Should you invest in apartments? Location, location, location Don’t sell your apartments, even after you die. Cap Rates Wind farms, solar farms, and old-fashioned growing corn farms. The farmer says “you always gotta eat”. Only fall in love with dogs. The Economist says “no one should own a home, but keep buying our magazine”.
Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.
Chuck LeFebvre: This is Chuck.
Ed Sutkowski: And I’m Ed.
Chuck: Today we have a guest.
Ed: That guest is Dave Leman. Dave is a CPA and Certified Property Manager.
Chuck: Dave welcome.
Dave Leman: Thank you. It’s great to be here.
Ed: Tell me a little bit about your background.
Dave: Well, I graduated from Illinois State University with a degree in accounting. Passed CPA exam in 1986. Went to work in Chicago for a CPA firm for a few years. Switched over to a bank, worked for Citicorp for a little while. Then my brother needed some help down in Central Illinois and asked me if I was interested in moving back to Central Illinois from Chicago. He had started a real estate management company in 1980. In ’92, they were growing pretty aggressively and he could have used another officer level employee there.So, I left Chicago and started working with Bill Lehman, my brother, in ’92. We’ve been managing real estate ever since. Now he’s actually phasing out, retiring a little bit, and his son Drew and I run our property management business in Pekin.
Ed: A number of units that you manage.
Dave: We manage just over 1,600 units.
Ed: What about those that you have a personal interest in?
Dave: About 1,400 of those.
Ed: So we are talking about 3,000 units.
Dave: No. I’m sorry. We manage 1,600, 1,400 of which-
Ed: Are yours.
Dave: -we have some interest, yes. Then we manage 200 for third parties.
Ed: You’ve been at this a long time as Certified Property Manager. What’s that all about? Like a CPA?
Dave: It’s close. The Institute of Real Estate Management is the organization that bestows that designation on those who have passed several courses and have done a certain amount of experience in the business. It really is a great educational program to go through if you want to learn how to handle real estate as an investment, whether it’s for yourself or for owners that you do fee management for. They also train our resident managers with an ARM, that’s Accredited Resident Manager designation. We like to send our employees there because they get a really good education on how to run the property like an owner would run it.
Ed: Chuck, I’ve been thinking about if I’m going to invest in apartments what should be– as a layperson speaking to your target, what do you think would be the most important criteria?
Chuck: Well, for me, I mean I would want to– Well, they always say with real estate there’s three things that are important: location, location, location. One of the reasons why I would be pretty hesitant myself to get into it is because I’m not sure if I would know exactly how to find the right location. But I would be fairly concerned with exactly where your expertise falls here, Dave, which is exactly after you own this thing, how do you go about managing it. I would feel like as an owner who doesn’t have that kind of training and background, how do I become acquainted with the information I need to understand whether I’ve made a good investment and when I need to get out of it and whether my manager, if I’ve hired a manager, is doing a good job for me. That would be my answer to your question.
Ed: See, I was thinking about– I have this excess, a megabucks, I earned all this money from– I was a CEO of a hospital, a CEO of a corporation. I inherited a gazillion dollars. I’ve got money. Dave nice guy, I want to buy some of– I want to construct. I want to buy. I want new apartments. What am I going to do? I’m coming to you and you’re going to tell me what? Location, location, location?
Dave: Certainly location is key and you can’t overemphasize that
Ed: What do you look at and determine–
Dave: Well, demographics. Who’s going to live in your apartments? Who do you want to live in your apartments? Or what slice of the population are you going to market your apartments to? Are you close to a university? Are you close to a major employer? What’s the crime rate in the area? What’s the outlook for jobs in the next five or 10 years? What are other properties selling for? How many other players are there in the market that are going to be competing with you for the same building to purchase? We found smaller markets can be better places for us to be profitable because there aren’t as many big players driving the cost of the assets up when we’re trying to buy them.
Ed: Well, Chuck’s question. How do you respond to Chuck’s question?
