Make Your Money On The Buy!
This is part 2 of the Contrarian Playbook summary. If you haven’t read part 1 yet click here. If you have read part one and you are here for part 2, I am excited to say you have come to the right place. In part 2 we will be going into the fine details of what kinds of properties to buy, what factors can make or break your purchase, and how to negotiate for the lowest purchase price!
Now keeping in mind the importance of your goals, knowledge, credibility, and resources. The next steps are crucial in a contrarians career. Manny calls this part of his book “Make Your Money On The Buy”. The following are the breakdown of his process…
- Select your property type (Residential)
- Select a winner (Residential)
Select your property type (Commerical) Select a winner (Commerical)
- Negotiate from strength
Note: I crossed out two chapters from his playbook. This will be explained later in the summary.
4. Select Your Property Type: Residential
- Single Family Residence (SFR)
- 2-4 Unit Apartment Complex (Plexs)
First, you need to understand the difference between an Owner Occupied Property and a Non-Owner Occupied Property. This tells the bank whether the owner of the property has decided to live in the building. Buy living in the building the owner will have lower interest rates available for loans. A non-owner occupied building is subject to larger down payments and higher interest rates.
- Lowest price point, most affordable to the new investor
- Can qualify for FHA or VA financing if it is owner-occupied
- Relatively hassle-free, property maintenance is larger taken care of by your Home Owner’s Association (HOA) management
- Pay dues to the HOA, who might not be running at 100% efficiency so it would be smart to review the basic financial info for the properties HOA
- Sharing walls with other tenants can cause issues like legal battles, this will devalue the property whether you are involved or not
- You must abide by the complex’s Covenants, Conditions & Restrictions (CCR)
- CCR imposes regulations on remodeling, parking, behavior, and many more things
- The ROI on condos do not offer the best rate of return when compared to SFRs and Plexs
- Condos do not have much of an upside in future value as SFRs and Plexs
- This means it is hard to add value to this kind of property
- Condos appreciate at a much slower rate
Single Family Residence (SFR)
- Second most affordable residential property
- Offers lower down payments then condos, typically 10% of the cost
- Can qualify for FHA or VA financing if it is owner-occupied
- SFR owner has much more control of the property and has more freedom to add value to the property
- meaning remodeling or adding more square footage to the property is possible
- The biggest issue is this property offers less cash flow, only one tenant, either yourself paying out of pocket or a different family
- High risk losing cash flow from the tenant, losing your only tenant means losing 100% of the cash flow
- Appreciates slowly like the condos
2-4 Unit Apartment Complexes (Plexs)
- Can qualify for FHA or VA financing if it is owner-occupied
- Qualifies for residential financing while generating a steady income
- Income from units can pay off all expenses
- By living in the building you are eligible for the full spectrum of tax deductions
- Low vacancy risk, if you live in the building and one tenant leaves, you are only losing 1/3 of your cash flow (better then the SFR)
- Value of a plexs appreciates at a much higher rate than the condo or SFR
- Will require more management but by living in the property you will be able to offset these expenses and handle them yourself
- Rental rates provide less of upside when it comes to increasing the operational income by significantly raising the rental rates
Overall the plex is the best bargain for your money, especially if you live in one of the units. The book talks about how living in the building will allow you to use your income from your 9-5 job as leverage for taking out better loans. The bank will see this as the properties the main source of income and give lower rates and loan you more money. Also, by living in the building you can help keep the piece (avoid lawsuits) and take care of little handyman work within all the units. This will decrease the number of expenses since you won’t have to call in services to do the job for you. Another positive is that the rental rates from the other units can cover expenses and a majority of the loan payments all while you live the apartment for “free”.
5. Pick a Winner: Residential
To begin your search you will want to first locate the general geographical location of your interest. This is typically a county such as Bergen County, Nassau Country, or Westchester County (Counties just outside of NYC). The next step is to find your submarket. These will be the many little cities/towns that make up these counties. It is extremely important as a beginner to purchase your first residential properties within 5-20 miles of your job/home. If you plan on living in the property then you want it close to work, if you plan on not living in the property you’d want to buy a property close to your home. This will lighten the stress of management on the property and make you a more hands-on landlord.
