Before you place a down payment on your next great real estate investment, you will likely look it over. However, what will you look at? Examining an income property requires not only analyzing the location, amenities, layout and building structure, but the rental history, income, expenses and other data related to tenant occupancy. Industry professionals take a threepronged approach 1) Inspect the property, 2) Learn about tenancy, and 3) Analyze the financials. Inspect the Property Look at the following: Location. Is it the property located in a convenient place? What is the neighborhood like? Is the neighborhood changing? Is the local economy growing, slowing, or going away? What is the community like, is it culturally diverse, have a rural character, or a college or university nearby? Structure. What is the building's condition? Does it require updates or repairs immediately? What is the heating or cooling system like? What are the room sizes? How many units are involved (if a multifamily)? What does the foundation look like? Land. Where does the building sit on the property? Is there a lawn? What parking is available if the property is in an urban area? Are there many trees on the property? How does winter affect parking areas and access to the building? Learn about Tenancy Understand tenant history. How long has the building been renting? What is the average length of tenancy? What is the historical vacancy rate (the length of time a space, called a unit, is not under a lease)? Has there been a particular type of tenant, such as a college student or a retiree? Learn about current tenants. When is each lease due to expire? What has been the previous manager's experience with each tenant? What do tenants like about the property? What do they not like? Analyze the Financials · Take a look at the following: Past and current income and expense statements. Determine the net operating income (NOI) for the current year and for the previous two years; the NOI is calculated by subtracting the total expenses for a period from the total income received. Income (Revenue) - Expenses = Net Operating Income Past and current cash flow statements. Determine the cash flow that the property will provide. This means the monthly inflow of rental payments and other income and the outflow of operating expenses, debt payment, and one-time charges, such as repairs. By taking the current NOI and subtracting your acquisition costs (purchase expenses) you will determine your actual cash flow, positive or negative, while paying the mortgage debt. NOI - Acquisition Costs (Debt Service) = Cash Flow Property tax statements. Although tax expenses are usually listed on documents like the income statement, examining the actual tax records can show you the tax assessed valuation, credits received, special assessments levied on the property, and the distribution of your taxes to county and local entities. Tax Assessed Value (TAV) + Assessments - Credits x Mil (tax) rate = Property Taxes Expense records. Invoices, contracts, purchase orders, and receipts tell quite a bit about what has happened at the property. The totals will likely be listed on financial documents like the cash flow statement, but, as with the tax statements, you will uncover specifics regarding the work that has been done. Checking actual transaction records also verifies the claims made on financial records. Once you have examined these three areas, the decision to buy or not to buy should be a simple one. If you have the resources, temperament, and attitude to make the investment work, consider making the purchase. Nevertheless, managing your purchase is about more than receiving positive cash flow. You should look for a more effective approach to improve the current levels. When you analyze the financials, think of ways that you can achieve better results, like doing repairs yourself (if you have adequate skills). Keep in mind that each income property manager is different, and you can bring unique approaches to managing the property. Obtaining Financing If you decide that you want to buy, the next question is, "How will you pay for it?" There are primarily four ways, cash, bank loans, owner or investor financing, and creative financing. 1. Cash. This is the least likely option for most people, and that is probably a good thing. Buying with no mortgage puts you at risk of a greater loss, eliminates the benefit of leverage (using other people's money), and removes tax advantages such as the mortgage interest deduction. However, if you do purchase with cash, there is the benefit of showing no debt on the purchase, which reflects well on your net worth. 2. Debt financing (mortgage). This is the traditional method of purchasing property, though much of the financing in the commercial arena comes through mortgage brokers. Banks offer financing at fixed or adjustable rates, and typically ask for 10 to 20 percent down. A lender will ordinarily need to review several financial documents such as Income and expense statement. Personal financial statements. Blueprints and diagrams of the building(s). Property appraisal. 3. Investor financing. Some institutions and individuals will offer financing in exchange for an equity (ownership) position in the project. Private investors look for a return on investment (ROI) that will come from the profit on the income. Some will lend up to 80 percent of the purchase price. The downside is profit sharing on the income or appreciation in value of the property that investors insist on having. 4. Creative financing. Although sometimes considered controversial, there are creative ways to complete a purchase through unusual arrangements such as creating a partnership, asking the owner to finance part of the sale, and substituting collateral are a few examples. It is recommended that a certified accountant or an attorney who specializes in real estate transactions review any creatively financed purchase. Making an Offer Now that financing has been secured, you are ready to make an offer. However, how should you approach the seller (or seller's agent)? The first thing to remember is this, the offer is your offer. You have reasons for buying this property; these reasons should dictate how you make the offer to purchase. Do not be swayed by the current manager's claims or competition from other investors. If you purchase based on outside influences, you may end up overpaying or ultimately buying the wrong property for you. You will need to have a grasp on the current and future economic environment, both in the property's region and for the country it is located in. Generally, your financing lasts for 20 to 30 years and you will want to hold the property long enough to realize significant appreciation and greater income. Determine if the commercial investment market is healthy, and if