Dave: How to go about managing? Hire a CPM.
Dave: I think real estate is a large part financial. It’s numbers and it’s– Bill’s son Drew and I are all CPAs. We all have a good handle on the financial angle of managing real estate, and to me, that’s critical. You have to understand the numbers of what the cash flow is going to be, how you can impact cash flow, how you can increase it, what your expenses are going to be, how to forecast what your expenses are, not only this year or next year, but the next five years. So I think the key- obviously location, can’t deny that, but after that, I think you’ve got to have somebody in charge who understands the nature of finance.
Chuck: I would also think being able to explain that to the owner if the owner’s coming to the table without that background so that they understand what they’re getting into. In my own mind, it’s very hard for me to separate the- sort of what I would say are the organic financial aspects of real estate ownership from the tax implications of it. It just seems like this is an investment where part of what you have to understand and part of what you have to maybe take into account in deciding whether to move forward with a particular purchase or a particular project is how that’s going to affect your taxes. Because real estate almost uniquely has some characteristics to it that can be both positive and negative from a tax standpoint. You can tell me where I’m getting this wrong because you certainly are more of an expert, I’m a little more of an outsider but it seems to me like there’s some attraction there and being able to take your depreciation deductions, and if you’re partially financing through lending, being able to deduct the interest, and then on the other hand, those same things come back to bite you with respect to being able to ever get out of the investment that those depreciation deductions are going to come back. At least some of them are going to come back as ordinary income if you sell. So you could be in a situation where down the road you still have a lot of debt to pay off and yet upon sale, you’re going to capture all this ordinary income and you could end up with maybe some negative cash depending on how things have worked. It strikes me as something that– I mean, do typically people have an exit strategy when they enter or is that something that, “Hey, if you go in, you’ll look at what’s this going to do for the next 10 years and count on holding it at least that long?”
Dave: That’s a great question. I can tell you our investment group has no exit strategy per se.
Ed: Other than death.
Dave: The pass away, right.
Ed: Why death?
Dave: Step up in basis.
Ed: That’s it. One theory is if you’re going to buy an apartment complex, you better plan on holding it until death. That’s not a necessary pleasant experience.
Chuck: No, no. That seems to be one of the least pleasant ways to get out of an investment.
Ed: Having said that, Ed the megabucks would say to you, “Look, before I do this, I want to know, first of all, what do you think the rents are going to be? What’s the net after management fees to me?” Doesn’t that dictate the cost of the land? I mean, I back into it. In theory, at least, mathematically, I’m paying X dollars for the land because I put the apartments on– What’s going to cost me for the apartments? What am I going to get out of this? What’s the present value of the future of these rents? What’s this project worth? So I’m really backing into it versus buying one. Is that–
Dave: Yes. That’s a good point, a good way to look at it. We buy primarily on cap rate, on NOI.
Ed: What do you mean by that?
Dave: Net Operating Income would be the revenues you take in minus the expenses you pay out. In other words, it does not include depreciation, it does not include interest expense. So, a Net Operating Income, that’s a key number. We look at an asset and we determine what we think the Net Operating Income is going to be. Then we apply a capitalization rate, which is like an interest rate or a rate of return that we want to make on our investment.
Ed: Let me give you an example. Let’s assume that cash flow, I’ll call it cash flow, is $100,000. If I apply a cap rate of 10%, that means I have to have– that property’s worth a million dollars?
Dave: Right. If our cap rate is 10%, if we’ve chosen that rate as what we think we want to enter into an investment to buy–
Ed: That’s what you should expect to receive?
Dave: Right. NOI, the cash flow is 100,000, then yes, we would pay a million dollars for that $100,000 a year cash flow. So yes, you are backing into the value by looking at what you think the revenue or the cash flow is going to be.
