How to Purchase Underperforming Properties with Construction Loans

A SECRET STRATEGY TO TURN LOSERS INTO WINNERS

I received a question from a Realtor last week that will give you insight into a purchase strategy that you can use with a commercial property whose current cash flow can’t support a loan large enough to complete its purchase.  In other words, loan to value is restricted to 50% or less because values have shot up and cap rates have declined.  We see this a lot on the coasts, in large cities, and on high quality properties.

In this particular situation, we were dealing with an apartment building in a beach community that was selling for 22 times the current gross rent!  (I kid you, not!)  And believe it or not, that is a fairly standard Gross Rent Multiplier in higher end beach communities in California.

The property could only support a loan of about $1.5 Million and the asking price was over $3.5 Million.  To purchase that property “as is” would require a $2 Million down payment and would only offer the investor a 3.7% cash on cash cap rate with its current income (less with the loan).  You’d be better off finding a good money market account!

However, there were two options we could take that involve looking at what the property could be, not what it is.  And herein lay one of the most powerful financing/acquisition strategies involving construction loans you could ever learn as a real estate investor.

Option 1 was to look at the building as apartments, but with upgraded rooms, exterior, and hallways.  Adding some granite counter tops, wood floors, better appliances, and the like would allow the new owner to raise rents approximately 33% to 40%.  This would raise the maximum loan to almost $2.2 Million on a permanent basis.  We could potentially get a construction loan to acquire and renovate the property in that amount, preserving the Buyer’s capital and increasing return.

Option 2 involved looking at the building as a potential condo conversion.  Condos located that close to the beach and the local towns were selling from $800,000 to $1.2 Million.  There were 9 units in the building.  Taking the low end of the range would give us a final sales value of $7.2 Million!!!  That’s a potential profit of over $3 Million on what might amount to a $300,000 renovation and conversion.  In this case, a lot of investigation remains to be done to see if this is a viable alternative.  On top of that, the overall market for condominiums has become rather soft and it might be a hard project to sell to a financial institution at this time.

So what’s the lesson?  In older investment properties, commercial properties that have been neglected by the current owner, or properties whose owners’ have fallen on hard times, there exists an opportunity for an educated investor to purchase real estate at a significant discount with high leverage!  Construction loans on commercial property usually allow the investor to come in with 15% to 20% of the total costs of the project, provided the construction loan doesn’t exceed 75% to 80% of the final, stabilized value.  On multifamily and tract homes, the loan to costs can be as high as 90%.

So the next time a lender tells you “no” because a project doesn’t cash flow, is in need of repair, or has had an ownership problem, turn the tables and consider using a construction loan to acquire and add value in one step.