you are in a buyer's market (more sellers than buyers) or a seller's market (more buyers than sellers). The timing of your purchase could have a large impact upon when and how much profit can be made. If you can find out the price the selling manager paid for the property, you will know how the asking price relates to what he paid. Is he selling at a profit or a loss? Also knowing when leases are due to expire may shed light on whether there may be tenant turnover soon. Ask how the price was set, maybe there is some flexibility there. The next thing to do is to understand the seller's motivation. It will help if you can discover why he or she is selling; this is not always disclosed but, with some clever questioning, you may be able to uncover the reason that the property is for sale. At times, a commercial property sale is due purely to poor overall economic conditions. Businesses may fail or move out, affecting a property manager's income. Other times, a manager may have other difficulties that prohibit him from holding on to the property. Perhaps the property itself is not performing well. A solid analysis of the property and economic conditions will tell you if you can improve the property's financial returns. If the property is for sale because it is poorly managed, you can make a lower offer because a lender will hesitate to lend full price if the numbers do not support the loan. When you know the seller's motivation, you can make an offer that gives you an advantage. For instance, if the seller is in financial difficulty you can offer much less than the asking price or you could convince him to accept unusual repayment terms. Perhaps you could offer a small partial stake in future profits in exchange for a lower selling price. Always construct your offer based on the most conservative figures you can use to determine income and value appreciation. Most importantly, make an offer that you can look back on in the future with satisfaction. Purchase and Sale Agreements Commercial and residential income property purchase and sale (P&S) agreements are relatively similar. This document outlines the conditions and terms of your purchase, so it is important to review the entire agreement. It would be optimal for you to create the agreement rather than use a standard form used by a real estate agent; remember, this is your offer, make it specific to what you intend to provide and what you want to gain. There are some standard clauses that can be included that are 1) pertinent to most transactions and 2) are enforceable in nearly all states in the U.S. They include, but are not limited to: Purchase price, appraised value, financing amount and terms, down payment, closing costs, escrow deposits. All the financial aspects of the transaction. Closing terms. Specifics regarding the actual purchase or sale of the property. Physical identification. Description and location of the property, including number of rental units. Current rent received. Details of each leased unit's income and security deposits held. "Subject to" provision (contingency). Actions that must be satisfied for the transaction to take place, such as passing a building or sewage disposal inspection. Disclosures. Explanations of environmental hazards, deficiencies, and other criteria that must be disclosed by law. Financial review. A requirement to make available all pertinent financial documents to the buyer. Items and fixtures included. Describes all appliances, equipment, fixtures, and other physical items to be included in the sale. Indemnification. Clause that forgives a party against damages, claims, and liabilities by an action that cannot be foreseen. Dispute resolution. Explains how disagreements between buyer and seller and about how specifics within the agreement will be resolved Before you present or sign a purchase and sale agreement, have it reviewed by an attorney who specializes in real estate transactions. This is a contract, which binds you and the seller to specific performances prior to closing the deal. Violating the terms of the P & S agreement can be costly. If you are uncomfortable with any conditions, discuss alternatives with the seller or his agent. Rights and Responsibilities Your Responsibilities Whether you manage your own properties or those owned by others, your role carries with it a significant amount of responsibility. You are accountable to tenants, neighbors, property owners, the municipality, the IRS, and contractors, among others. You will likely perform several functions when managing the property. To perform the job, there are a number of duties you are responsible for. They include: Attracting tenants. Interviewing tenant applicants. Checking references. Paying expenses. Making repairs or hiring contractors. Performing maintenance or hiring contractors. Paying taxes. Performing exterior duties (such as snow removal, lawn care) or hiring contractors. Collecting payments. Managing tenant behavior (creating disturbances would be one example of poor behavior). Performing eviction activities. Responding to emergencies. The most basic responsibility is to ensure that the rental unit is habitable. According to a booklet entitled Becoming a Landlord produced by the Federal National Mortgage Association (Fannie Mae) "'Habitability' may be defined differently from jurisdiction to jurisdiction, but at a minimum you must Maintain all common areas, such as hallways and stairways, in a safe and clean condition; Ensure that the electrical, plumbing, sanitary, heating, ventilating, and air conditioning systems are operating and properly maintained; Supply running water, hot water, and heat in reasonable amounts at reasonable times; and, Provide trash receptacles and arrange for the removal of trash and rubbish." But simply providing a "habitable" place does not guarantee you will have success filling the rental units. Managing the property effectively means improving on the minimum standards. For example, clearing snow from the front steps may meet the requirement for ease of access regulations, but clearing a path to vehicles will enhance the management's relationship with tenants. Your responsibilities include managing the environment that your tenants share. This may require you to handle disturbances and disagreements between tenants. It is important that you maintain a neutral, professional position when dealing with tenants because property managers are expected under the law to act fairly and reasonably. The best practice is to clearly define expectations in the lease, and to handle each incident according to the requirements of the agreement. Maintaining the Property A critical obligation of the property manager's role is to provide a rental space that is free from physical hazards to tenants and their belongings. You are expected by law to maintain