Chuck: That cap rate I mean just to– in case there’s people listening because 10% is an example that you can misinterpret as mean, I know you multiply, but what you’re saying is that if you pay a million dollars, you’re expecting to get a 10% return on that, which is where you get the $100,000, so you’re doing the equation backwards. You’re saying that, “We’re expecting 100 million dollars NOI and so, what would the purchase price be in order to generate $100,000 at 10%?” That just happens to be a million in this regard.
Ed: I like that, I’d like to digress a bit and talk about wind farms. Folks have come in and they have these wind farms that are very small piece of ground with easements, huge structures, and generating $100,000 a year or triple that with escalators, with maybe a 10 or 20-year term with options to renew. Well, how do you value those guys, because that’s on a piece of ground, say 160 acres, so you’re valuing the 160 plus this wind farm. How do you factor in the fact that they’re going to be there and that they’re going to renew versus apartments?
Dave: Yes, I can’t speak to windfarms.
Ed: In terms of the value, you’re assuming a stream of income with the apartments, right? But with the wind farm, if the lease runs out, or the organization goes bankrupt, you’re stuck with this farm with a nice- a wind farm on it.
Dave: With costs associated with removing it.
Ed: So, on one hand that stream of income is easily identifiable, no management fees and whatever, but how do you factor in the risk?
Dave: Yes. When I see the wind farms and now solar farms, we’re starting to see some offers for that on land. It’s the same thing. You spread these solar panels out all over your farm and it’s great, generates revenue and as long as that company stays solvent and they can pay you, great, but if they go under, you’ve got to remove all that otherwise you can’t farm your farm anymore.
Chuck: These are typically not the utilities that are– Right, it’s usually some other organization that you’ve never heard of. It’s–
Ed: They put together all the credits. It’s a tax shelter.
Chuck: Yes, Sea Venture Partners for is wanting to rent this land from you and you have no idea how much, maybe that particular organization only exists to rent your little piece of land and has no balance sheet. So you could be in a situation where the industry could be booming, it could be a great investment overall and yet the one tenant that you have just happens to go under because of mismanagement or whatever.
Ed: Remember, those guys, that industry is grounded. The predicate is taxes. You’re getting tax credits, someone’s getting tax credits or benefits.
Chuck: Well, yes. I think that anytime you get into the power generation field of any type, you’re talking about so much integration with public policy. I mean, I would probably say the comment you just made Ed, probably applies to any kind of-
Chuck: Well, any kind of industry where you’re talking about that’s going to intersect with a public utility. So, you could end up with the same types of issues with people building cell towers or people doing– I mean, the wind farms and the solar farms probably all have this issue where you could have regulations change, and then suddenly, it’s no longer attractive for whatever reason.
Ed: Stepping back, I’m trying to rank these investments. Let’s assume we have an index fund, total stock market index fund. We know we’ve got liquidity and we know it’s going to work as a function of gross domestic product, and we can get out of it tomorrow, even at a loss. Then you have, for example, the apartments, where we’ve talked about the criteria, but if you lose one tenant, you don’t lose the entire apartment building. Then we have a wind farm, for example, where the rate of return that you should be getting in a respectable wind farm, should exceed that of the apartments because it’s not marketable, you got insolvency risk, you got a governmental risk. You got nothing but risks. Is that fair?
Dave: Yes, I think that to work in back to the cap rate concept, you would enter into an investment in one of those regulated industries with a higher cap rate, which would be- a higher cap rate drives the price down. In other words, if you’re going to get $100,000 revenue stream from a wind farm, whereas you might pay a million dollars for an apartment complex that gives you the $100,000 cash flow stream, you might only pay 500,000 for the wind farm, which would be a 20% cap rate. So, yes, I think as an investor, if I were to consider one of those more risky propositions, then I would demand a higher cap rate, which would mean I would pay less for the same cash flow.
