Lipstick on a Pig. Getting your multifamily property ready for a sale

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1 Lipstick on a Pig Getting your multifamily property ready for a sale You ve put a lot of time, effort and money into purchasing and maintaining your income property, and now it s time to cash in on all that effort and sell the property. Maybe you want to do it again with another, bigger property. Or maybe you re getting ready for retirement and want to cash out and take it easy. No matter what your reason for selling, there are a few things you can do in the six months or so prior to a sale that will make your property more marketable and help you fetch the maximum possible sales price. Note that I m not saying absolute maximum price. There s no such thing. Just as it s impossible to pick a top or a bottom in the stock market, it s impossible to predict with 100% certainty what tomorrow will bring in the real estate market. You may get lucky and find a motivated buyer who just has to have your property, or you may be scheduled to close on the day the stock market crashes. Both have happened to me within the last five years, and the best you can do is roll with the punches. By the way, don t get all upset about the Lipstick on a Pig title. Of course we all know your property is not a pig. (But it makes for a great title, doesn t it?) If these suggestions are helpful to owners of pigs, just think how helpful they can be to you, the owner of a jewel in the rough. Is it time to sell? The first question you need to ask is Is it time to sell? Sometimes you may not have a choice. If you re compelled to sell now because of financial issues, retirement, health or other such issues, you don t have much of a choice. Time is critical and you don t have a lot of flexibility. Here, you re faced with simply maximizing your sales price and not becoming chum for all the sharks that are circling in today s foreclosure-rich market. In this case you do what you can to get the property ready for sale, choose an aggressive, experienced broker, and go for the best deal you can within a timeframe you can live with. First of all, you need to decide what your goals are. Often both a broker and a seller will simply assume that the goal is to get the absolute maximum price for a property. That s an admirable goal, but it s not always the best financial move for the seller. For example, in today s market (Q1-Q2, 2011) sales prices are down anywhere from 10% to 50% from the peak in Some will want to hold out and try to wait out the market and get back to our top prices. While that sounds good, in most cases it doesn t hold up to a stringent financial analysis. The physicists are still working on the time machine, and I m not willing to bet that they ll have it perfected any time soon. You can t go back.

2 What s happened has already happened. None of us caused the situation and none of us can magically snap our fingers and make it go away. The best we can do is to understand the market and do the best we can to take advantage of it and come out ahead. So why does holding out for better prices not always make sense? The obvious reason is that you have no assurance where prices are going. We may never get back or it may happen tomorrow. If you re looking for a crystal ball, go talk to a fortune teller. You don t need a fortune teller to tell you that everybody s in the same boat. And all of the boats out there are affected by the same rising or falling tide. While your sales price may be down from the historical highs, your opportunities to purchase replacement properties are probably better now than at any time in the past 20 years. If you have unlimited funds available, you can just do what the stock market pros do in a falling market. Average down. If you have 100 units that you re into for $50,000 per unit, you can buy another 100 units today at $20,000 per unit. Now you have 200 units at an average price of $35,000 per unit. Unfortunately, most of us don t have unlimited funds and can only take advantage of these lower prices by selling or trading existing assets. Here, you make the decision based upon your return on equity with various options. If your return on equity is more by trading or selling into another property, it makes financial sense to do it, no matter whether or not you get the absolute, maximum price you think the existing property is worth. If you re not moving into another property this doesn t do you a whole lot of good. You could have made a lot more money if you had sold in 2006, but you didn t and you can t change it. It s water under the bridge. Make your best decisions based on today s market and move on. Getting the top price Assuming you ve decided that it s time to sell, you have the opportunity to make some changes that can help you maximize your sales price and terms. A lot of the factors that affect your eventual sales price are beyond your control. Market conditions, availability of financing and the tax environment are almost always in this category. There s little or nothing you can do about them. You need to concentrate on the things you can control and work on them in the most time- and cost-effective manner.

3 These items fall into several general areas: Financial Performance Financial Presentation Curb Appeal Tenants Staffing Marketing Financial Performance There are two aspects to your property s financials, financial performance and financial presentation. The difference is basically reality versus perception. Financial performance refers to the actual bottom line of the property while financial presentation reflects how well you are able to communicate this performance to a prospective buyer. Both are important but financial presentation only becomes important when you re trying to sell the property. There s a reason that multifamily investments are called income properties. They generate income. That s the main reason they re built. It s the reason people buy them, and in a capitalistic society, it s the only reason they exist. To a buyer, the income stream is the primary concern. Sure, they want nice properties, they want pride-of-ownership properties, they want happy tenants. But when you distill out all the emotion and the feel-good, do-good aspects, all of these reasons boil down to one thing, increasing the net profit of the property. A nice property generates more income than a doggy one. Pride-of-ownership properties attract better, higher-paying tenants than run-down ones. Happy tenants stay around longer and decrease your vacancy. So, your first consideration in making any changes to operations must be Does it increase the net income? Just how important is the net income? For every dollar you increase the annual net income you can expect to receive ten dollars at sale time. This is based upon the rule of thumb that values a property at a 10% CAP (capitalization) rate (CAP = NOI/sales price). The exact amount of the increase in value depends upon many factors, but a 10% CAP rate serves us well for comparison purposes. Most property investors are familiar with the concept of leverage as it relates to buying and selling property. Use some of your money and a lot of somebody else s money to buy your properties. The same concept of leverage applies to managing your income stream. Make a small improvement in cash flow and reap a much larger return at sale time.