Next, you will want to research your submarket. Say there are 10 towns in the county you are interested in. The overall county may be heading up in price but maybe one or two towns are lagging behind. This is where you can find great properties at a discount with a future for growth. Remember you aren’t looking for your dream home but for a good investment. This means you want to select an area that has a rising demand for residential areas. This will increase your profits when you go to sell the property. Don’t forget to check on the local news and community information to see what factors could affect your purchase.
Important data to cover before purchasing:
- Population Growth
- Employment Data
- Local Demographics
A location with a growing population, strong employment, and safe neighborhoods is the ideal property to invest in. If there are multiple towns that offer these opportunities then go out and see them for yourselves!
Criteria for the right SFR or Condo
#1 Priced at a Discount
- Compare local/similar properties using the price per square foot data, this is your best data point to find discounted properties
- Be on the lookout for properties labeled “Distressed”, “Seller Must Sell Fast”, or “Sellers Very Motivated”. Here you will be able to negotiate for a better deal on the buy
#2 Good Location
- Find locations away from schools, freeways, and high crime areas
- Properties in cul-de-sacs or very quiet streets are the best locations
#3 Good Lot Size
- The earth only has so much land available. The more the land you have the more money you can make from it.
#4 Presents Upside
- Don’t buy the biggest/prettiest house on the block. You cannot add value to that property
- Look for the more run-down properties with solid foundations. A simple paint job and landscaping can add serious value to the property
- Also, adding extra square footage will increase the properties value
- You can also use “ugly” things in the property to negotiate for a lower purchasing price! It is all about the purchase price!!!
Criteria for a 2-4 Plex Apartment Building
The previous 4 criteria for SFRs and Condos also apply to Plexs. Although, when searching for a Plex there are additional factors you need to account for.
#1 Below Market Rent
- First, do not invest in rent-controlled areas. These are killers towards your real estate career
- Finding Plexs’s with below-market rents means you can easily add value to the property and increase the rent, making more profits
#2 Good Unit Mix
- Having one-bedroom or studio apartments can become an issue. They command less rent and have a higher tenant turnover rate.
- Purchase Plex’s with 2 bedroom / 1 bathroom units are preferable
- Also, having multiple bedrooms means you can charge rent per bedroom instead of per unit
#3 Low Crime Area
- This is a no brainer, be smart and do your research
Now after identifying your submarket and accounting for all the factors it is time to begin your search! Manny has suggested using Zillow and MLS for finding properties. Through these websites, you will be able to gather data and analyze the current market direction. Also, don’t forget to contact a local real estate agent you have worked with. Even contacting your local bank for possible foreclosures is a great idea (if you have a good relationship with your bank).
Next in the book is Play 6 and Play 7. Since both these chapters discuss the fundamentals of commercial real estate I have skipped over them (Hence the crossed out chapters way above^). As the book discusses before starting in commercial real estate it is best to get a solid base in residential real estate first. This is because commercial real estate properties are much larger and require more capital. Therefore, I have skipped over these sections in the book and when the time is right I will return!
8. Negotiate with Strength
Making Money On The BUY!
After deciding what kind of property you wish to purchase the next step is negotiation. Your strategy is to be a credible investor and give to get. What this means is sellers are more inclined to sell their properties to an investor who is credible. Being able to provide documents of your past real estate experiences will go to show you are serious about the property and have the means to purchase it. The concept “Give to Get” demonstrates the respect you can have towards a seller. This is not a sign of weakness, giving to get will put you as the buyer in a better position over other buyers.
Call the Listing Agent. This will give you automatic feedback on how motivated the seller is. You will also be able to get a better idea of the property that may not be available through your research. A great question to ask a listing agent is if their are any existing loans on the property. You will also want to confirm the occupancy rate. Find out info on the tenants. Are they long term? recently vacated? good people?
Manny’s favorite question to ask a listing agent is there any room for negotiation on the price? If so, how much? You won’t get the exact answer your looking for but use your people skills and you can determine the overall feeling of negotiation. Lastly, if the seller is motivated, schedule an appointment to walk to the property. If there are no initial red flags and the property seems to fit your criteria, you can get started on your initial offer.