Chuck: What’s amazing to me though, in the context of that comment is that, it strikes me as one of the investments you can make in real estate where you have some of the least certainty is simple farming and yet, the cap rate that those guys will accept is remarkably low. Isn’t that–
Ed: a different issue Chuck. I mean, the farmers that I’ve been involved with knowing, seeing a farm, going and walk around the farm is the absolute end of the world. It’s a big deal. I know one client that own some farms in Iowa, never saw the farms. I mentioned that to other farmers, they said, “What? That person’s crazy, never saw them.” seems to be this psychological return in owning farms and the theory, at least from the statistics I’ve looked at, if you compare a farm ownership over the last 20 years with stock market owners, owners of common stocks, they’re pretty much the same, except the farms aren’t as marketable.
Chuck: What I’ve been told is that, at least in total return, you’re looking at a fairly equivalent investment over a long period of time. Having said that, of course, you do have tax favorable treatment when you’re talking about an investment in the stock market because now you’re talking about something that’s generally generating qualified dividends as opposed to ordinary income.
Ed: You could imagine they had and offset that qualified dividends against the investment expense.
Chuck: It strikes me that sometimes when we’re talking about investments, you’re looking at risks that are- maybe the price is driven more by apparent risk than actual risk and people bring their own emotions into this. I think the perception I would restate what you just said a little bit differently and say that because the farmer is not making improvements, structural improvements on that ground, they feel like there’s some safety in that investment because the ground will always be ground. Yet, as we’ve learned in recent history, you may not have a market for your product like you thought when you bought the farm.
Ed: I see the farms as the riskiest, and challenge me on this folks, farms as the riskiest potential investment. You’ve got government regulation, you got tariffs, you’ve got issues with crop care. I could have a crop, you’ve got weather, you’ve got– I mean, it doesn’t stop.
Chuck: When you have an apartment building, you have to worry about the local competition, when you’re farming, it seems like you could suddenly– When you buy that farm in 1975, you think you’re dealing with domestic competition and maybe people in one country, and then 20 years later, you’ve got three or four other countries where suddenly those are major competition for you. So, yes, it strikes me as kind of amazing the amount of faith– I think it is kind of an article of faith for some of these guys. The faith that they have in the stability of that industry. It’s certainly is stable in the sense of a well-managed farm will continue to be productive over time. It’s just you have all these factors that are–
Ed: Yes, farmers always say, well, you always got to eat. People have to eat. are we eating beef anymore?
Dave: Right, I think that would be a really interesting– It would be easier to take that comment at face value if the thing you were growing was something that humans consumed, but people typically do not eat directly soybeans or the corn that is grown, at least seen on local farms. Those are generally used for other purposes. Corn was a great deal if that was used to produce ethanol and soybean is used for a lot of industrial applications. So, it’s not merely eating. There’s a whole industry here.
Ed: You can have a logical way and rationalize any investment. I like to see the farms, I like to see the apartment, my view is don’t fall in love with the investment. If it’s an investment, treat it objectively and don’t fall in love.
Dave: That’s good advice.
Ed: If you want to fall in love, get a dog. Dave, I would tell you, in my readings, more specifically there’s a January 18th, 2020 special report published by The Economist. This report is captioned ‘shaking the foundations’ which addresses the idea of owning a home, and it beats it up, that concept suggest that no one should own a home but you should rent. So, if that article is correct in addressing home ownership internationally, there could be no better industry than the one you are involved in.
Dave: We’re looking good. I’d like to hear it.
Ed: I wish I were patronizing you but that’s the way it is. How do you respond to that? Should you buy more apartments David or-?
Dave: Well, I think so and I think what we’ve seen on– I’m talking on micro-level here. I’m talking Pekin, Peoria, this 60 miles of radius from where we are right now. What we have seen is a lot of high end houses are for sell and without buyers. People we’ve seen that bought homes under the assumption that your home is your best investment, bought a home and in 10 years sold it for less than they paid for and they may have owed more than it was worth at the time they sold it. So they are looking at that and saying, “That was not a good investment.” Now they’re going to shy about going to buy another $300,000 or $400,000 home. So, I think there’s that phenomenon that we experience that maybe since 2007, 2008, over the last 11 to 12 years. What we’ve also seen is the higher end apartments, by high end I mean rents of $1,200 per month up to $2,400 per month.
