In 2017, Coso Capital Group purchased a 20-unit apartment community (pictured above) from an owner who had it listed for some time. The property was listed at a price of $1,200,000. We made an initial offer of $875,000, but the owner countered at a $1,000,000 or so. There was not much wiggle room with the price on our part as the net operating income did not substantiate paying more. We passed and just continued checking if the property was listed.
Several months later, the property was still listed so we decided to submit another offer. The offer price was similar as before and again the seller wanted $1,000,000 or so. We continued watching the property and then submitted an offer with seller financing. This was at a higher price, but at favorable terms that allowed us to create a good amount of cash flow. The seller surprisingly countered, but the terms were not favorable, so we declined. After a year of offers back and forth, we asked for updated financials from the seller (the financials were only updated once per year). Surprisingly, we noticed the income had gone up a bit from the year before. This higher income allowed us to increase our offer by about $75,000 to $950,000. The seller accepted and we were under contract.
The investment was purchased with a community bank with financing at 75% loan to value. We now needed the remaining 25% of equity. We reached out to a few real estate investors who wanted to be capital partners of a multifamily property with an experienced company. The raise was about $265,000 in equity for the down payment, renovation funds, reserves and working capital. The plan was to use about $75,000 of our own money and obtain the rest from capital partners. As a sponsor or organizer of the investment, we like to have skin in the game. Additionally, we also were the guarantors on the loan which means only we would be responsible for it, not our partners. The offer to investors was an ownership position which included part of the cash flow and back end profits at sale.
The strategy with the property was a value-add investment. This means the value of the property is increased by improving the operations of the property. The value of commercial real estate is based on the net operating income it produces and a market capitalization rate. Increasing the net operating income of the property, increases the overall value of the investment. Our goal was to increase the annual net operating income by about $24,000 over a 5-year timeline. This would be a $300,000 value increase. After about 2 years, the investment had already exceeded our projected income targets for the 5th year. The expenses had been reduced by $10,000 and the income increased by $30,000.
The projected annual cash on cash return was 8% to capital partners for 5 years and an internal rate of return (IRR) between 15%-16% by the end of year 5. The investment achieved a 23.43% IRR by the end of year 3. The IRR considers cash flows and profits from the sale as well as the time the property is held. Investors received checks every 3 months the first year and then monthly checks after year one until the property was sold in May 2020.
When we acquired the property, we immediately improved the curb appeal by removing old palms and making sure the lawn was kept sharp by finding a new lawn service company. Additionally, several capital improvements including parking lot repairs, replacing old carpets, HVAC units, water heaters and installing a new drain field were completed.
After owning the property for three years, we consulted with our capital partners about the sale of the property. It was agreed to put the property up for sale in late October of 2019. Capital partners were given the option to receive their profits at the sale of the property or buy another property with the company via 1031 exchange. All partners agreed to reinvest the funds into a new property.
1. Know Your Market.
An external appraisal was performed to confirm the initial listing price. The appraisal came back lower than expected, but we still moved forward with a higher initial price. We are glad we did. We received over 15 offers at or near the listing price. Eventually, the investment would have lost out on $200,000. We've learned appraisals are just a professional opinion. Make sure to know your market to understand its' value and essentially, the market has the final word on value. The property sold for $1,525,000.
2. Persistence and patience.
During the sale of this transaction, Covid-19 hit hard in early March. Three business days from closing, the lender Arbor Realty tried renegotiating the loan terms. They requested the buyer to fund over $200,000 in additional funds at closing. The lenders concern about the pandemic were valid, but to wait a few days prior to closing was highly unprofessional. Additionally, I learned the lender Arbor Realty Trust had just ordered a $100 million-dollar stock buyback order. This means they had capital but were using it to buy back their stock at a devalued price because the stock market crashed instead of lending it out.
Arbor also charged the buyer for processing fees and other fees to release the inspection and appraisal reports. The fees for the reports were fair game, but the rest of it was just abusive. The buyer lost out on about $15,000. We agreed to give them more time to find a new lender and they were able to close in May 2020.