I’ve mentioned a pending real estate deal a partner and I have been working on for a while. I thought I’d give a quick update on how we came upon this opportunity, what we’ve done to date, what’s left to do to close the deal and all the lessons learned along the way. To recap, I’m borrowing from my 401(k) $50,000 since I have no doubt the ROI is much better than equities or bonds (if you’re saying “tisk, tisk”, see why I have all my bases covered on this loan) and the properties are at a local college – where the damage potential is high but cash flows are very lucrative. We minimized our down payment and with rates at historic lows, we snagged an attractive 5.5% loan which is great for commercial ventures.
- The Deal – It’s a pretty sizable deal with 5 dwellings and about 25 students (give or take). My partner has multiple properties at another college and these gigs have been cash-flow machines, especially on larger scale projects since you spread many of the fixed costs like property management, accounting, legal, repairs, etc. Since there’s usually very little vacancy risk on heavily populated college campuses and you don’t need to plow a ton of money into the properties. You remember what your college housing looked like, right? It’s just gotta be “good enough”. Finally, parents tend to pay the bills and there’s a much lower incidence of deadbeat renters. We have the leases and joint, so if some dude drops out of college, the other 4 are on the hook to pay the rent. Given the size of the deal, I have a smaller stake, but I’m learning a ton along the way – and profits are split according to ownership in the venture.
Legal and a Bunch of Other Stuff
- Agreement of Sale -We were initially presented with an agreement of sale from the seller that was written from scratch instead of on the boilerplate for our state. This was a hassle as it didn’t have all the right provisions and we had to have an attorney do a line by line review and we had to negotiate a few terms to wrap up. This took several hours of attorney review and ended up costing a few thousand. The cost of doing business I suppose, but had it been on the boilerplate form, it would have been cheaper – but he insisted.
- Financing -We have our financing secured. Aside from the 5.5% rate, importantly, we only had to put down 25% (some lenders want more for commercial ventures) to maximize our ROI. I had to provide 3 years tax returns, explain a few things over the phone and that was it. I was kinda surprised they didn’t ask for my bank statements or recent W-2 forms or anything? We also put our wives on the deal since it’s easier to attain financing that way. In excluding spouses, banks fear what happens in the event of divorce or whatever where the ownership is called into question upon divorce settlements.
- Setting up an LLC and multiple LPs -We set up a rather elaborate series of financial entities to protect our personal assets – these are college students after all! So, we have 1 LLC with a 1% ownership and 3 different Limited Partnerships. We funded all 4 entities according to our agreed investment splits, but let’s say there’s an “event” in one of the properties. If a settlement exceeded our insurance policy, the financial damage would be limited to the assets in that LP and only 1% of our LLC. This also acts as a barrier to our personal assets. This might have been a bit more conservative than some (some investors might have just set up a single LLC), but this would also prevent our other properties from being taken out. The operating agreements for these entities were rather lengthy and cost over $1000 to set up. But since this was my first real estate deal, I wanted legal representation and we didn’t have a template to work off of when there’s a majority/minority investor arrangement.
- Appraisal – The appraisal went pretty well. One minor glitch. When we set up the agreement of sale, the seller had wanted a particular amount for all the properties. So, we somewhat arbitrarily split up assumed property values based on rental income and assigned a sale price to each. Well, the appraisal came in high on some properties and low on others. Importantly, the total appraised amount worked out to be roughly what we agreed to, but we may have to go back and amend all the documents we’ve already signed and the bank financing. Hassle – and I’m on vacation next week. This is an example of why it’s great to have a partner. I kept things moving while he was traveling/vacationing and likewise.
- Insurance – We got a quote from the insurer who insures the dwellings now for the current owner. His rates came in right on spot with where my partner had estimated based on his properties at other colleges. We also made sure that the policy covers rental loss. For instance, if there’s a fire and we needed to rebuild, while the structure may be covered, we’d be losing a year’s rent. So, the policy covers that.
- Title Check – We used a title company my partner has used before and they’ve worked out OK. There were no crazy liens or other hazards noted, but there is some weird easement issue we’re still trying to figure out. There’s a sewer easement noted on one of the properties but nobody can seem to figure out “where” it is. The risk that it would interfere with the property is low, but we would like to figure out what the deal is before closing.
- Property Management – For us, this was a MUST. These students beat the hell out of the houses. I lived in a similar situation for years and I know first hand. When we walked through these properties, we saw the familiar holes in walls, kicked in doors, busted windows and the property managed said it all just happened that past week. Evidently, the students don’t mind losing their security deposits, but importantly for us, we could never manage something like this ourselves being 1.5 hours away. We’re retaining the property manager that’s working for the seller now and he’s been doing it for years. He knows all the contacts for trades, the town, police, etc. , has his own contracting firm and gets tenants to sign the leases each year as well. We’ll pay him attractively enough to keep him on since this isn’t something we’re interested in taking on, especially when the properties are already projected to be profitable from day 1.
- And More – For anyone that thinks getting into real estate is just cutting a check and then collecting rent, they may be in for a shock. At least up front, to cover your bases, there’s a ton of up-front due diligence, negotiation and decision-making. Then along the way, even with a property manager fielding emergencies and filling the units, there are various bills, accounting and other issues to deal with. So the partnership model is nice – we can each learn all facets of the business and fill in for each other when needed.
So, some of the startup costs (primarily legal) were a bit higher than we projected, but even after these up-front closing costs are accounted for and with some slack built in for upkeep, we anticipate making a 15% return on cash and about 25% or more when you factor in equity build, a conservative 1% annual capital appreciation, and tax benefits. To be conservative, just sticking with the cash portion, even if those numbers are off and we earn only 12-15% a year indefinitely, that’s a great return with no volatility and non-correlated with stocks. I’ve been looking to diversify our holdings in every way possible since I’ve been so aggressively invested in stocks (See Darwin’s Portfolio) all these years and this is a nice start.
If you’re interested in real estate investing and want to follow me through closing, turnover of the properties and the ridiculous stories that will ensue in renting to male college students, make sure to follow via email or RSS.