By the time that you get to analyzing a property, you will already have done your market analysis and you have a few MSA’s that you like and that make sense to invest in. A good MSA has a population that has been growing over the last few years. You also understand who are the major employers of that area, and how many employees do they have. And out of these top five employers, is there diversification of industries, meaning, these top five employers should not all be government employers, they should not all be in the healthcare industry, or they should not all be in the oil industry. It’s really important to have diversification in the employment side just in case one of the industries takes a dip at some point in the future. Ideally, you want to be investing in a primary or secondary market. And by definition, a primary market has over 100,000 people living within a five mile radius. A secondary market has between 30 and 100 thousand people living within a five mile radius, and a tertiary market has between 4,000 and 30,000 people living within a five mile radius.
There are exceptions to this. If you are really familiar with a tertiary market, and it has been growing, and you know that there isn’t a ton of competition for whatever you are investing in, or that there is enough demand for what you’re investing in. One more thing that could be a valid point for investing in a particular MSA could be the fact that you know that something is about to happen in that city or that area. For example, there is a city called Lake Charles in Louisiana that has billions of dollars being invested in for oil and gas refineries. That is bringing a lot of jobs to the city, and a lot of housing and infrastructure is needed to support that population growth. Note that even if you do know that something huge is about to happen in that area, you really need to be confident that that is happening. For example, there is a city near San Francisco called Oakland, and Uber announced that they were going to move their headquarters over there. People started buying properties in Oakland left and right. And about a year later, Uber decided not to move there.
Luckily, Oakland is still growing, and that is a plus for these people. However, they could have taken a big risk if the city was not growing or if other employers were not moving to the area. But I remember specifically people saying that Oakland is the biggest known secret, it is going to be booming because Uber is moving there with their thousands of employees, and they never did.
Now that we got the MSAs out of the way. Let’s jump into the actual analysis. I will be using a real property that I came across. It is a self-storage portfolio in Missouri. They had four properties and an additional property was in a strip mall, so they were leasing it. This property was interesting because it was in one of our target markets.
We asked for the offering memorandum, sometimes the OM is readily available on the website that you find the property, sometimes you just need to sign a non-disclosure agreement before getting it. The first thing we do when analyzing a property is taking all of the financial analysis numbers and putting into a spreadsheet. That’s all of the existing income, and all of the expenses on the Excel spreadsheet. Everything is broken down as it shows in the OM.
Some of the expenses for this particular property are: online advertising expenses, bank charges, employee benefits, insurance, here is a line item for the leased property that is on the trip center, payroll expenses, management fees, security expenses, telephone expenses, repair expenses, general and admin, utilities and the most important one, property taxes. Property taxes are the expenses that can kill deals for inexperienced investors. Why? Because the real estate agent is going to put the existing property taxes on their analysis. And typically you are buying the property for a higher price than what the seller bought it for. And so property taxes can double and sometimes triple as it is in this example. And if you don’t realize that until the last minute, or even until after you purchased the property, that can be a huge problem. So in this example, the real estate agent put the existing property taxes, and for a 3 million dollar property, these taxes were $20,000 per year.
I asked the real estate agent, what do you estimate the property taxes will be at the $3 million purchase price? And the real estate agent answered $61,000. That is three times what they had in their financial analysis. This is something that you really need to be watching out for, for these type of deals, and also for other asset classes. As we have talked about before in the retail world, even though your tenants will pay for that tax, you really want to be considering if they can afford to pay for these additional taxes. And in the retail example, a lot of times they may have in their lease that the only increase in tax that they’re willing to pay is an additional 10 percent per year, for example. And 10 percent per year isn’t going to cut it if your property taxes are being tripled, like in this example. So here we are. The total property expenses are about $240,000 and the total net operating income is $133,000 with the new property taxes.
