Are Residential Home Values at their Price Bottom?

Mortgage resets do not  close the high volume to be adjusted until 2012.  Some suggest  the  “bottom” for residential real estate is  still a decade away.  At the same time, rental vacancy  is currently at a high and may  worsen some before beginning to recover.

Understanding the dynamic of existing vacancy, prospective continuing fall of single family housing values, ongoing employment weakness, the existing larger shadow inventory of housing are important factors in pricing and revenue models for residential investors. Additionally, considering likely significant interest rate increases must be part of the investment calculation.

An investor need not understand each of these items implicitly. Instead, investment decisions need to adjust for these items by making conservative rate forecasts for their lending costs, making conservative cash down payments to protect against weakening values effecting Loan to Value (LTV) ratios, providing strong operating reserves protecting against leasing weakness, and seeking purchase terms that account for potential negative equity losses even if after a purchase.

As a fundamental step, investors should couple the above with purchases that are significantly below replacement cost and offering strong fundamental market position like high traffic, great features and amenities, and room for alternative revenue streams.

The first point should be to protect your return on investment assumptions after accounting for higher than expected rates and reserve demands. As important, Investor must protect their assets. The investor should protect against loan covenant demands and build in cushion against market shifts that can negatively impact Debt Service Coverage Ratio (DSCR) or LTV.

Investors who take this approach to the projects can expect to meet their cash flow goals, be positioned well for asset gains as the market recovers coupling with replacement value price drivers provide upward momentum for their asset. In this manner, their investment will be bouyed by the conservative cash flow support in place.

Blake Ratcliff

The Real Estate Guy

Alternative Sources of Residential Cash Flow and Cash Value

An apartment complex or a single family home offers one primary source of income.  However, for the smart investor, residential real estate can offer many more sources of income.

Some are obvious including:

• Corporate units,
• Washer dryer rentals,
• Pet Fees,
• Cleaning Fees,
• Application fees,
• Laundry Services,
• Storage,
• Etc.

Some are less obvious and can provide a much needed boost to marketing your residential rentals.  A few of these could include:

• Furnishing features like flat screen televisions, lawn service, or maid service at a profit;
• Roommate lease plans; or
• Including cable and high speed Internet

These type  packages are worth considerable attention today because with large percentages of prospective residents beginning their search for next rental home or apartment online seeking unusual search strings (the choice of terms a consumer puts in a search engine like Google) make the unusual services and amenities powerful differentiators.  Thus, not only does potential revenue for the rental home rise, the potential market size is increased for the innovative owner or manager.

For owners with large numbers of units, other revenue streams become possible such as advertising to residents, subcontracted business services to residents and others.

When considering, alternative revenue the tax and asset value ramifications of each stream is important also.

For example, services like furnishings may offer depreciation.  Or, products like storage may become rental income.  In fact, in general including services as part of the rent is valuable for multifamily rental properties.  A revenue stream that is rent based can increase asset value 10 to 15 times the impact to Net Operating Income depending on the market capitalization rates.

These ideas and concepts can be the basis for steady and significant  increases in rental residential revenues, income, and cash flow for large and small owners alike.  Investors can use this to improve and existing portfolio or as the basis to complete “value add” purchases successfully.

Blake Ratcliff

Due Diligence and Investment Advice

Strong investor mentors and a well rounded network of fellow investors is a great way to improve investment results for buyers. For example, I had a discussion with an investor in a small residential property that she is intending to buy with seller financing.  However, she would prefer not to close until March 2011 because she is displacing another payment she carries at that point in time.

The seller is motivated, but not very sophisticated.

After hearing all the points, several suggestions to meet the investors needs:

• First, delay by  offering a sales contract that included several items including completing the survey and appraisal (selected by the investor).  With some work, she should be able to identify a surveyor and an appraiser that will require more time to complete their work.  Through this effort, I’ve suggested the closing can be pushed into mid to possibly late March.
• Second,offer 5% down in cash and the first 6 months mortgage payment into escrow with the final down payment into escrow and closing at 6 months.
• Third, deposit the cash in escrow at the offer with the investor’s lawyer.  The cash in escrow will act as a strong enticement to cause the  seller to accept the offer.

The point of all of this is that the deal is a matter of understanding the seller’s needs and motivations, cash constraints and imagination (this is part of the value of having the right lawyer).

Blake Ratcliff

The Residential Real Estate Guy

The Sales Contract and Residential Investment Due Diligence

Understanding the pitfalls and opportunities of the sales contract are critical residential investing skills.

Often buyers take the sales contact for granted assuming that all parties are acting in good faith.  This can be an extremely costly choice.  Instead, investor security requires viewing and acting on the negotiation, development, acceptance, and execution of the sales closing as a critical financial decision.

What does this imply?

First, while negotiating the contractor there are many critical warranties and representations that the  buyer should insist be included.  A list of my favorite are:

• That the current residents meet the seller’s quality requirements including:
  • Rent as a % of income,
  • Credit scores,
  • Criminal background check, or
  • Community policy standards;
  • That all leases and applications signed between the beginning of due diligence and closing meet normal resident qualifications for credit, background, employment references, and rental reference;
  • That the seller provides an inventory of all items conveying with the sale of the property and all items not conveying with the property;
  • The seller’s  inventory should include a statement of the condition, make, and model of each item above $50 each;
  • That the seller warrants that the property will be maintained in the condition existing at the completion of due diligence with such repairs being made as required under the contract;
  • That the seller will maintain the property at consistent rents and occupancy without losing more than 5% until closing;
  • That the buyer will maintain retain all financing contingencies through due diligence, until:
    • lending is approved,
    • until property condition reports are complete,
    • until environmental phase I and if required environmental phase II are complete,
    • until survey’s are complete,
    • until the buyer verifies deposit account amounts,
    • until the buyer verifies rent and other income deposits,
    • until the buyer verifies expense and other cost checks,
    • until the  title search is complete, until liabilities and liens are established as not existing, and
    • until the appraisal is complete with any  deposits held in escrow until that point in time;
    • That the seller shall warrant that the income  and expenses for the property are true and  complete and that no  other properties or businesses owned by the seller have absorbed the costs falsely  altering the revenue, expense, or capital costs of the property;

A number of other items should be included in the sales contract.  Further, the buyer must specifically verify each of these items during the leasing process.  Verification includes checking and documenting the results of that verification.