Ed: Wait a minute, $2400 per month?
Dave: We’re getting those rents in Peoria and–
Ed: In Peoria, what would they be in Chicago? 5,000?
Dave: Probably 5,000, that’s a good guess, I would say double. But who is moving into a $,2400 a month apartment? It’s those people who will otherwise be ellegible or potential home buyers that see it as more flexible. They get pretty new construction, they get modern decor. They can move out if they get unhappy after a year or once they’ve served a year, they go to a month to month lease, after 30 days, they can move if they need to do. I think we have a population that likes flexibility and has been burned a little bit on home ownership and consequently, they’re looking at renting thinking, “That’s appealing to me.”
Ed: What about counseling your daughter who has graduated from accounting school, so to speak? I call it college school. My grandmother said we go to grade school, we go to high school, you go to college school, or you go to law school. Anyway, she’s a recent grad, admires you in accounting. She’s thinking of buying or renting, what’s your discussion?
Dave: She’s thinking about buying because she likes the stability and she thinks she’s going to be in a market she’s looking at for at least six, seven, eight years. I talked with her about that. She’s going to be married this summer, so I talked with her fiancé and we discussed what price level they might be interested in. I took the real estate taxes and the interest on the loan, I encouraged an 80% loan, and the insurance that you’ll have to pay on a home of that dollar value. Those three costs are, when you talk about home ownership, those are costs that don’t give you any hard asset or any real asset. Those are soft costs, let’s say, or truly money that is not going to be recovered. So, on the home she was looking at, those numbers came out to be about 800 to $1,000 a month, again that’s interest, insurance and real estate taxes, not any of the principal for the home. Now, go look up what you can rent an apartment for in that 800 to $1,000 a month market and there are some pretty nice apartments out there at $1,000 a month and you can move into that and you have no lawn to mow, if the furnace breaks down you call the landlord and he puts in a new furnace or he fixes it. I mean there’s no those home owner expenses. So, renting is pretty appealing to her in that situation. There are other benefits of home ownership, I recognize that. I own a home and I like my home. I have my backyard that I can do whatever I want to in and there’s some pride of ownership in owning a home.
Chuck: So, little more privacy–
Dave: Yes. Right. I understand the pros and cons but I think what we’re seeing is purely on a dollar basis, on a financial basis, renting appears to be becoming more and more popular or more and more appealing.
Ed: I can see that from the point of view and also for the senior citizens of the world, but let’s assume you’re in the mid point there, are young and old, so to speak, and how many hours of the day are you going to be sit and be at home? You got a day job and you’re sleeping, so what percentage of the 24-hour period are you really enjoying the house? I don’t think people look at it from that perspective.
Chuck: I think more and more people who are particularly in the cities, my impression is that there’s culturally- when you’re talking about younger people, this kind of a shift is not just applying to home ownership but car ownership and marriage, all kinds of things have to do with long-term commitments that there’s an issue with, hey, why buy when you can rent, might be an attitude that-
Ed: Look at Uber.
Chuck: Well, that’s a great example. So, you’re seeing more and more of this generationally. That doesn’t surprise me at all now. I’m not sure how much of that really filters outside the major metropolitan centers into areas even like Peoria which is certainly a city just not one of the major cities.
Ed: Rock Island, that sort of stuff, those sort of activities. It strikes me when I look at investments, very rainbow of investments that you can be selecting among, apartments are right up there with the only issue is you got to die to make it worthwhile elsewhere.
Chuck: Well, and even there, that can be a little bit complicated even there, right? Because typically you’re going own that inside some type of vehicle, like a limited liability company or something that I would assume in most cases it’s some entity that’s been taxed at least as a partnership. So, an LLC or an LLP or just a general partnership, then if there’s ever more than one owner, the one who dies can get out but- unless all three owners die simultaneously, the investment is kind of locked in. Right?
