Investing with an Edge: How Strategic Capital Drives Profitability
As you may have read in a previous post, we recently closed on a property in Troy, NY. As part of sharing the journey, we thought it would be helpful to share how we modeled and analyzed this deal. Step by step, we’ll start from the back-of-the-envelope and talk through the deep dive before the go/no-go decision. A key component of our flexibility and strategy is avoiding external equity holders. Assessing old buildings to determine the long-term cost of ownership is a dark art, at best. A twenty-year-old roof may leak tomorrow or in another decade. Anyone who says they know the answer to ‘when will my roof leak?’ is lying. Given the numerous unforeseen risks the market tends to bid down these assets, essentially a type of distressed asset. While on average, old properties harbor many more hidden risks, finding one in above-average condition presents a tempting cost/value arbitrage.
My first step when evaluating a deal is to calculate the R/C ratio. The R/C ratio is the monthly rents divided by property cost. This basic test ensures that there is enough revenue to meet your business objectives. Some investors speculate on the value increasing rapidly and are willing to accept a low R/C ratio. Other investors may only be interested in deals with significant free cash flow, setting a higher R/C threshold as a deal hurdle rate. Of course, at this stage, we know nothing about the actual costs or rents. Given that a property needs a physical inspection before acquisition, we use estimated operating costs and rents to avoid wasting time on prospects outside our model.
Most real estate listings on residential (Zillow, Redfin, etc.) or commercial sites (CREXI, Loopnet, etc.) do not list the property’s rent roll. At best, some commercial sites will have listings that provide a cap rate, but while that indicates revenue minus expense, you have no idea if the expenses are high, low, or reasonable. The objective is to determine if the property you are reviewing is worth the effort of additional analysis or even a tour. For this property, renting the residential half of the building would easily hit a 1% R/C ratio. The listing indicated that the building had three apartments and commercial space; a studio, a 3-bedroom, and a 4-bedroom. Looking up comparables for the apartments on Zillow, I saw some very wide ranges. For example, a $700/month studio and a $1,500/month studio. For nearly all the apartments I investigated, I found a nearly 100% difference between the bottom and top of the market.
Our candidate property hits the 1% R/C benchmark with zero out-of-pocket investment. The problem is that this 150-year-old property has a lot of problems. The last owner left many issues unaddressed for decades. We may get a 1% R/C, but net zero free cashflow in the first few decades. So, the operative question is as follows: if we can buy 1% R/C with lots of deferred maintenance and we invest additional capital, will we be rewarded a higher R/C ratio and cure all the deferred maintenance? In this case, yes, yes, and YES! In markets with such large price ranges, customers are clearly paying for well-appointed interiors and premium location. In this case, we found a great location, where the interior appointments were poor, that could only attract tenants willing to pay bottom-of-the-market prices.
To bring greater focus to our analysis, we need a better sense of what a project to improve the property will cost. To bridge the 100% price range in the market, we need to transform these living spaces from “eww” to “wow”. It takes knowledge and time to get this right. If you know nothing, you can grind out a decent answer, but it will take a lot of time. For about one hundred dollars, you can buy the latest Gordian Contractor’s Pricing Guide, probably the same book most contractors will use to price a bid on your project. If you are doing a bigger project, sometimes it is helpful to think about things as a “percent of gut.” A total gut will likely be around 50% finishes and 50% everything else. So, our conversations with local architects landed us at an estimated $250/sqft gut cost in the Troy market, we can guesstimated we needed less than half a “gut.” We landed on $100/sqft, given the property’s condition, to get very close to the top of the price range,
The investment thesis for this property is as follows:
The property has an R/C ratio of 1%.
An investment of 70% of the property’s cost will double the revenue - phase 1
An additional 100% investment will quadruple the base revenue - phase 2
The final R/C ratio is 1.25% with essentially a brand-new building
The math isn’t that complicated: an R/C ratio of 1.25 annualizes to revenue as 16% of price. Along with a cost of capital at 7% or 8%, there is lots of room for expenses and free cash flow. When fully capitalized, we expect this investment to provide money market-like free cash flow yields on the value of the property, while paying down the principal and capturing price appreciation. All that said, the real cherry on this sundae is getting lucky enough to be in the right neighborhood at the right time. Manhattan’s trendy neighborhoods in the 80s, Brooklyn’s in the 2000s, and Detroit in 2010s. So, it may be a double, triple, or homerun. Only time will tell.
There are two key phases to this project. The first brings the existing units much closer to the top of the local price range. While the second unlocks unused space nearly as large as the existing units, by adding additional residential units at the expense of the commercial space. This is a very capital-intensive strategy. While there are short-term risks, a miscalculation of the scope of deferred maintenance on an already occupied property can consume all your free cash flow and, in severe scenarios, may cause a loss of investment principle over the long term. The primary obstacle to executing this strategy is access to the capital required for construction. Traditional construction loans have very high closing costs and interest rates nearly double those of 30-year fixed mortgages. There are short term financing options for investors that will sell the property after construction to recoup the cost of capital. If you, like us, intend to hold the property after improvements, significantly reducing the short-term cost of capital can be the difference between a profitable deal and a lemon.
For this project, the personal touch of meeting with all stakeholders and understanding their needs enabled us to craft a win-win deal that unlocked a huge chunk of working capital. In our current project, we found a seller passionate about the building and the community. The former owner, a bubbly and gregarious octogenarian (80-something-year-old), lived in Troy his entire life and had owned the property for the last 45 years. In his own way, he put a great deal of blood, sweat, and tears into a property he loved and appreciated. With a seller like this on the other side of our deal, we had a high degree of alignment on what we both sides wanted from the deal. As you may have read in our previous post titled, ‘I convinced a stranger to lend me $250K in 30 minutes’, the previous owner bought into our vision for the property and gave us a significant private mortgage, an all-around win-win. The former owner got his asking price along with a better-than-market interest rate on a short private mortgage. For us, the added access to capital will allow us to execute phase 1, rent the existing units, refinance to capitalize phase 2, and execute to the finish line.
It’s not an exact science. The objective is to align the project goals with the budget and then work like the Dickens. The strategic approach of investing at the purchase price and using each new slug of capital to drive up the investment yield has proven to be highly effective. By carefully evaluating the property's potential and incrementally adding capital, we are able to transform a distressed asset into a profitable investment. This method not only maximizes returns but also mitigates risks associated with deferred maintenance and market fluctuations.
With the right strategy and capital allocation, even properties with significant issues can be turned into valuable assets. In fact, they are the highest long term free-cash-flow opportunities. This approach highlights the importance of finding an edge, thorough analysis, strategic planning, and timely execution in real estate investment. By following this method, investors can achieve substantial returns and build a profitable portfolio over time.
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