safe conditions within and around the buildings. Providing locks and adequate lighting for the exterior and common areas are measures that meet common regulations, along with sturdy building construction and proper working order of electrical, heating, and plumbing systems. Removing hazardous material like lead paint or asbestos is required by law to protect tenants, as is waste storage and removal. Tenant health and welfare are common protections in many landlord and tenant laws across the U.S. Updates are a normal part of maintaining a property. Replacing appliances and equipment in the property is typically the manager's responsibility, along with exterior painting or replacing fixtures, or signage repair on commercial properties. Unless it is a critical measure, updating rental space is best done between tenants. Fresh interior paint may be necessary following a tenant's departure, and appliances should be replaced every 15 to 20 years. Exterior painting is usually done every ten years or so. If you plan to manage the property for the entire mortgage period, you should expect to do at least some updates over that period. Repairs should be handled in a timely fashion. Damages caused by the tenant are generally viewed by law as a responsibility of the tenant. However, events such as an appliance breaking down or damage caused by events of nature are the responsibility of the manager or owner. Lack of heat, no running water, electricity outages, and exposure to outside elements or hazardous materials are emergencies that require immediate attention by the manager. Otherwise, it is allowable to attend to a repair in a reasonable time period. Keep in mind that delayed response to necessary repairs that cause further damage is generally considered negligence by the party causing the initial damage. Tenants should notify you if something needs repairs. If you are not skilled to perform the work, it will be helpful if you have a list of contractors that you can contact; those who repair critical systems like a furnace on an emergency basis are best to hire. Seek a contractor you can work with on a continual basis. Providing rapid response to repairs will strengthen your relationship with tenants. The property must provide ease of access for tenants and visitors, both during entry and emergency exiting. This usually means keeping hallways and stairways free of obstacles. In some cases, you may be required to provide additional safety measures. Some regulations (called building codes) require a certain number of fire escapes per story, for example. According to many states, a unit that has at least two egress (exit) points would be considered adequate access in case of emergency. Some properties must also provide access for disabled occupants. Check with your local code enforcement officer or city manager to determine if your property meets regulatory criteria. Maintaining a property is not only a duty but also a selling point for your management ability. By performing regular maintenance, you accomplish two things: 1) preventing the possibility of greater cost and inconvenience due to expensive repairs; and 2) showing tenants that you care about the building they occupy, this will improve your chances to attract and retain the best tenants. Laws and Regulations As a property manager, you must comply with a variety of laws and regulations. Housing standards, building codes, environmental regulations, and property owner and tenant laws all affect how you must operate your management system. You will likely encounter federal, state, and local requirements, so it is important to learn what they are. You should periodically obtain updated information, as laws and regulations change or be added. Figure 4-1 lists common requirements you must comply with, along with sources of information. Figure 4-1 JURISDICTION REGULATIONS SOURCES Federal Public health laws Civil rights U.S. Housing and Urban Development U.S. Department of Health and Human Services State Landlord or tenant laws State Attorney General's Office or Consumer Protection Agency Local Housing codes, building codes Code enforcement officer Local housing authority Fire or health department City manager The landlord-tenant laws govern the majority of a property manager's responsibilities. Because the relationship is somewhat unbalanced in favor of the property manager, especially in residential income properties, the regulations are in place to establish fair principles that must be adhered to by each party. These regulations cover areas such as: structural requirements, providing adequate waste and food preparation facilities, eviction procedures, security deposit collection, notification requirements, safety and health requirements, and rent collection rights. Keep in mind that these laws are constructed to protect both parties, and intended to provide standards that each party can expect during tenancy. For instance, a property owner's right to entry prohibits a renter from denying access to the rental unit but generally requires adequate notice to the renter prior to the property owner's access. There may be some activities that are governed under more than one jurisdiction. In addition to federal laws governing anti-discrimination, some municipalities now have their own ordinances that protect renters' civil rights (for instance, discrimination against unmarried residential renters). In most cases, these ordinances enhance existing federal statutes; in a case where there is conflict between two regulations, the federal laws generally supersede (overrule) state statutes and local ordinances. Tenant Responsibilities Of course, managing an income property is not a one way relationship; your tenants have responsibilities as well. Besides the commitment to pay rent on time, tenants are generally required by law to: Keep the rental unit and the area surrounding it clean and in good condition. Notify the manager of significant damage promptly. Refrain from disturbing neighbors (like loud noise). Repair damages that the tenant causes. Allow access to the manager or owner at reasonable times. Notify the manager about long term absences from the unit. Provide adequate notice of lease termination. Provide a security deposit to cover repairs or missed rent payment. Unless the tenant has violated a condition of the contract or a law, or regulation, he or she has the right to occupy the rental space for the entire lease period. In many residential property situations, leases are designed for one year periods and, in some cases, the right to occupy the space may be extended on an at will basis; this means that the lease can be terminated at any time by either party. However, the terminating party typically must notify the other of their intent with a notice of at least one rental period (such as a month).