Ed: You’re right on. Just this last week an individual who owns half of this apartment building in a partnership lost the other owner. So the decedent get’s a new tax basis, but the surviving owner does not, so they have to go through an exchange or something or pay the tax.
Chuck: Because they have to sell it.
Ed: They have to sell it.
Chuck: Because of the death of one owner.
Ed: Yes, so you’re locked in. Putting it in another way, if you’re going to own an apartment building, you better own it yourself, you’d better own it in an organization that is disregarded for tax purposes and you better plan and owning it until you’re a ghost.
Chuck: How much is that your experience Dave in terms of shared ownership versus a single owner?
Dave: I agree with Ed and I think he makes some good points, however in practice, I’d have to say we’ve strayed from that a little bit, but I’ll explain. Typically we invest with groups of four, five, six investors, all of which have a close relationship, a family, for Bill and Drew and for me, we’re brothers and one son, but the others, lifetime friends, attorneys, people we’ve known and worked with for 20 and 30 years. So, we trust each other at a level other than a limited partnership where you don’t know the other investors. All that to say there’s that issue of, let’s say five guys own an apartment building and one passes away, so it goes to their– Now, let’s say that child steps in as the new member of the LLC, we trust each other that nobody would force a sale or our agreement probably is that somebody could if they were in that situation, but we all have an understanding to consider the best interests of the group and each individual in the group. So, it’s a little unique in that we have that relationship with our investors.
Chuck: It seems to me like, even aside from the question of trust, that someone who is inheriting that interest might be someone where they just don’t have the comfort level to stay in that investment or whatever. This is a very personal investment and-
Ed: Or Chuck bankruptcy. The one owner who goes bankrupt.
Chuck: Yes, but I’m thinking that someone wants out because it’s not a good fit for them personally and they have that really the best opportunity is right upon inheritance to say, “Hey look, other four partners, I don’t have any dispute here with the wisdom of what my mother or my father did in getting into this but I don’t want to stay in it, and I know that if I come to you five years from now, I’m going to have a tax hit that I won’t have if I sell today. Is that part of the planning for you guys to have that exit strategy for an individual owner lined up or do you have to plan it by ear?
Dave: I think just at the top of my head as I think of every deal that I’m invested in with these various groups, and really there’s maybe 10 or 12 guys and 6 or 7 will do the first deal and then five years later we might do a deal and there might be some of that same 12 but a different mix of 5 or 6. Does that make sense?
Dave: As I consider those, every one of the deals I can think of if one of the members passed away and the new member that inherited the share was in and said, “This doesn’t fit for me,” I know that the others in the group will buy their share. At that point, you would pay for your market value which should be equated to the step up and basis so that person that inherited that share should be able to get out without a tax issue.
Chuck: Right. It seems like that would be a pretty critical for someone– You in your family you’re this professionally, I mean this is what you do, but for someone who is thinking about this as part of what otherwise would be a whole collection of investments, in my mind that’s one of the things I’m always thinking about is, getting in is one thing but then how do you get out.
Ed: Yes Chuck, you focus is on, in my experience is exit strategy. How do you get out of this thing, which is why I tend to prefer equities to anything else in the world, I can get out. I know psychologically I’m not going to get out, I’m going to stay in and hopefully long-term capital gain and leverage it because I can leverage it easier than that. I don’t have to give anyone financial statements, it’s what’s the value and maybe you can leverage it up to 40%. What’s the interest rate, what’s the dividends. That’s easy for me, I don’t have to respond to anyone else.
Chuck: I know but Ed, Dave is about to tell you how much these apartments make and then you’re going to change your mind.
Ed: Well, yes, I agree. It’s not unusual to see what 32, 34, 36 units, $2,500. It could be very good, on the other hand they can stay forever. All I’m saying is getting out is almost as important as getting in.
