Show a little faith, there’s magic in the night
You ain’t a beauty, but, hey, you’re alright
Oh, and that’s alright with me
-Bruce Springstein “Thunder Road”
Today I will discuss small deals that aren’t beauties. I will show that:
- You can start small in real estate and parlay your way into larger higher quality assets
- There are various types of inefficiencies in real estate–left for dead deals in left for dead markets as well as off market deals
- Factors that reliably produce alpha (mean regression vs. momentum)
- The only type of financing besides long term debt that interests me
Mesquite Apartments: The First “Cigar Butt” Purchase
The first time I laid eyes on Mesquite, a largely vacant 7 unit apartment building in Las Cruces New Mexico, a variant of Bruce Springstein’s lyrics in Thunder Road came to mind. To torture his words, something along the lines of:
Show a little faith, there’s magic at this site / It ain’t a beauty, but, hey, it’s alright
It wasn’t a beauty, but it was cheap. The property had been marketed forever by a Bankruptcy Trustee. In other words a third party whose sole reason for being was to sell this property. We bought it for $160,000 in the summer of 2016 through a small partnership that I run that owned a few other small assets. There was a four bedroom house on the site that was probably the original construction on the site and the six apartments wrapped around the perimeter in an upside down L. I knew that the house was worth about $85,000 on its own so after renovation expenses, I was buying the other units for less than $20,000 each.
For physical due diligence, I flew to El Paso, drove to Las Cruces, walked the property with a GC, drove to CVS bought peanuts and soda and drove back to the airport. If we were buying the property today I would not visit the site. Increasingly I find eroding benefits to physical due diligence of small assets. Having renovated dozens of homes, these days it is easier to jump on a video with contractors and other vendors.
We spent ~$40,000 repositioning the property. When fully leased, I estimated we would have gross potential rents of $3,400 per month. There are many lessons I learned on this deal. Firstly, the pro forma gross yield attracted me to the deal. My expected gross yield would be 20%. I believed this would allow me to achieve a 11.5 cap rate based on a vacancy and credit loss rate of 10% and an expense ratio of 40%. However, 3 of the units were one bedrooms and 1 unit was a studio. We were literally getting $400 a month for these units. At this kind of rental amount it’s critical that you have long term tenants because the cost of turns will kill you.
In addition every apartment unit, whether you are renting it for $3,400 a month or $400 a month, needs heat, a hot water heater, needs a swamp cooler, condenser or a mini split. For my 1 bedrooms and studio, having a water heater blow out and replacing it for $850 eats up over two months rent! There was little I could do about “water heater” type risks but I could reduce our credit and vacancy risks. Our property manager rented several of the apartments through a local program that provides financial assistance to tenants increasing the length of time the average tenant stayed in our units. When all was said and done we were in the deal for a 10 cap.
Whether you are buying hog futures, equities, silver or real property, there are two broad strategies for investing–momentum and mean regression. In the stock market, FANG investors and the ETF vehicle typify momentum investing, while net nets and Graham and Dodd typify mean regression style deep value investing.
Mesquite, while a small deal, captures all of the elements and learning opportunities that you can get from a larger deal. It was a mean regression play in every sense of the word. I was not betting on the future being a brighter place. There was no thesis that an airport was coming, or a highway, or a sudden population boom. My bet was that a tertiary market that had not recovered from the Great Financial Crisis (GFC) would follow the rest of the country and would begin to recover.
First, the market in Las Cruces had been left for dead following the GFC. In 2016 days on market for homes in Las Cruces were nearly 100 days before they’d go into contract. You want to be paid for providing liquidity. Buy the unfinanceable illiquid asset in the illiquid market, where repositioning the asset helps you on the one hand to increase the asset’s liquidity (your buyer can now get conventional financing), but also where a market recovery assists you on the other hand, further increasing the asset’s liquidity and therefore price.
Secondly, the asset itself was left for dead. We were not buying the income statement so to speak as this was not a cap rate deal. We were buying the potential of the assets. Remember, buy the balance sheet and sell the income statement–buy the assets, sell the cap rate.
By the summer of 2019, the market in Las Cruces was recovering. We sold Mesquite for $300,000 for a gain of ~$90,000 (not including income while we held the property). We never reliably achieved the income I expected as vacancy on the front house hurt us. Our trailing 24 month, monthly rents average about $3,000. At $300,000 this worked out to about ~7 cap rate on our sale price, exceeding my expectations. Mesquite illustrates that at the right purchase price your business plan does not have to go perfectly in order to have a satisfactory result.
Tucson Mobile Home Park: The First 1031 Exchange
We did a tax deferred 1031 exchange with the proceeds from the Mesquite sale (our down leg) into a mobile home park in Tucson (our upleg in the exchange). The 40 space Tucson park was purchased for $700,000 (plus closing costs). The deal was never marketed or formally listed for sale. Two mobile home park brokers that I had previously worked with brought me the deal off market. We assumed an existing loan of ~$433,000 and put the balance down from our 1031 exchange.
1031 Upleg Acquisition Back of the Envelope
Purchase Price $700,000
Principal $177,000
Loan Assumption $433,000
Deferred Gain $90,000
Additionally we budgeted $150,000 to reposition the Tucson park. I will write more about this park in the future but initially we had a lot of work to do to EMPTY the park and we still have A LOT of work to due to FILL the park. Still we will get there and when fully leased up, based on today’s market, we could sell this park for $30,000 per space. Assuming we eliminate a couple of spaces to improve the appearance of the park my expected future sale value is $1,140,000. Certainly the market can change. This is a game of risk, but when I look at our expected sale price vs. our expected cost basis in the deal, we will have a gross margin of ~34%.
Where things get interesting is if my partners decide to later sell this park and 1031 exchange into a third property. Ignoring loan amortization and depreciation, a sale price of $1,140,000 would mean we will have principal of $177,000 and a deferred gain of $323,000 going into our next exchange. In other words we would have $500,000 of capital for our next investment.
Besides the right long term fixed rate debt, tax deferred gains are hands down my favorite kind of financing. They are a form of borrowing where Uncle Sam provides us with a zero interest rate loan with no predetermined maturity date. You get to decide if and when you want to recognize the deferred gain and pay the “interest” (taxes) on the gain.
1031 exchanges allow real estate investors to create a trade that would be the envy of deep value stock market investors. You can pick up a proverbial “cigar butt” (an uglish cheap asset), take one last free puff, sell it later and defer your tax liability indefinitely. Through a 1031 exchange, the government provides an investor with an interest free loan that has no maturity date attached to it. Eventually, you can even trade into a higher quality, non cigar butt style asset.
What am I likely to do with $500,000 of principal and deferred gain in a third trade?
1. I would likely look for a multifamily asset that already has or is eligible for HUD debt.
2. I would trade into a larger mobile home park park in Tucson where, on a pro forma basis the park is eligible for agency debt. While I’ve discussed HUD debt here I have not discussed agency debt. Big picture, it is 10 year fixed rate, nonrecourse, assumable debt provided by Fannie Mae or Freddie Mac under their Small Balance Loan program.
3. We would for example have the flexibility with these two financing options to purchase a higher quality asset (like a 3 star mobile home park vs. 2 star) for between ~$1.5M and ~$2.0M. Without taking into consideration us adding value to these assets, I would expect these assets to produce net operating income (NOI) of ~$97,500 and $130,000. Based on recent interest rates, this NOI after interest expense would work out to ~$52,500 and ~$62,500 per year.
For now, our work continues repositioning our existing 40 space mobile home park.
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