Now, we have still not put the loan payment in this financial analysis, the loan for commercial properties is around a 70% loan to value (LTV). In this example, at a three million dollar purchase price, our loan would be two million dollars, and we would have to put one million dollars down. The term of the loan will be anywhere from 20 to 25 years. So what you do is you go to a loan or mortgage calculator, and you can just Google “loan or mortgage calculator” and you put the loan amount. In this case, two million dollars. You put an interest rate that is a little bit above what the market rate is just to be on the safe side. Today I am putting a 5% interest rate, and then you put a mortgage period of 20 and 25 years. And this is for you to understand what your payment will look like for both 20 and also 25 years. For 20 years, in this case, it will be $13,200 per month, times twelve, because we’re calculating yearly, that’s $158,000 in mortgage expenses. Note that this is with the principal reduction. This is not interest-only. We’re calculating the highest possible amount that you would be potentially paying. We’re going to put that in our analysis, and just with this calculation alone, we are going to be negative $24,000 per year on this property.
And of course, you’re not going to stop here because we have more work to do in understanding the potential upside for this property. However, this negative $24000 is a big red flag already. The next step is we’re going to be looking at self-storage properties that are close to this location, and we will see how much they are charging for similar units that each and every single property in this portfolio is charging. This portfolio had properties there were actually pretty close to each other. So we just had to do analysis on the competition that was near these properties. And most of them were overlapping.
We quickly found out that this portfolio of properties was charging rents that were at least 10 to 20 and sometimes $30 more per unit size than any of the competition. This means that there is zero upside for increasing rents because they were already significantly above the competition. This is exactly where we stopped. We said there is absolutely no upside for this property. There is no upside in increasing rents. They are already charging significantly more than all of the competition near every single one of these properties. And the property that was being leased on the strip center, they were making zero dollars! They were not making a penny out of that property, which was very interesting.
The seller can want three million dollars all day long. However, from an investors’ perspective, there is zero upside unless you are just looking at parking three million dollars in cash on a property that is making okay money. That’s the only reason that I see someone purchasing a property like this. And there are families and businesses that are interested in purchasing these properties just because they want a safe place to park three million dollars, in which case they’re just getting that 6% Cap. Typically, these people are going to park their money on a property that has a 15 or 20 year lease, and that lease is backed by a big company. So they would probably park it in the retail property that has a really good tenant, with really good credit, that has signed a fifteen or a twenty year lease.
When going back to the financial analysis, you also want to dig deep into the expenses. Can you cut some of these expenses? Is that going to make sense? In this case, even if we cut $10,000 in expenses, we would still be on the red $14,000 per year. And this is not a good sign, at least for this property.
I also want to share an example of a property that we had in contract in 2019. All of the numbers looked fine. There was some upside in increasing some of the rent. But when it came time to get the actual bank statements on the income, and the deposits, because the bank that you are going to get the loan from requires a historical proof of income. The sellers could not prove even 50 percent of the income. They were supposedly getting cash. They had no copies of the checks that were coming in for that property and they could not prove any of the income on the property. So we had to back out of that purchase. Even if the numbers end up looking good, you will probably run into something that is going to stop you in the tracks. And it’s perfectly fine to back out of an offer or to change your purchase price. In this example, we backed out of our offer, but before we backed out of, I said that we can adjust our offer based on the numbers that they’re proving, which was 50 percent of the numbers that they were claiming they had.
That means a 50 percent reduction in the purchase price and we can continue with the closing process. And the other alternative I gave them was to decrease the purchase price a little bit, only pay them at the cap rates that they could prove the income for, which was 50 percent of the income. And then one year later, after we have taken over the property and we see that all of the numbers are actually true, and we can prove to the lender that these numbers have been coming in. We actually keep track of the income properly. Only at that time we would pay the remaining price that we offered. And so that is the solution that I came up with. They did not want that, they wanted the full price, which again, they can want that all day long. However, people are not going to end up purchasing this property if they cannot prove the income to the bank, also, it is very unwise to buy something that the seller cannot prove that there is income on the property. These are just a couple of examples for self-storage property analysis. There is a lot more that goes into it. There are a lot of questions that we ask the real estate agent and it’s really important to understand the entire picture. It’s a good idea to go back to one of our first episodes titled “Questions you should be asking the sellers agent when interested in a property.”