Terrain Apartments Q1 2016 Update

Our partners closed on this 152-unit Pittsburgh area property in December 2015.   At the time, the property was being operated as a Quality Inn extended stay hotel so, with the exception of a few holdover extended stay tenants, the property was 100% vacant at the time of purchase.   On the plus side, we were able to acquire a property with great potential at a terrific price.

During the first quarter of 2016, tremendous progress has been made in all phases of design, renovation and marketing.

Exciting, contemporary designs have been rendered for all interior and exterior common areas that we believe, when construction is complete, will offer amenities and community appeal that are rare in the Pittsburgh market.

Interior renovations have proceeded at a brisk pace.   At the end of the 1st Quarter, 144 of the units, or 95%, have been completely converted which is 9 months ahead of our original schedule.  These renovations have transformed the tired and dated hotel suites to sleek, modern apartments that appeal to today’s renters.  Exterior renovations were started in February when the weather cooperated and are now in full swing.  Painting of building exteriors is 75% complete and areas for community pool, outdoor seating and dog park have been prepped for makeover.  Renovations to the clubhouse are also underway and will include a new business center, fitness center, doggy salon, computer kiosk and beverage station.

An aggressive marketing plan has been implemented to incorporate rebranding of the property and a multi-channel strategy including online marketing (www.terrainapartments.com), billboard and movie theatre advertising to drive renter traffic.  At the end of the first quarter, occupancy was at 13.8% with signed leases for 39% of the units.  More impressively, rents achieved have been above initial projections for studio apartments at $795/month versus $725/month as originally forecast and for two bedrooms $1100/month versus a projected $925/month.

We now anticipate all renovations to be complete during the 3rd Quarter of 2016.  As common area renovations begin to take shape now in time for peak rental season, the visible improvements can only help in making the property more attractive to potential renters.  While there is still work to be done, we are very pleased with the progress of this project on behalf of our investors.

See additional pictures and artists renderings

Our partners have several very exciting projects in the pipeline that we will be offered to select investors in the next few months.  If you would like to be one of the “First Look” investors to see these opportunities or if you just want to continue to follow us, please click the sign up button below.

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The Power of Value Investing

Warren Buffet is generally regarded as one of the most successful value investors or our time.   Mr. Buffet became very wealthy by employing the value investment principles first popularized by Benjamin Graham.   While value investing is commonly referred to in the context of securities, the same principles apply equally, if not even better, to multi family real estate investments.

In this first of a series of blogs, we will explore how value investment concepts can be applied to successful apartment investing.

Purchasing at a Discount to Intrinsic Value

One of the most fundamental tenets of value investing is to purchase at a discount to intrinsic value. Purchasing at a discount results in a built in margin of safety against further declines.  Seems sensible enough, after all who doesn’t like a bargain?   The challenging part is really in calculating the intrinsic value with a reasonable degree of confidence.

In the world of stock investing, intrinsic value is ordinarily calculated through fundamental analysis that projects future income and discounts to a current present value.  Determining the future returns of a stock can be difficult even for the most skilled investors.  Most well capitalized companies are complex organizations.  They may be involved in multiple businesses and diverse markets, each with unique sets of opportunities and risks.  As a result, they are a challenge  to understand even for company insiders or full time analysts following the company.   Smaller companies may be less complex, but information may be also harder to come by with fewer analysts following.  Stocks for companies in new and emerging industries are especially challenging as the business models and earnings potential are often unproven or subject to additional technological innovation and disruption.

As a general rule, the less complex the business model and the greater the stability of earnings, the easier it will be to determine intrinsic value.

Intrinsic Value in Apartments

At a high level, the business model for multi family apartment buildings is  universally understood.   An apartment owner rents apartments to tenants in return for monthly payments.   A successful owner keeps the vacancies low, the rents at market rate, and manages expenses.   Although the mechanics of achieving these goals can be professionally challenging  for the property manager, an investor does not need to be an industry insider to understand the model.

Relative to most publicly traded company stocks, there are relatively few inputs needed to determine the value of an apartment building.  The primary method of calculating fair market value is via the following formula:

Valuation Formula

Net Operating income is simply the annualized amount of rent collected less all operating expenses excluding any debt service. The Cap Rate is a market rate of return based on similar properties in the local market. A knowledgeable commercial broker or investor in the area will know the market cap rates.

By way of example, if the 12 month training NOI is $100,000 and the current Cap Rate for similar parties is 10%, the FMV would be $1,000,000 ($100,000/10%).   If the apartment operator is maximizing the NOI of the property and the local market conditions are relatively stable, then the intrinsic value of the property would approximate the FMV.  For a stable. well managed property, a discount to the intrinsic value of the property would be a purchase price of less than $1,000,000.

