Multi-family investment: buyer beware!

A meeting of the minds on price, especially on the part of banks that have foreclosed, is leading to a rush in the sale of multi-family properties. Many are still priced too high, however, because of the high mortgages taken out in the 1980's. And in light of the plethora of city and state regulations that govern their owners, many wonder if these buildings are any bargain.

Brokers insist, however, there is money to be made through the ownership of rental housing.

Because of potential problems, the experienced owners buying these properties are conducting extensive due diligence, said Pauline Jones, a broker with Lee Odell Real Estate.

One of those owners, Rubin Pikus, president of Milbrook Properties, who operates multi-family buildings in the Bronx, Brooklyn Heights and Washington Heights, recently made his first purchase since 1988. "Today you must do a lot of homework before you buy a building," he agreed.

Pikus first looks at the rent roll room average, particularly if there is a high rent in a neighborhood that doesn't warrant it. "If rents are topping out don't buy it," he warned.

Jones believes the rents are not always topped out since the lenders have not been properly managing them. "If someone came in and took care of the building you could start increasing your rent and getting out the illegal tenants," she said.

Neglected Properties

For these same reasons, however, attorneys warn that regulations may have been overlooked, endangering rents.

Mark Rudd, a partner with Rudd, Rosenberg, Mitofsky & Hollender, said before an owner ultimately abandons a building to a bank, as a result of failing to keep its mortgage current, they have stopped properly managing the building in other ways and may be collecting illegal rents or have violations pending. "If somebody is going to let a property go, they are not going to call up the bank one day and say everything is up-to-date and my building is in great shape and I'm charging the correct rents," Rudd noted wryly.

Abatements

Some properties may be able to take advantage of programs that allow increases in rent or tax abatements in return for improvements to the property through the J-51 tax abatement program and the Major Capital Improvement (MCI) increases.

The fact that the building is a bank foreclosure doesn't matter, said Azriel Golowa, a partner in Rottenstein & Golowa, Ltd. and is a real estate consultant for tax abatements such as J-51' s and MCI.

"They have to put money into the building and do items that are eligible and comply with the individual specific requirements," he said.

Robert A. Knakal, managing director of Massey Knakal Realty, which handles small to mid-sized property sales on Manhattan's East Side, said, in theory, the MCI is beneficial but not easy to implement. "They are not granted for a year to two years and then they are retroactive and are a bookkeeping nightmare," he cautioned. "Then the tenants can file protests and complain."

Renovating vacant units, however, is a straight forward procedure that, Knakal said, is attainable. "When investors look at a property they assume they can get the vacancy allowance and 1/40 for renovating the existing unit," he said.

The potential returns on investment are attracting many investors who would otherwise not be interested in real estate. "We have cases where you can get a 25 percent return on your money," Jones said. "I have a building in Brooklyn that has a 50 percent return but you need a strong management company," she added, alluding to its location in a less inviting neighborhood.

Often the presence of some commercial place is the key to adequate returns.

Knakal's firm conducted an in-depth analysis of 30 multi-family properties on the Upper East Side and found an average operating incomeof30 percent of the gross with an average of 55 cents of every dollar paid toward expenses. Pikus said if the property can support a return of a minimum of 10 percent after all costs are considered -- including capital ization of the purchase price, legal fees, costs for improvements to put it back into shape and all of the soft costs and if the rents are not topped out, then he would investigate further.

Analyzing the Price

In the late 80's people were buying for 10 and 12 times rent rolls, Jones explained, but now properties are turning over to a high of 4.5 times rent rolls, but more often less.

"If you're paying more than four times rent you won't have the economics to do the deal," Pikus added. "A good starting point would be 2.5 times the rent roll."

Knakal said properties in some neighborhoods are turning over for as little as 1.5 to 2 times rent rolls, with value based on net operating income and not on a gross rent multiples.

"That bottom line figure is critical," he said. "Today it's cap rate first and multiplier second. '

Most people are using a cap rate appropriate for the neighborhood against the net operating income, he added.

Investors are also favoring buildings with actual incomes. It is critical to have actual income, Knakal explained, as the old premium for a high degree of vacancy now equates to a lot of renovation.

"Actual income is the way to finance especially when there is no seller financing,' he added.

When analyzing the costs, Pikus said, he utilizes a room expense number for each item, such as oil and repairs. One attorney familiar with income and expense statements, estimated average expenses for low- to middle-income buildings would run $10 to $200 per room per month. In the upper-income luxury buildings, he said, $400 per room would not be unusual because of employee expenses.

Dan Margulies, executive director of he Community Housing Improvement Program (CHIP), said the Rent Guidelines Board, which sets rental increases based on owner costs, estimates costs in he low $300's to high $400's per unit per month. It costs HPD approximately $3,500 to $4,000 per unit to run a buildng each year and various organizations rave pegged water meter costs at $400 to $900 per unit per year.

Environmental Problems?

Pikus also considers whether the buildng already has a water meter and if lead paint and asbestos are present. 'I am looking for the violations and then the physical conditions," he explained. "If here is a lot of chipping and peeling paint or the basement pipe is covered in asbestos, then I know there will be costs to abate those conditions."

Additionally, the City Council is soon to act on a bill that would require various lead abatement procedures.

Rents Legal?

Attorney Martin Heistein, a partner with Belkin, Burden, Wenig & Goldman and former counsel to the Rent Stabilization Association, recommends a check of all the numerous city agencies involved with city housing to search for violations and up-to-date payments. Some of these include the Building Dept. for certificates of occupancy and such things as boiler registrations; the Environmental Control Board for outstanding sanitation summonses or ECB liens; and the Department of Finance to ensure the $10 fees have been paid for rent-stabilized units.