Chuck: True but on the other hand let me play devil’s advocate here and you can maybe color this with some real numbers, but if you’re in the stock market great investment in terms of total performance but in terms of cash flow, you’re maybe getting 3% on your investment in the stock market versus what if you get into commercial or residential real estate.
Dave: I would say we shoot for 10% cash-
Dave: Yes, and there’s a lot of variation. I mean there are deals we’ve bought that we’re going to be happy with a 6% return, but there’s other ones that we want 13 or 14, and based on location, where it’s at, the amount of risk for other factors. So, I think 10% is- I feel comfortable saying that across our whole portfolio, I would expect 10% to be pretty much attainable for everything.
Ed: I look at just the basis, what’s your tax basis for this subject investment, what’s your return on cash, not on market value, but on tax basis. In other words, what you put in, land cost is static, and the value of the improvement, less the depreciation, that’s your tax basis. So, if you’re getting $100,000 a year on a tax basis of 100,000, that’s not a bad investment, versus if that’s on fair market value which could be a bad investment. My role is you’re buying your hold, challenge me on this folks. I mean, you can make all kinds of bad investments and hopefully 80% of the investments you make are going to work out, you know 20% are going to be bad. Make sure you understand that you’re not going to bat 100%. Having said that, when you can select them on the stock market firms, equities, private hedge funds or private equities, is it fair to say you should be thinking about diversification?
Dave: Absolutely. I preach that to anybody who’ll listen. I practice that.
Ed: The kids would not listen. they will not listen.
Dave: Yes, I think it’s smart to diversify, absolutely. I’m certainly concentrating in real estate because it’s my livelihood and my hands are on it all the time. I know the most about it.
Ed: Yes, but should you be?
Dave: That’s a good question
Chuck: It’s okay, Ed and I are heavily concentrated in equity and law offices, so, we all have our witnesses here.
Dave: What’s appealing to me in real estate is I can control it to a degree. I can control the market, but if I take $100,000 and buy Apple stock and see something in the future that I think it’s going to hurt Apple stock or hurt our business, my option is to hold it and hope that that doesn’t happen or to sell it. Where if I put $100,000 in a real estate and I see the dynamics changing and I see some concerns, I can adjust. I can lower my rents if the market is going to get soft. I can improve the property, put in granite countertops where there are Formica. I can refinance if we’re hit in a tight cash flow situation and I know that for the next three or four years, revenue is going to be tight and I’ve got equity in the building, because I’ve had it for 10 years, I can refinance and take out some cash to carry me through operation. So I like the control of real estate.
Ed: I want to challenge both of you guys on this. Let’s assume the unit is 100,000 bucks. Mortgage is paid off. What’s the next to do? If you own that apartment building, what would be the next thing you would do?
Dave: Buy another one.
Ed: Exactly, and from that you buy another one, and you buy another one. So, if you can leave it alone you can pay the tax, to the extent there’s an income tax, you can leverage this but you can’t with firms, you don’t have enough cash flow, you can’t with the stock market unless you’re doing mortgage loan, but with apartments the opportunity of it ending up with not 32 but 132, if you live long enough and you get lucky enough, I think it’s an opportunity that we haven’t really addressed.
Chuck: Because of the cash flow. Now when you talk about these cash flow that you’re gaining out of these, are those figures taking into account that part of that purchase price is financed or is that cash on the barrel pricing.
Dave: I’m not sure I understand your question.
Chuck: Well when you said before that you were looking to get 10% or in some cases 6%, is that 6% or 10% on an investment that is heavily financed or is that, hey, if I paid full price with cash, with no financing, I would expect to get 10% return on that investment?
Dave: Yes, good question, I understand it now. I would say the 10% is on the investment, assuming financing. In other words, I think the market right now for a cap rate is, let’s say 6% or 7%. So, if I’m paying cash for an asset in real estate, I would expect to get 6.5% return on my cash, but if I had $100,000 and I was willing to leverage it and go buy and finance the asset, and I buy on a 6.5% cap rate, I would expect a higher return on my cash invested.