First Round of Negotiations: The Offer
Your Letter of Intent (LOI) will set up the rest of the negotiation. It is important to hit hard, but remember to establish your credibility when doing so. Typically when Manny sends his LOI he also attaches a letter from his lender, brief bio, all his real estate holdings, and references from brokers he has closed deals with. Obviously, as a first-time investor you won’t have all these documents. So provide what you can to show you mean business and you are not here to mess around.
Following your LOI you will want to implement your Give to Get a strategy. There are three incentives you can provide for a seller that will put you ahead of other buyers
- Offering cash for the property, Cash is KING
- Offer a shorter due diligence period
- Offer a sizable non-refundable deposit
If you do not have the funds for paying in cash or offering a non-refundable deposit don’t stress out. You still have the ability to offer the seller a shorten escrow and due diligence period, which is often the greatest incentive of all.
- Write your Letter of Intent
- Include all incentives
- Short Escrow/Due Diligence
- Compile all relevant documents to boost your credibility
After sending your LOI you will wait for a counteroffer. If the seller submits a counteroffer try to get feedback on what they are looking for to improve your LOI. If the seller accepts you now move into escrow and due diligence!
Second Round of Negotiations: Escrow and Due Diligence
Lets not forgot that as contrarians we make money on the buy! In this part of the process you can dig into the property and find areas of poor quality. This will help in negotiations to lower the seller’s price. There are three key components of due diligence. They are property inspections, tenant interviews, and collection/analysis of the current financials.
For a property inspection, you should request the following documents
- Environmental Site Assessment Reports (Phase 1 and Phase 2)
- ALTA Survey
- Property Condition Reports (if any)
- Certificate of Occupancy
- Title Report
Following the collection of these documents, you will want to have your inspector walk the property with you. It is crucial to have an inspector walk the grounds to point out possible safe code violations, roof life span, mold growth, bad chemicals, and condition of the overall building. This will point of possible issues in the property that can later be used for negotiation.
Tenant interviews for residential properties is simple. Talk to as many as possible and ask questions like…
- How do you like leasing at this building?
- Are there any issues you would like to discuss?
- If and when we close escrow, is there anything we can do to improve your stay here?
Side note: prioritize interviewing tenants with renewals coming within the next 6-12 months, you will want to talk to them first. Also, if you find out a tenant is leaving soon you can use that for negotiation.
You will also want to review the financial statements. For residential properties, it is much simpler than commercial properties. For residential properties you will want to calculate the cap rate yourself, do not trust the given cap rate. Here you can account for any issues you’ve seen throughout the property and use this data for further negotiations.
To calculate cap rate you first want to determine the annual expense for running the property and you will want to look at the yearly revenue. Use the most recent rent roll to arrive at the annual gross revenue, then subtract the annual expenses to get your net operation income (NOI). Now using NOI you can calculate your cap rate. Take NOI and divide it by the sales price to get cap rate.
Something important to mention is there will be multiple expenses for you to account for when crunching the numbers for the property. You will have to account for your loan payments, leasing commissions, tenant improvements, and capital improvements
Lastly, you will calculate the sale price based on your figures. Accounting for all the due diligence you had done throughout the property. Your revised offer will be sent to the seller for the final review. It is important to not get greedy in creating your revised offer, but it is also important to not give in to the fear of losing the property! You have done the research and due diligence, so your request for lowering the selling price will not come as a shock at all.
The Final Inspection and Closing
Anything can happen in the world of real estate. So right before closing go and see the property one last time to ensure everything is in proper order. This will limited the surprises for you once the deal is closed. Once the deal is closed you will want to review all the statements and ensure none of the numbers have been fudged. You also need to set a time up to pick up your new set of keys and make sure you tell your new tenants where to send rent payments!
Bottom Disclaimer: To those who read the book and noticed I left out parts pertaining to commercial real estate and are disappointed about it… Commercial real estate comes after a solid base is created in residential properties. Therefore, since I am a beginner, I skipped those chapters and will come back when the time is right.