December 2019

Recession or no recession. Harmless or ruinous. Next year or 5 years. Who knows but keep in mind a few important trends. Millenials and Gen-Z-ers are renting rather than buying at astonishing rates. That trend is expected to continue. And commercial apartments have held their values significantly better than any other real estate class through prior recessions. That’s not to say throw caution to the wind. No, don’t do that. But there is hardly ever a time when you can’t look back a few short years and say I wish I bought then.

And clearly the China trade war won’t continue. It is highly controllable by a few people at the top of our respective governments. So it’s subject to manipulation for political benefit. And it’s election season. It seems predictable how it will play out, even accounting for surprises. Think about who will benefit when the deal gets done. Agriculture? Tech? Aerospace? Who will get hurt in the U.S. – manufacturing? Will a trade deal encourage more off-shoring?

Are you seeing an end-of-year slowdown in purchase and sale activity? Certainly in single-family-homes the end of the year is usually slower because families don’t want to move during the holidays. But commercial real estate investments may be a different matter. Taxes drive decisions and opportunities dry up on January 1. Look for anxious sellers, stay close to your brokers. Good deals can appear unexpectedly.

Arizona – hot now (yes, pleasantly in the 60s this time of year, but I’m talking real estate) but for how much longer? Phoenix, Tucson, or ? We’ve been hearing of good deals found in Arizona, and we hear of the area being over-bought. Low cap rates, 20-30 offers, all the signs of too much competition to get what is a good deal.

But what else is driving this market. Look to the west – California. The trends in CA have been toward higher taxes and more hostility toward businesses. Not just landlords and rent control but the kind of regulatory and tax environment that suppresses business investment. These are long term trends and neighboring states like Arizona benefit.

Interest rates, unemployment, inflation, and taxes can change quickly, but states’ choices regarding taxes and regulations are very slow to change. These trends last. Arizona understands this and, at least so far, has nurtured an inviting business climate.

How much do you keep in a reserve account, and what is it for That gorgeous apartment building you’re buying, how is the roof? When will the HVAC units die? Did you put dollars away to be able to pay for it? And what else could fail?

These questions can nearly always be answered. No, you can’t plan for storm or fire damage but that’s what insurance is for. Big assets like roofs, though, you can and absolutely have to plan for and there are straightforward ways to do that. Let’s think about how this is done.

Are you buying an apartment building, or already own one? If you already own one and it’s small and you have deep pockets, you’re probably in good shape. You just pay up each time to replace whatever wore out. But real estate investors do their best to plan and anticipate issues. Regardless of what stage you are in your apartment investing path, follow these simple guidelines.

First, capital improvements are different from capital repairs. When you replace an asset that already exists on your property, that is a capital repair that you should be funding as “Replacement Reserves”. When you’re putting in a pool or replacing laminate countertops with quartz countertops, that is a capital improvement that you are funding as “Capital Improvement”.

Inventory the assets on the property that could wear out. Water heaters: what’s their lifespan, what’s their age, and what condition are they in today – all of them. HVAC: same questions, and are they indoors or outdoors. Roofs: again, same question, when were they last replaced, how many years are left.

Estimating their expected life span is very difficult, because it depends on a lot of factors. An outdoor HVAC unit in rainy Seattle or snowy Cleveland could rust out faster than in dry Arizona. Find out the lifespans of these assets from reputable contractors in your area. Have your roofs inspected by professional roofing specialists. Many property inspectors don’t inspect roofs or estimate remaining life. Be sure your inspector is qualified, and pay them for this service.

Then do some simple math to determine how much money you have to put away to be prepared for replacing these assets. Do you have 50 water heaters, with 10 needing to be replaced in the next year, 20 have 5 years left, and the remaining 20 have at least 10 years? Assuming you’re holding your property for 7 years and the cost of replacement is $1,000 (no, that probably isn’t the actual cost, but just for illustration), you’ll need $10,000 this year and $20,000 in 5 years. And HVAC, 50
units, 5 will die in 2 years, 25 will die in 4 years, and they cost $4,000. That means you need $20,000 in 2 years and $100,000 in 4 years. Now you add up those costs and easily see what you need each year to cover them.

Here is what you need to save:
Year 1: Year 1 cost + 1/2 of year 2 cost + 1/3 of year 3 cost + 1/4 of year 4 cost + 1/5 of year 5 cost = $44,000.
Year 2: 1/2 of year 2 cost + 1/3 of year 3 cost + 1/4 of year 4 cost + 1/5 of year 5 cost = $34,000.
Year 3: 1/3 of year 3 cost + 1/4 of year 4 cost + 1/5 of year 5 cost = $24,000.
Year 4: 1/4 of year 4 cost + 1/5 of year 5 cost = $24,000.
Year 5: 1/5 of year 5 cost = $24,000.

Simple? Yes except that now you have to do this for a few more assets. It can be time consuming to gather this information and estimate it but it is necessary.

Here’s an example for a building with 8 units:

Keep in mind that you need to include replacement reserves in your underwriting. If the seller’s repair costs were nice and low, don’t get lured into thinking yours will be too. You might have a lot of old fridges, stoves, etc. that need to be replaced soon.

Who We Are

Cardinal Oak Investments acquires, improves, and manages under-valued commercial apartments. We buy B and C class properties of around 100 units in the Southeast and Midwest. We look for properties whose amenities, aesthetics, and appeal have fallen into obsolescence, whose care reflects tired management, and whose location is where a stable workforce wants to live.

And we partner with like-minded investors looking for stable assets that produce good cash flow and strong appreciation.

Founded and managed by John Todderud, Cardinal Oak Investments has acquired properties on both coasts and in between creating annual double-digit returns.

For more information, schedule time with me or contact us.

Please note: Past performance is no indication of future performance.