a private lender instead of going straight to the bank for the money through a construction loan. Good question!
The answer? It helps us best leverage our money so we are able to work on more projects at the same time. If we were to go straight to the bank for this deal, we would get a lower interest rate, but we would have to bring between $250-$300K to the closing table. This is because we would be responsible for the down payment of 20-25%, in addition to closing costs (such as an appraisal and environmental tests). Plus, we’d be funding the construction.
It just doesn’t make a lot of sense to pay so much in closing costs when you will hopefully only hold the property for 6-8 months. With a private lender taking that burden off us, we are now able to take that extra money and invest in other projects. This can mean the difference between doing five deals or 10,12, or even 15 deals in a year!
As far as hard money loans, it’s really the same reason. Hard money loans can charge 8-12% interest and require about 15-20% down. They also have their own origination fees and additional closing costs. So while they may pay for some of the construction expenses, we would have to deploy much more capital to use a hard money loan than a private lender.
And the interest rate is about the same as private money—or in some cases 2-4% higher. There are certain processes and withdrawal standards with hard money that aren’t always the easiest to navigate and can slow down your timeline, as well.
Overall, you really have to be dialed in on the project and know what it will take and the timeline you can work within. In our professional opinion, if the timeline will take more than 12 months to complete, getting a bank involved makes sense. If it’s going to be shorter than 12 months, try to capitalize on private money (if you have those relationships) or use hard money loans.
Related: Best Deal Ever Show: $4.7M Profit on Very First Multifamily Investment
Walkthrough
In the video above, you’ll notice our special guest: Athena Brownson from Compass Real Estate. Athena is a great residential agent who is looking to get more investor clients and was really looking forward to seeing our process as investors and flippersâshe wants to know what we look for in a property.
As we walk through, the first thing we take note of is the layout. This is key—because no matter how much we update the property, if the layout isn’t functional for the tenant, it will be much harder to get the unit rented (especially for market rents).
As far as renovating, we always put ourselves in the shoes of the tenant. What is important to the person who will be living here, and what will make them pay more to rent it?
A few specific things we look for when walking units are:
- Anything that “doesn’t belong”
- Example: A closet in the living room
- Open layout (or potential) to make it feel as spacious as possible
- Location & size of kitchen
- Can we use open shelving instead of upper cabinets to save money?
- We want modern colors and style (industrial for this property)
- We want rehab to stay under $8K
- Size of the bathroom
- If studio or 1-bedroom, stand-up shower
- If 2-bed or 3-bed, family with potentially younger kids may rent and want tub/shower
- We want white paint
- 12’ x 24’ tile in shower and on floor to add pop of color or enhance style
- We want new vanity with light fixture and mirror
- Size of the bedrooms
- If the heat source is a boiler and the boiler is over 20 years old, that’s a must-replace! We usually put in forced air units that do both AC and heat.
- Can see $75-$100 more per month in rent when a unit has its own controlled heat and cooling
These are key elements we focus on because these are the factors that tenants care about most and will drive up rents. We also look for opportunities to add value to the units.
With this specific building, all six units were 2-bedroom/1-bath, but two of the units had an option for a third bedroom by converting a storage space. So when we finished, we had four units that were 2-bed/1-bath and two units that were 3-bed/1-bath.
With this added bedroom, we can get an additional $150 (on average) in rent for two units. That is over $300 per month in rent or $3,600 a year for simply adding an additional bedroom and closet!
The Numbers Behind the Deal
Let’s take a look at how the numbers work out. Overall, the rehab budget for the whole building was $160K. This includes all exterior work (landscaping, exterior paint, roof, recessed lighting, new AC units, etc.) and our typical 10% contingency.
When we acquired the project, there were only two units that were rented. Those tenants weren’t happy for several reasons, so it was fairly easy to convince them to move out. We helped them locate replacement units.
With the building empty, we were able to move quickly and without interruption on the rehab, but we had to move fast—we didn’t have any rental income coming in to offset any of our operating expenses. With everything included, we were at about $7K per month for operating expenses, on top of construction costs.