In general, the buyer can expect that issues are likely to crop up during the period between due diligence and closing.  The buyer should seek recompense of some sort for all material amounts either prior to or at closing viewing each instance as an opportunity  to potentially materially improve the deal.

Blake Ratcliff

The  Residential Real Estate Guy

Business Plans and Risk Disclosure

Even if you are not preparing a formal offering a disclosure  of risks is a good idea on an offering.  This disclosure includes many standard items and should be carefully modified to be project specific based on project due diligence.

Below is Standard List of Risk Issues to Address and Customize based on due diligence results:

• Economic Uncertainty
• Competitive Environment
• No Operating History and No Profitability
• No Recurring Revenues
• No Financial Statements for Company;
• Cash Flow Projections do not Reflect any non-cash tax deductions
• Affiliates and Related Party Transactions
• Common Management
• Need to Attract and Retain Key Employees
• Need for Additional Funding
• Potential for Dilution of Interest in Company
• Nonvoting Interest
• Lack of Public Market
• Unregistered Stock
• Illiquidity
• Absence of DistributionsDilution and Company Valuation
• Speculative Investment
• Nonexclusive List of Adverse Changes that Would Adversely Affect The Investment by Subscriber
• Availability of Information

Some of these may not apply to your project and should be dropped.  Some of these may  require specific statements for your project.  In either case, the risks should be modified to reflect your project.  Additionally, this list should not be considered absolute.  If you have more, they should be added.

Blake Ratcliff

Residential and Multifamily Cash Flow Investment Executive

Join our LinkedIn Group – International Residential Real Estate Investment Association

Personal Guarantees

Everyone hates guarantees.  Nevertheless, fallout from the financial crisis is  they will be more common rather  than less.  So, the question can not be simply how  to avoid  them (definitely the preferred course).  Instead, investors need to consider how to assure they are not exercised.

This process begins during your project due diligence.  The key factor is assuring that regardless of what occurs now or in the future the value of the asset will easily exceed the amount and level of the  guarantee.

The risk of a guarantee is manageable so long as the asset value under a forced sale will exceed the  guarantee amount.  This is the critical measurement investors must make.

Stuff to Think About – Bubbles, LOIs, Contracts

One lessonwe investors can take away from the “Great Recession” is avoid bubbles.  Of course the question you may ask is how.  Does anyone believe we intentionally  invest into  bubbles.  The short answer to that is yes.

Consider this, in China real estate in the city is appreciating at a 20% annual rate.  Is this a bubble or not.  If an individual continues investing into that growth, there is no possible response except you are investing into a bubble.  Not all bubbles burst, but investing into them is a sure way to be caught in a bad position.

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Check out this link for a good discourse regarding whether to start with an LOI or a contract when making an offer to buy.

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Barclay’s Capital downgraded Reits to neutral this week but upgraded multifamily from negative to neutral.  Residential rental is looking up!

Due Diligence Document Management and Storage

Most of us assume we won’t be taking the seller to court.  In general this is a reasonable assumption.  However, sometimes events do not transpire as we might expect.  Because of this, the due diligence process requires preparing documents anticipating that potential exists for legal issues.

The approach should provide for:

1. Keeping copies of all agreements,
2. Keeping copies of all correspondence from the seller, the seller’s broker, and attorney’s.  These should be kept with the item to which they apply,
3. Assuring all info is requested and the status of this info noted as received with copies, not received but closing without this and noting as an issue to the seller,  not received and not closing without receipt,
4. Post closing all  the information should be verified as complete, status noted to your legal representative and a copy sent to the seller.
5. The objective should be to protect your rights under the  contract as fully and for as long as possible.

Partners

Putting together an investment can be challenging.  In the midst of working out the business plan, answering lender questions, preparing financials, completing residential property due diligence, or checking apartment comparables, you have to find time to raise money and develop partners.  And as challenging as that can be, another important consideration is have you thoroughly vetted your partners.  Are you on top of their personal and financial position?

Food for thought.

Reviewing Historical Financials During Due Diligence

First, relying on the current owners’ historical financials for an expectation of your operating expense is fraught with risk.  Essentially, you are making the assumption that you can and will operate the property  in very much the same way the seller is.  This assumption can prove incorrect for a wide range of reasons.  The risk averse investor must bring a clear understanding of their expenses to the closing table and be guided heavily  by this understanding.

This earlier point stated, historical financials provide much needed hints about a given property’s costs for some key areas including: 1) utilities, 2) key  maintenance issues such as appliances and air conditioning, and 3) landscaping.

Your costs for labor and management, cost of supplies, and cost of contractors are brought to the  property by your mode of operating.

The last factor determining your cost is the combination of your physical inspection of the property, the property condition report, your market study, and your operations and management plan.

Each of these items should be combined to create your financial projections.

Blake Ratcliff

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