One key issue, Pikus noted, is to determine if the rents are legal because if agency procedures are not followed and the units are not registered legally for any year, the rents can be rolled back to that year. Owners are also being hit by triple damage suits in cases where annual registration statements were not filed.

"If there was no registration on the building then I can't buy the building," said Pikns. "The rent roll is no longer legitimate."

"A person," Heistein said, "would have to be crazy to buy a multi-family building and not check the open docket listings with DHCR."

Obtaining information on violations and rent challenges, however, could take from weeks to months.

Margulies recalled one purchaser who, more than six months after closing the deal, received a shock along with his Freedom of Information Act information that told him there were more than 240 violations and overcharge complaints pending.

To temper such results, Rudd said, an arrangement should made with the seller to reduce some of the purchase price or the mortgage if significant violations or other information is discovered after closing. Banks will not agree to an unlimited amount, he said, but might agree to a cap, such as reducing the price up to $25,000.

"What the prospective purchasers don't realize is that letting the building go for non-payment of mortgage was the last thing the owner did and there were all these things along the way," Rudd said. "The savvy owners know to look but the guy who shows up at this auction and tries to pick up a six or eight unit building gets ambushed with this stuff."

Margulies agreed: "The universal lament is thatpeople bought because they couldn't resistthe terms from thedistress sale and then find they are buried by DHCR. It's not something you can plan for."

The purchaser may also be liable for years of overcharges and treble damages, Margulies warned. "That applies to the present owner,' he emphasized, even if he just bought the property.

DHCR makes a subsequent purchaser responsible for any overcharges, Rudd explained, because otherwise the owners would keep selling the buildings to wipe out the complaints.

It also takes three to five years to get a hardship application processed to increase rents. Said Rudd: "You think its hard to get information out of DHCR? It's even harder to get a decision out of them."

Getting The $$

If a building and its price look reasonable, Pikus sends a questionnaire to the current owner that inquires about outstanding bills and checks for compliance with certain measures.

"And either the deal dies or I go to his office and see what is missing," he said, adding, "That's why there are not a lot of deals."

The lenders and receivers were not aware of these problems or the economics when they lent on the properties, Pikus observed, and today, he said, they are still not conscious of it.

"When they are selling a building with a $400,000 rent roll, you could be buying a pig in a poke," he said. "They just say, 'we can't take any less' and don't look at the economics."

Even so, Pikus says Freddie Mac and other ,lenders have a difficult position because they are extended beyond the values.

The banks are inundated with product, Knakal agreed noting that currently, more of them are being reasonable. These lenders are selling for what they can get but most are not willing to finance and that is reflected in the price, he added.

Jones said it is difficult to obtain financing from the Resolution Trust Corp. for its properties. Freddie Mac is looking for all cash, she said, although that might change next year.

Sometimes, the current owner will take back a mortgage, or has one that can be assumed. 'In come cases, you can come in with a letter of intent that you can get a mortgage and may be able to go to contract," Jones said.

Each deal is unique, Heistein agreed. We see all kinds of deals including all cash, singlebank financing and buildings that are purchased with government involvement.

Most purchasers, Jones said, are experienced owners that know that the market has really reached its bottom and the interest rates are still low but starting to inch up.

Some banks are lending 60 percent to 70 percent loan-to-value but the owner must have 30 percent to 40 percent in equity for the acquisition and then more equity to finance the renovations because they cannot get a construction loan. "The capital outlay ... is very high," Knakal noted.

Additionally, he said lenders will not look at buildings that do not have elevators or contain less than 40 to 50 units.

Pikus foresees many of these small properties either staying in the hands of the banks or being sold to someone who doesn't stand a chance of keeping it.

Most of properties taken in rem by the city used to be buildings with 20 units or less. Now, Felice L. Michetti, commissioner of Housing, Preservation and Development, said, that unit count has dropped to 15. "They are the most difficult buildings to recycle back," she said.

"A 20-family house is not going to make it in this world," Pikns added. This is the type of property you have to own and live in, he explained. "It's not an investor prop erty."

Real Estate Tax

Margulies has noticed an increase in the purchase of eight- and nine-unit buildings with stores. Some 15,000 of these small 'mom and pop' properties were taken out of the commercial property tax class designation last year and placed in a protected class with limited assessment increases.

"The annual tax cap has made them more predictable, "Margulies explained. "Normally a building under 20 units is not attractive to anybody but it's amazing what predictable and reasonable taxes can do to the market," he observed.

"One of the things that Rubin Pikns made a point of at a CHIP seminar on Investing is whether he can successfully challenge the property taxes," said Margulies.

While many purchasers assume the new property tax assessment for a multiple dwelling will be based on the city's old unofficial policy of 45 percent of the sales price, that is no longer the case.

The city is taking the income and applying their capitalization rate or a gross income multiplier in some neighborhoods and then taking 45 percent of that value, added Margulies.

For example, the low end of gross income multipliers is four, so the city takes $1 of rent and multiplies it by four to get $4. They assess it at 45 percent of the $4 which equals $1.80. Taxing it at 10 cents per hundred equals 18 cents to the city for every dollar of rent.

'It's a very significant cost factor,' Margulies continued." More of our rent dollar goes to the city government than to the landlord.

"The majority of the owners that I know,' contends Margulies, 'will never buy another building in the City of New York because in the last few years they have learned to invest in other things that are simply more attractive and there is no reason for them to touch New York City real estate again."

The regulatory situation has not yet deterred Pikns from continuing to look for possible purchases. "I'm in it with both feet,' said Pikus. "This is what I do."