Once everything was completely renovated, we put renters back into the units and started collecting rents. We decided to use a billback system for utilities (RUBS). For this building, electricity was separately metered but gas was not, so the gas, water, sewer, and trash are all included in the RUBS bill. It amounts to roughly $100 per month per unit on top of rent.
The key thing with RUBS is that it’s got to be a direct cost, not something a landlord makes money off of. So when we get the units rented, the stabilized numbers are as follows:
One item to remember is that there are probably lease-up fees to be included, as well. But since we do it ourselves, those numbers are already built in.
Once we develop the property and stabilize it, we still have our private money invested at 8% interest. We don’t usually like to hold onto interest-only loans longer than we have to, so we figure out the net operating income (NOI) and the operating expense ratio so that we know how to market the property to an investor. Because whether we sell this property or hold onto it, the NOI and operating expenses will be the same.
For the Denver market on five units and above, the average operating expense ratio is between the high-20 and low-30 percentage range. So, we are right on target!
We can also look at the monthly cash flow numbers while we are holding the property. While we aren’t making huge piles of cash by any means, we’re feeling good—while in the process of selling the property, we aren’t bleeding money either. This allows us to wait for the right offer.
When we go to sell this property to an investor, the metric used most often to compare properties to each other is called cap rate. As a refresher:
Cap Rate = NOI / Purchase Price
In the Denver market, we are seeing an average of 5.25-5.75% being good cap rates. So, to find the price we should sell the property for, we can multiply our NOI by each cap rate to find the range of prices we can list the property at.
As a reference, the further into the Midwest you go, the higher the cap rate is—essentially, the “more bang for your buck.” There you’ll see cap rates closer to 8%.
On the flip side, on the coasts—both in California and New York—you are seeing smaller cap rates of just 2-4%. This is why many people like investing in Denver. You can get more out of your money than if you invested in a government or treasury bond, but it less risky than investing in a Midwest city that may suffer severely in a recession.
Based on our analysis, running comps on surrounding listings, and talking with neighboring investors, we actually feel confident that the price point we list at will be somewhere in between 5.25-5.50%. However, it will likely lean more toward the 5.25% end.
While this may be a bit aggressive, we are still seeing multifamily properties move quickly in the market. Denver doesn’t seem to be slowing down anytime soon, so we feel confident that our quality of product will be able to sell right around the $1.4 million mark.
Ultimately, we sell these smaller multifamily properties to investors who are looking to park their money somewhere in a turnkey property. For our business strategy, we tend to hold onto the bigger properties with more units, as we can justify the maintenance and property management expenses through economies of scale.
Holding 20 of these smaller six-unit buildings can be cumbersome if we have to rely on every unit in every building performing so that our cash flow is on track. Neither strategy is right or wrong, it’s what fits best for your business and situation.
So, let’s look at the numbers from the buying investor’s perspective.
There are four ways to make money in real estate. Visually, it’s great to use the Return on Investment Quadrant™. It really helps show you that while cash flow is important, it’s not the only way you are making money on the investment.
The chart below shows us that a typical investor who has put about $374,233 into the deal will receive a 22.26% return on that money—or about $83,287—after the first year. Please note that when you see “appreciation” on this chart, we are talking about rent growth, not the 2-3% price appreciation that single-family homes trade at from year to year.
Let’s also look at the investor numbers after holding the property for five years.
One of the biggest appeals of real estate and a major factor that draws all of us as investors into these projects is the compounding effect real estate has. The ability of rent growth year after year, the ability to have tenants pay down your debt, and the great depreciation and tax benefits from these transactions, make wealth attainable for the average investor.
Most people can’t say they have made close to $700K on an investment over five years. Hard to deny the power of this, which is why we love doing what we do!
Conclusion
At the time of publishing this blog, this property is under contract for $1,360,000. This is lower than our target sales price of $1,400,000. However, since the building was being leased up and sold in the middle of the COVID-19 pandemic to an all-cash offer with a 30-day close, we were very happy with the price and terms.