Chuck: Is that part of how you decide how you’re going to structure that purchase? Like, “Look, I need to get–” let’s say you decide you’re going to be greedy in one year, “Look I’m looking for a 12% on this deal,” so that has to work. You have to come up with some combination of cash and financing that all in you’re getting the cash flow you need and if you can’t you’ll walk away from the deal?
Dave: Yes, that’s it exactly.
Ed: So then you will never buy an apartment without regard to cash flow, positive cash flow. Putting it another way, I’ve heard, that’s going to appreciate, so I can afford not to take any cash out, it’s going to pay our interest and principal. That thing is going to appreciate, is going to be the greatest thing since sliced bread.
Chuck: That would make me nervous.
Dave: We typically don’t make that assumption.
Ed: Okay. What’s the ratio of debt to equity that you look for in buying an apartment?
Dave: I think 20%.
Dave: Yes, 20% down. For one thing, the banks are going to require some percentage.
Ed: With personal guarantees.
Chuck: Right. 20% is what we typically feel comfortable with, maybe 25%. We are pretty conservative. We do not highly leverage. When I say we, I just mean our investment group that I mentioned earlier. We like to be able to sleep at night knowing that our projects are well-capitalized.
Ed: They say- Chuck, is a 80,20 rule, about that?
Chuck: We keep running into that. Those loans, are they amortized on relatively short schedules or what’s typical to this industry?
Dave: Typically a 20-year amortization.
Dave: We can get the rate fixed for five years, usually. All this is negotiable, the banks will tweak this and that to compete with each other but generally, we look for 20-year amortization that the interest rate is fixed for five years, and then a cap of an increase after five years, let’s say 3.75% for five years. After five years, the rate will adjust based on a liable or prime rate, but it’s capped at maybe 2% more, so your next five years will be capped at 5.75.
Chuck: Are the banks typically putting a balloon at the end of that or do they actually have it on their books as a full 20-year loan?
Dave: I don’t know that it’s always the same. I can tell you we approach it as a 20-year loan, we think that we will pay. Our strategy is actually to pay it down super-aggressive. We take almost all cash flow and apply it to the loan. So, if we’re doing a 20-year loan, in our books and our projections, we probably have that paying off in 13 years or 14 years.
Ed: David, Chuck, Ed’s world is interest rates determine value. The amount, the interest you’re paying with your borrowing determines the value of the asset you’re about to purchase.
Chuck: Do you see that in this industry that if rates go down, do you start seeing the pricing go up on properties?
Dave: Yes, definitely. We get more aggressive as a buyer, if we know we can borrow money at 3.5%. It makes deals work that don’t work at 7% interest.
Ed: You’ll see this in the stock market, see the private equity market, to the extent you can borrow at a lower rate than hopefully you’re earning, that drives the economy. The end of the story is apartments create a terrific opportunity in a diversified portfolio but you have to have a good manager, unless you’re committed to that as your full-day paid job activity.
Dave: Yes, I would agree with that.
Ed: So, diversification and continuing to do your day job which could be picking up sticks or selling shoes or whatever, if you don’t know the investment, make sure you know the person that’s handling the investment, is that fair?
Dave: Yes, I agree with that.
Chuck: Is that fair, would you recommend that someone get into this if they don’t know the investment but they trust you, or would you say, “Listen, you’ve got to have a little more interest in knowing what’s really happening here before I’m going to partner up with you and be your manager?”
Dave: Good question. I feel better when my client understands real estate very well, because it’s not a simple thing for the layperson. If you are leveraged, there’s risk. If someone’s life savings is $100,000, and they invest it with a $400,000 loan, and we hit some tough times, that’s an unpleasant life for that person. There was some investment firm, I think that said, an uninformed customer is our best customer, I agree with that.
Ed: Well, thank you. Any other observations so I can sleep at night because I have no leverage.
Dave: It’s a good place to be.
Ed: Yes, thank you.
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