4 There are three major areas that affect your cash flow: rents, vacancy and collections, and expenses. It doesn t matter where the bump to your bottom line occurs. An extra dollar in income gives the same effect as a dollar decrease in expenses or a dollar less in vacancy. That s in theory. It s what your accountant will tell you. It may be less than accurate when you talk to your broker about it. We ll talk about these differences when we talk about financial presentation, but for now, let s listen to your accountant. Improvements to financial performance can t usually be done frantically in the month or so before a sale. It s a process that ideally begins on the day that you buy the property and continues until the day you sell it. The good part is that it helps you every day throughout the process. A healthier bottom line helps you a lot while you own the property and a lot more when you sell it. Let s look at each of the following contributors to your bottom line with a special emphasis on how they may look to a prospective buyer. Rents You should always be pushing your rents as high as possible with the caveat that if you push them too high you ll suffer in other areas such as vacancy, collections, and resident retention. It s very important that you or your manager conduct regular rent surveys of your competition and keep records of these surveys. In comparing your rents to the competition you need to take an honest look at your property and make the most objective analysis you can possibly make. Sure, the retaining wall you built around the flowerbeds may have improved the property, but unless your residents are willing to pay you a little more in rent to cover the expenses, it s not directly helping your bottom line and it won t pay you back at sale time. As you re pushing the rents higher, listen to your tenants. At lease renewal time ask them what they d like to have done to improve their units and how much of a rent bump they ll pay for it. If you can make small improvements that would be meaningful both to existing tenants as well as future ones, calculate their rates of return. Make the improvements if the Return on Investment (ROI) justifies it and you can afford the expense. Try to structure the accounting so that you can show the improvement as a capital improvement and not an expense item. If you re getting ready to sell, your tax strategy changes. If you planned on holding the property, you d be trying to expense the improvements in order to cut your tax burden. If you re planning on selling, you won t be realizing the ordinary income decrease from expensing. Instead, it becomes a capital improvement that adds to your basis and saves you capital gains taxes. Remember to take into account the tenfold results of leveraging net revenue on sales price. If you can increase your net operating income by $10 a month, that s $120 annually. That translates to an increase of about $1,200 in sales price. Now, if you can

5 further leverage that improvement by the number of units in your property, you can see the possibility of massive changes in value from relatively small investments in the property. This cuts both ways. Just as you can sometimes increase your rents, sometimes the environment forces you to lower rents. Don t be afraid to lower your rents if necessary to fill vacancies, but don t be too anxious to do it either. Consider the ROI and make decisions based upon the numbers, not upon emotions or the fear of having a vacancy. It may be worth it to eat a month or two of vacancy if the alternative is to lose three or four months of rent due to rent reductions. If you do have to lower the rents, consider doing it with a short-term concession and/or a shorter-term lease so that you don t have to suffer through the reduction for an entire year s lease term. Realize that potential buyers will be paying particular attention to your vacancy rates in the period just prior to a sale. One of the first things that a buyer asks the broker is Why is the seller selling? If he gets the reading that your vacancy rate is suddenly higher than normal and if he doesn t hear a good story as to why it s happening, he begins to smell a distress situation. So it s best to be able to show four to six months of stability just prior to the sale in order to avoid this appearance. As mentioned earlier, it s a process and requires some advance planning in order to maximize the value of your asset. Vacancy and Collections Your vacancy rate tells both you and a prospective buyer a lot about the operation of your property. Obviously, you want to keep that vacancy as low as possible, but you don t really want it to be zero. If you have zero vacancy, odds are your rents are too low. When doing rent surveys, always try and get an accurate vacancy rate for the competition. Compare these vacancies with the averages published by your Apartment Association and with your own averages. From a brokerage standpoint, you don t ever want to try and sell a buyer on the fact that you have a zero vacancy rate. They won t believe it even if it s true. Once they start questioning your numbers, they ll question all your numbers. There are several things you can do to minimize your vacancy rate. Train your managers to keep a waiting list. Be sure and get addresses for all prospects. As you market the property to tenants consider some sort of a drip campaign that helps you keep in touch with both current and prospective tenants. Of course, you should be attentive to your tenants needs for the entire period of their leases, but be especially attentive in the three months prior to lease renewal. Now s a good time to make sure that the tenant doesn t have any issues and that they realize that you re taking care of them.