Of course, not all properties are managed to their full potential.  Rents may not be at market rate or vacancies and expenses could be high relative to similar well managed properties.    Future rent revenue, occupancy and operating expenses are really the only variables needed to estimate future NOI.    Not only are there fewer variables to project than for most publicly traded stocks, there is generally much more data available.   Rent market rates and occupancy are tracked daily by brokers and data services in all metro markets.  Operating expenses for apartment buildings are also supported by ample historical data and generally run around 45% – 55% of gross rent revenue.

Even if the property is currently being managed to its full potential, the future earnings can be impacted by changing market conditions.   The future earnings potential will be negatively impacted in local markets with declining fundamentals and conversely will benefit from improving fundamentals.   However, once again there are relatively few factors to evaluate.  Population and job growth are by the two most important factors.   Once again, there is abundant economic data that is readily available for investors in all metro markets.

Buying Apartments at a Discount

As previously discussed, the FMV of a property is derived from the future NOI and the capitalization rate.  The capitalization rate is market determined and not subject to influence by the investor or apartment operator.   The future NOI on the other hand, can be heavily influenced by the investor or apartment operator.   By understanding and making conservative and supportable estimates of future rent revenues, vacancies, and operating expenses, the future value of a property can be easily determined.

Assuming stable capitalization rates, if a buyer can make improvements to improve NOI over time, then they will improve the value of the property.  However, unlike in the case of many stock investments, the apartment investor should not be paying full price for the future projected earnings potential.   While it is in a seller’s interest to convince the buyer that they should pay up for future increases in rent or lower operating expenses, why should the buyer pay for work for improvements that they themselves will have to make in the future?   The seller should not be compensated for the buyer’s future investments in time and resources.

If the apartment investor has sound reason to believe that they can improve NOI and can purchase the property at a value based on current performance of the property, then the property is being purchased at a discount to intrinsic value.  Of course, many sellers will not be satisfied to only get what the property is currently worth based on their own efforts to date and will want to be compensated for future potential.   When faced with this problem, there really is only one answer for the value investor.   Just like Warren Buffet, the investor should be willing to be patient, and continue to look until a true value investment opportunity comes along.

The Failure of the 401(K)

I am one of those guys who did all the “right” things.   I went to college and got a sensible degree….Accounting.   I went to work for a big accounting firm and then went to work for several large companies working my way up the corporate ladder.   All along the way, I dutifully contributed as much as I could to my 401(k).    For a long time it actually looked like I was going to hit my goals with ease.

Then the 2000’s hit.   I stayed in the market with a sensible allocation of funds and by the time the dust had settled on the decade, my portfolio had only grown as much as I and my employers had contributed.  Actually it was a little less.   The real growth after inflation of the S&P 500 for the decade was a negative 3.4%.   Sure the current decade is much improved for now, but how many lost decades can we survive as investors?

Even though my nest egg by 2010 was not as large as I wanted it to be, I was still better off than most people.   I had a successful corporate career and was able to save more than most.  But, I still did not feel secure.   We live in an amazing time where if we take care of ourselves and are genetically fortunate, we can live healthy lives for a very long time.   We are on the precipice of discoveries in human longevity that will allow people to routinely live productive lives well past 100. Maybe I will not be so fortunate, but if I am a beneficiary of these breakthroughs, I don’t want to be worried about outliving my retirement account.

I am far from alone in my concerns.  A 2014 Harris poll found that 74 percent of Americans were worried about having enough income in retirement, and in a survey published recently by the National Institute on Retirement Security, 86 percent of respondents agree that the country is facing a retirement crisis, with that opinion strongest among high earners.

Clearly, something is wrong with the current system.   If even the high income earners are feeling insecure, then we need to rethink our approach.

I think that there is a better way and it only requires a subtle change in how we think about our financial security.   The key to financial independence is not about amassing a particular nest egg in our stock portfolio.   Even most of the high earners will never grow their portfolios large enough to feel truly safe.  Real financial security comes from having a source of income that is not tied to the vagaries of market dynamics or an ability to trade hours for dollars.  There is only one way to truly achieve financial freedom:

Build assets that generate enough passive income to fund your desired lifestyle without ever needing to invade your principal.

Most people will never achieve this goal in the stock market.    The facts have proven this to us over the last three decades.   Luckily, there are other alternatives.   The two most proven paths to financial freedom have been owning a business or owning real estate.

Not only are these the most proven paths, but at least in the United States, the federal government provides enormous incentives to follow one of these paths.   Yes, the 401(k) code does allow you to accumulate tax deferred income, but these incentives pale in comparison to other opportunities in the tax code.

For high wage earners, the biggest expense is almost always taxes and there really is not a close second.   To achieve financial freedom, it is not about how much you make, but about how much you keep and how quickly you can grow income producing assets.   Quite simply, the more you can save on taxes the more you will have to invest in your own future.

I will get into more specifics on this topic in future posts so please click the link to follow my blog if you want to hear more.   Until next time, happy investing!