Mr. Alexander is a gentleman that is looking to build his investment portfolio through residential real estate. He is looking at investing in a 4-plex in a historical district located within Boston, Massachusetts. The building is located on Revere Street and has a listing price of $350,000. Mr. Alexander is evaluating the possible commitment to understand what he stands to gain from the annual cash flows while at the same time understanding the risks involved. The subject property is located within a historical district and is not yet capable of housing tenants.
Property will require significant improvements prior to inhabitation. Client will be looking to secure a mortgage to facilitate the purchase of the property. All variables must be assessed and measured to provide Mr. Alexander with a recommendation to purchase said property and make any adjustments to the structure of the deal or to pass on deal all together. Our client also desires to live in the apartment building, and this must be taken into consideration both from a fundamental perspective as well as financial one.
Strengths Mr. Alexander is an accomplished carpenter and can make many of the improvements to the subject property himself. In addition to the carpentry skills, Mr. Alexander wants to manage the property himself. This will allow him to increase his monthly cash flow as he will not have to hire a property manager. Recently the subject property was classified as being part of a historical district in which the area will not see any more buildings constructed. This provides safety from over saturation within the market.
Buildings are not permitted to have improvements made to the exterior as well, without proper approval from the council. This ensures that direct competitors will not be making face-lifts to their properties and thus making the subject property less desirable. The subject property was left in a perfect position to make improvements to create immediate equity. The current owner ran out of capital to make the necessary improvements, but left a shell that can be remodeled to Mr. Alexander’s specifications. Our client met with a contractor, who confirmed that it would cost approximately $165,000 to complete the original plans.
The current assessed value of the property is stated at $400,000, however with the improvements to be made by the current owner, there is a projected value of $500,000. However, with Mr. Alexander making the improvements to the property himself, along with the average rents in the area increasing, the value is now projected to be worth $562,500 a 12. 5% increase. Issues/ Weaknesses Mr. Alexander is new to the property management arena and has no experience with multi-family dwellings. Due to our clients limited capital he cannot afford to hire a property manager.
Because Mr. Alexander will also be working his normal full-time job, and doing the property management as a ‘side-job’ the ability to manage multiple subcontractors will be highly inefficient and could lead to disgruntled tenants and higher vacancy rates. Also, the client will be extinguishing his savings with the purchase of this property and would not have the funds necessary to facilitate a major fix to the building, given that occurrence (ie. , roof, HVAC, etc. ). A reserve of 5% of the buildings value is the industry standard. Opportunities
This specific property provides our customer with an affordable beginner investment. It is located within a district that has been deemed a historical area and thus will remain a residential district for the foreseeable future. The annual cash flows from this property would allow Mr. Alexander to build up the necessary equity and capital to invest into larger structures in the area in the not-so-distant future. If the client is able to effectively manage the property himself he greatly improves his cash-flow which in turn will allow him to make additional investments sooner.
The property itself is located far enough off of the street to create a ‘grander’ entrance as well as a garden. Both of these amenities would increase the value of the property while not violating the councils policy of preserving the character of the area. Another possibility for the property would be to convert the apartments to purchasable condos upon the completion of the construction. If our client were to net $200,000 for each of the proposed 2-bedroom units he could essentially live in the building for free. Threats One major issue facing our client is the lack of experience within this arena.
While he does possess the ability to make improvements to the property, he lacks the knowledge of city building permit requirements. The time required to become familiar with these statutes could greatly affect the timing of the repairs. Each month he spends making improvements is a month of using capital to make payments on what would normally be variable costs (ie. water, power, etc. ). The bank has made an allowance for a 6-month interest only construction phase. However, if the client cannot meet that deadline he stands to make principal payments without having the rents from tenants to offset that obligation.
Another key concern for Mr. Alexander at the fundamental level is the issue of acting as property manager as both the owner and inhabitant of the building. By living within the building you lessen the distance with your tenants which can affect the ability to raise rents when that time comes. It also makes you very accessible and can lessen the quality of life you might otherwise get if you had an outside firm manage the facility. Analysis/ Recommendations It is my recommendation that our client not pursue this deal at this time for the following reasons.
The borrower is very limited with capital. The funds needed to finish construction, along with the fees that will be assessed through financing will not provide any room for unseen construction or permit requirements. The only way in which this deal can be fully funded is through the execution of a second mortgage on the property. Because of this the borrower’s financial state would further come under scrutiny from the bank. Given the best circumstances the bank would charge between 14-16% for the loan product, thus further reducing the cash flow from the property.
In addition to the high rate, a subordinate loan product will not allow for a 20 year amortization typically opting for terms 10-years or less. Assuming that Mr. Alexander is able to secure a loan for $47,000 ($19,000 cover shortage + $28,000 allowance for future repairs) he would reduce his debt coverage to $11,500 annually (this figure is counting rents from the unit he would be renting. If you do not count his rents he is short $7,600). Client must look at improving initial capital contribution before purchasing subject property.