Real Life Steps Investing In Real Estate
In 2002, when the Tucson apartment market was hot, Kim, Ken McElroy and I purchased one of our first investments together. At the time, Ken was managing the building for a fee from the owner. The property was not listed with real estate agents. Ken and his partner were the property managers of the property. Consequently, we knew the operations of the property very well and were able to determine a fair market value for the property because we had access to the financials. When the owner said he wanted to sell, the project changed hands to Ken, his partner, Kim, me, and two other investors. The building was 144 units. The property, however, had an adjoining ten-acre piece of land that was zoned for multifamily housing. We saw a golden opportunity.
Once we bought the existing apartment house, our next step was to begin construction on an additional one hundred units on the vacant land. Then with the increased rents a few years later, we could refinance the property, and Kim and I got all of our initial investment money back. This means each month we receive a check from the positive cash flow, and Kim and I have zero invested in the project. If you do the math, this means Kim and I have an infinite return on our money. In layman’s terms, an infinite return is truly money for nothing…every month.
Project: 144 apartment units + 10 acres vacant land
Location: Tucson, Arizona
Price: $7.6 million ($7.1 million for the 144 units and $500,000 for the vacant land)
Financing: $2.6 million in equity from investors $5 million via a new loan
Plan: Build 108 new units on the 10 acres.
Financing for addition: $5 million to build the 108 new units. The existing property and the 10 acres were used as collateral for the new $5 million construction loan.
Total units: 252 units when complete
Total package: $2.6 million equity + $10 million debt
New basis: $12.6 million
New appraisal: $18 million.
An increase in rents increased the appraisal.
New financing: 75 percent leverage = $13.5 million
($18 million x 75 percent = $13.5 million)
Paid off old loans: $13.5 million – $10.0 million = $3.5 million
Return to investors: $3.5 million
Net transaction: Kim and I invested $1 million.
From the $3.5 million return to investors, we received $1.4 million. $1.4 million is reinvested in a 350-unit property in Oklahoma.
Taxes on $1.4 million: 0
Our Steps to Purchasing the Property
We negotiated a deal with the current seller of $7.1 million for the existing apartment community and $500,000 for the adjoining land. All together, the total purchase price of the acquisition was $7.6 million—just a little over $50,000 per unit.
Once we had reached acceptable terms on the purchase and sale agreement, my partners and I executed the agreement and placed the property in escrow.
During our due diligence period, we focused both on the property itself and the adjacent land. As I’ve said, residential property was fairly easy for us to analyze since we had been managing it for years. We knew pretty much everything there was to know.
The adjacent property was another matter. We knew that we wanted to develop the land so that we could build another set of apartments to complement the existing ones, but we didn’t know the extent to which we would be able to do that. Over the due diligence period, we had a series of meetings with architects, engineers, subcontractors, and city planners to determine what exactly could be done on our potential parcel of land. When we were finished, we knew we could get approval to build 108 extra units and make the overall property a 252-unit apartment community. To obtain financing for the entire project, we contacted several mortgage brokers and began to gather quotes for our loan.
After meeting with and receiving bids from the architects, engineers, subcontractors, and the city, we were able to put together a rough construction budget and estimated cost of building the new 108 units.
You need to be able to show a potential lender what your plan is and that you have thought it out completely. A plan by itself is not enough because the timeline determines the way in which the lender will distribute the money to you.
We had already determined our purchase price, made our offer through a letter of intent, negotiated a purchase and sale agreement, performed due diligence, and started a construction plan. Now we needed to take our vision and find a lender that was the right fit.
We went about determining the amount of leverage that the property could reasonably sustain. When you are using OPM (Other People’s Money) for a multifamily investment you want to be sure that the operations of the property can pay for the mortgage and still provide a good return to the investors.
Once we found the loan we were looking for, we had all the information we needed to present our investment opportunity to our investors. We had a property in escrow under a purchase and sale agreement, the start of a business plan that included a detailed construction plan for the adjoining land, and the financing terms. The only remaining task was to actually raise the remaining equity for the down payment.
Our business plan and our discussions with lenders helped us determine the amount of equity we would need to acquire the property. In the case of this property, we needed a little over $2.7 million to cover our down payment and initial start-up construction costs. We didn’t have a lot of time to raise the money but we knew that it would be easy because of its significant upside.
We closed escrow. This is where the hard work of the past months came to fruition.
After an increase in rents and the value of the property, we were able to refinance the property for $10.5 million—nearly $3 million more than we had purchased the property for. With that refinance, we were able to pay off the existing loan for the property and the construction loan we had obtained to build the 108 units and combine them into one loan. Additionally, we had left close to $500,000—all of which was tax-free—that we were able to distribute to our investors.
We refinanced Edgewood for the second time, and boy was it worth the wait. When all was said and done, we were able to refinance the property the second time around for $15.6 million. That is a full $8 million higher than the original purchase price, and $5 million over the last refinance. All in all, the investors made 40 percent on their money, not including depreciation and tax savings, which depended on their own situations and the amounts they invested.
Since we have zero invested in the property, our ROI (return on investment) is infinite.
Kim and I put in $1 million of our money into the Edgewood project. In total, we received $1.2 million in return, and we cash flow $300,000 per year.
From a tax standpoint, we are winning. The cash flow we receive each month is tax free. The initial investment that we got back is tax-free (because it’s debt) and on top of that, we reinvested the $1.2 million and that is tax-free.
This is exactly how you get rich in real estate.
Editor, Rich Dad Poor Dad Daily