Step One: Build a Team
Team-members:
Attorney
Accountant
Property Manager
Realtor/broker
Insurance Agent
Banker
Handy Man
Property inspector
Appraiser
The best way to go about this is to first find a reliable, knowledgeable accountant or attorney and then ask them for references for the rest of the team. As you begin looking at properties certain names may begin surfacing multiple times. Go with these leads and check out the individuals.
I used a knowledgeable accountant as the cornerstone for my team and built from there. Don’t scrimp on the fees for these services. This is not an area to be cheap – you get what you pay for.
Form the Correct Entity
In real estate you need two forms of protection;
1) The correct type and amount of property and casualty insurance and
2) Asset protection provided by entity formation.
I recommend holding your real estate in an LLC. The reason being is that it offers more asset protection than a sole propreitorship, it is not taxed twice like a C Corp, it has more flexibility than an S Corp and it does not have the headaches of a partnership. For more information see “Why You Should Turn Your Hobby Into a Small Business.”
If you own many pieces of investment property you should consider splitting them up into separate LLCs. Multiple assets in the same entity bucket are exposed to each other.
Step Two: Identify a Real Estate Market and Submarket
Level One Research
After identifying the city you wish to invest in, start keeping up with local newspapers business journals and online publications. You are looking for a picture of population growth, planning and development and employment in order to further narrow down your market into a submarket which can be a specific area of town such as a neighborhood or an area defined by its proximity to major employers and/or highway access.
Level Two Research
Now is the time to go to your market, if out of town and develop your team. Spend time interviewing people, realtors, real estate investors, government officials and staff people. Try to determine a supply and demand picture in the area. Are certain areas overbuilt? Is a new employer coming to town and where will they be located? With everyone you meet, clearly communicate your goal. This will help your resources be of more service to you.
Level Three Research
Call up any referrals you may have received and see if they can point you to more websites and information that can narrow down your submarket.
ID the Submarket
In the end, ideally the supply of rental in your submarket should be low and the demand should be high.
There are three drivers for real estate supply and demand:
1) Employment, improvements and access – jobs are plentiful, redevelopment is planned,
New highways are on the way.
2) Population – people aren’t fleeing the area for warmer climates.
3) Location – the specific building has drive-by visibility.
Step Three: Submarket Microanalysis
1.) Compare rates, features, and amenities on properties in submarket – use an analysis spreadsheet.
2.) Read up in the paper, etc. for submarket changes.
3.) Drive the submarket, write-down potentials, other addresses and phone numbers of high potentials in visible locations – it could be that some potential properties are not for sale.
4.) Meet with people in submarket and get info.
5.) Narrowing down to the property.
a. Already have a property goal in place – example: looking for a 4 plex.
b. Look for out-of-state owners.
c. Look for distressed owners.
d. Seek out property that meets your criteria.
e. If not for sell then contact owner and tell them you are interested in buying.
Step Four: Analysis
I have included a sample analysis spreadsheet at the bottom for reference.
1.) Verify property income -- verify rent roll which is the rent for each unit and check for vacancies
2.) On the gross rent multiplier analysis spreadsheet -- find a gross rent multiplier at 8, 7 and 6. Anything over 8 is difficult to cash flow from.
3.) Run the operating budget using the cash flow analysis spreadsheet (8% vacancy estimated expenses. Taxes verified, insurance quote) If you verify expenses great. If not, estimates for the rest - reserves, repairs/maintenance, yard work etc. -- find cash flow from this.
4.) Find the Cap Rate Value = NYOI / R.
This and the gross rent multiplier value will give you a price target that you should not go over in your offer.
Note: if the building is older, repairs and maintenance and reserve will be higher than previous figures in the owner’s budget. Utilities can go up.
5.) Calculate the loan payment in cash on cash return.
Step Five: Tie Up the Property
Issue a letter of intent.
This maps out the deal points, the price and leads to the price negotiation.
Purchase and sale agreement – this can be issued in addition or in lieu of the LOI but an attorney drafts this generally after the terms of the letter of intent have been sorted out. This document details the purchase price, down payment, initial deposit, escrow, time frames for contingencies, pro rated rents, taxes, insurance and security deposits. It also lays out the details for securing a title report, financing and due diligence, the time frames for pest control and physical and lead based paint inspections.
The main contingency that should be included is that the buyer must find financing suitable to his or her needs. This will serve as a catchall.
Step Six: Perform Due Diligence on the Property
Part One:
In this step, you uncover 100% of the details about a property and you generate an operating plan, a plan to improve the cash flow of the property. You perform a thorough walk-through of every unit and factor adjustments into purchase price – either a detrimental discovery is fixed or the price is lowered.
For a thorough due Diligence Check list, see Rob McElroy’s book, “The ABCs of Real Estate Investing”, pages 134 through 137.
General areas covered:
File audit
Interior inspection
Government agency reviews
Service agreement review
Exterior inspections
Part Two:
Obtain all books and records.
24 months of income and expenses.
Service agreements.
Current rent roll.
Utility bills.
Payroll info.
B. The property plan = the goal for the property
Develop a plan to increase the property cash flow and value.
For example, can you build a laundry facility and/or raise rents? Would it be beneficial to seek out new insurance quotes for a lower rate? How can you attract new, quality residents in a timely manner? What if you bid out the landscaping or hired a maintenance man?
Step Seven: Develop an Operating Budget
Fill in what you are finding out to be the real numbers in the cash flow analysis operating budget.
Use the standard income but also look for other income opportunities.
Expenses
Marketing
Utilities
Capital repairs
Management costs
Repairs and maintenance
Property taxes
Insurance
What are the true costs you are finding?
Step Eight: Confrontation Time, Bringing Your Findings to the Table
Again, for any detrimental items found, the sales price should be adjusted lower or the property findings should be fixed.
Confrontation items that should be addressed:
Vacant units
Future vacancies
Bad tenant profiles
High maintenance expenses
Pest control issues
Higher utility costs
The property tax is higher
Fire code violations
Other violations
Step Nine: To Property Manage or To Not
If you decide to go with property managers, the following is a short list of the tasks a
property manager should handle:
Solving general problems
Leasing the property
Increasing the cash flow
Handling legal and contracts
Maintenance
Rent collection
Paying the bills
Managing the budget
Evictions
Customer service
Handling other legal issues
Guidelines for hiring a property management company
1.) The fees should equal 8 to 12% for single-family residence, 4 to 8% for multiple.
2.) The property manager should have at least three years in the business.
3.) Has an accounting department.
4.) Ask for references.
5.) Has policies and procedures already laid out.
6.) Belongs to professional affiliations and associations such as the National Association of Realtors.
7.) Has real estate licenses.
8.) Perform legal and background checks.
9.) How many employees and what are their backgrounds and duties.
You should fire the property manager when:
1.) The property does not perform well.
2.) Operations do not improve.
3.) No partner mentality from the property manager.
4.) He neglects the physical condition of the property.
5.) There is high employee turnover.
6.) Inconsistent or incomplete reporting.
D. Set up systems for maintenance accounting and rent collection.
Interview property managers.
Run criminal and credit background checks on new applicants.
Enforce the policies and procedures.
Step Ten: To Sell or Not
Maximum future potential income = 100% occupancy
Raise the rents and minimize expenses to have good reporting of income for selling purposes.
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