6 Expenses A dollar saved annually in expenses can be worth up to ten dollars on the value of the property, so it is in a seller s best interest to reduce the expenses as much as possible. Unfortunately, this can t be done on a short-term basis. Most buyers will want to look at several years of expenses in order to get a handle on the operational expenses over time. Even if a seller can manage to cut current expenses, it won t make a whole lot of difference in the sales price unless these numbers can be shown to be extendable into the future. A good place to start looking for such items is in energy savings and green improvements. It makes sense to invest in energy saving technologies if their ROIs justify it. Thus, an investment of $10 that saves $1 per year theoretically increases the value of the property by $10 and thus pays for itself in one year if you are considering resale value. If you were looking at the same improvement as a long-term owner who wasn t planning on selling, you might consider that this $10 investment would take ten years to pay back. With the effects of leverage on net income, the payback becomes one year. It s possible to make rapid improvements to your bottom line by implementing a RUBS (Resident Utility Billback) system that bills back your tenants for utilities that have previously been paid by the owner. There are laws that regulate this and there are companies you can pay to implement it for you. It s worth it to investigate the ROI possibilities of implementing such a RUBS system. If you ll look at just about any sales brochure for an income property, the odds are you ll find a statement by the broker that the new buyer can find upside returns by implementing a RUBS system. It s almost a cliché, so much so that the promise of implementing RUBS is much less valuable to a seller than is a history of actually implementing one. With the promise alone, the buyer will naturally ask, If it s so easy, why didn t the current owner do it himself? Financial Presentation If you want to get maximum value from your property, you must be able to present your financial information to a prospective buyer in the best possible light. There s two parts to this, both being equally important. First, you have to be able to attract a buyer s attention to the point to where he s willing to make an offer. Second, you need to be able to back up your financials in his inspection/due-diligence phase. While it s painful to not be able to attract his initial attention, it s ten times as painful to go through the entire marketing-offer-inspection process only to have the transaction die because your numbers aren t what you stated prior to the offer. The key to success is having a financial accounting system that can adequately track and present your financial information. This can range from a simple spreadsheet tracking

7 income and expenses up to books of financial data provided by your management company. Buyers will look at certain fixed expenses and pretty much take them at face value. Such items as taxes, insurance and utilities are relatively easy to present and aren t usually subject to a lot of interpretation. Other items such as maintenance, cleaning, repairs, capital improvements, and management expenses will vary from operator to operator and will be looked at in different ways by different buyers. There s a basic conflict in presenting accounting reports. Since most accounting reports are done with tax reporting in mind, you are trying to show the absolute minimum operating profit to the IRS. When you re presenting financials to a buyer, you re doing exactly the opposite and trying to present the maximum operating profit. Keeping separate sets of books for buyers and for the IRS is generally frowned upon and could end up with you wearing an orange jumpsuit, so we don t recommend it. If the IRS doesn t get you, the buyer might start talking to his attorney if you give him a cooked set of books. The solution is to keep financial records that adequately describe the nature of the income and expenses and allow you to differentiate the real items from the tax items in discussions both with the IRS and with a potential buyer. One big area in which this makes a difference is in the area of repairs versus capital improvements. For the tax man, you want to show as much under maintenance and repairs as possible and minimize the capital improvements. For the buyer, you want to be able to show him two things. First, this was a capital improvement and adds to the value of the property, and second, it s not an ongoing expense that he ll face every year. Consider a small, family-owned property. If the family company is set up properly, you can legally deduct many items that don t really belong on the income and expense statement. For example, every time I go to visit my daughter in Austin, we plan a board meeting in Austin. Voila, instant deduction. You can also deduct insurance and other benefits for your manager who just happens to be your daughter. You might not make the same offer to a manager who wasn t related. That s great for tax day but not so good when presented to a buyer unless you can point out that it s a tax item only. Most buyers have been to this rodeo before. They know how the game is played and if you can show them how you re playing it, they ll not only understand the financials but also realize that they can do the same thing when they buy the property themselves. The solution is creating your accounting system with enough detail that they can strike out entire line items after having them pointed out to them. Thus, rather than just having one line item, Auto Expense, you might want to have sub-items such as Maintenance Auto Expense, Corporate-Related Auto Expense, etc. By properly designing your accounting system in the first place, you can make it very easy for a buyer to get down to the real Profit and Loss Statement (P&L) numbers. If you re already stuck with an accounting system or if you have a couple of years of older accounting data, the best you can do is to adequately annotate the records and explain how these items break out.

8 Often, accountants and sellers don t want to make the breakout obvious on the Profit and Loss Statements (P&L s) themselves under the theory of security through obscurity. If I m going to get audited, make em work for it. In that case, a separate annotation to the P&L with the details and breakouts may be the better solution. If you re doing such an annotation, it s a good idea to reference specific general ledger items that will support the descriptions in your annotations. That s it for this edition of the newsletter. Next time, we ll discuss improving curb appeal and some of the other non-financial aspects of your property that can help you increase the value of your property. If you re in a hurry and want the entire white paper now, me at joe@lumbley.com and request the entire document.