Tenant Stabilization via Open Market Purchases
Looking at commercial real estate listings for multi-family apartment buildings, it is really stressful to just have a vision of “who is going to be priced out of their apartments next.”
Case Study of a Property For Sale
Today’s example is a building advertised on commercial real estate listings as having a 3.57% cap rate, with a purchase price of $2.7M. Total net income after operating expenses is listed as $96000/year, with an average 1BR rent of $1800/month, and an average 2BR rent of $2300/month.
Now, for the current owners, these rents work fine. They’re pulling in $8000/month after expenses, and bought the property in 2001 for $675k, meaning even if they had a mortgage (they don’t seem to; probably a cash purchase by the real estate LLC), they’d only be on the hook for $3000/month in purchase loan costs.
They did do a gut renovation in 2001, probably doing significant updates to the building. What this means is that this building seems likely to be “worth” more than what they’re getting — the rents are below market largely by a choice by the landlord, not because that’s the max the market will bear — but they’re still making a tidy profit at the current price, and they acknowledge that this is an explicit choice. The listing comments that “The building is professionally managed with a focus on tenant retention rather than maximizing the rent roll.”
But the new buyer… they won’t be able to do that. At a $2.7M purchase price, they’d owe $15k/month on a mortgage at a 4% rate typical of an investment property. With only $8000/month in operating income, $15k/month is not a feasible number to pay for this!
So the current owners ackowledge the building is currently rented under market by choice. What does our operating income look like if we increase the rent to the median, rather than renting it below the median price?
In total, with 3 1BR units, 3 2BR units, they can likely pull in $14.4k at market rates ($2300 for 1BR, $2500 for 2BR, based on median prices on Zillow). While the building is nice, and has some unique features (each unit has a fireplace for example!), I don’t think that it’s reasonable to expect much more than the median rent from this building in its current state.
But even that won’t be enough to cover the nut on this either: even if they ditched the management company and became a slumlord, they’re still coming out behind. You’re only increasing your total revenue by ~$3000/month; you’re still losing money every month at that rate.
So, what will likely happen here?
- Perhaps the new owners were able to talk down the purchase price, and have good financing options available to them that let them borrow at lower rates. If you’ve got access to investment cash at a 2% interest rate rather than 4%, you could probably approximately break-even, especially if you could talk down the price a bit.
- More likely is that a combination of rent increases and unit modernization will combine to take these currently affordable units out of the market and create units that are significantly more expensive than the median rent.
What does unit modernization look like? Hard to say, but what I can imagine happening is a replacement that’s more than a coat of paint, but less than a gut reno. Redo the kitchen with new appliances, replace the berber carpet with something that doesn’t feel like it’s from 1996, and maybe put in some granite countertops to make it feel more fancy, and you’ve got something that *feels* more modern — and can fetch a higher price at pretty low capital investment. With $10,000 in capital investment, you can probably bump up your monthly rent by $250/month. (What does “Luxury” actually mean? “has a stainless steel fridge we bought at Home Depot for $1100, rather than a white enamel one.”)
Or maybe our market is so tight that you don’t even need to do this: once the pandemic ends and students are back next fall, you just bump the price, put it on the market early, get some good photos, and have a responsive property manager: you’ll probably pick up some above market payers who are happy to have the convenience, “mere blocks to Central and Inman Squares”.
And hey, if things are really tight, you can always ditch the property management company entirely: you’ll save $2000/month, and you can just do like most landlords in the area do and completely ignore any tenant complaints!
The existing tenants are managed under a model that had capacity to prioritize their happiness. But after the sale of this property, there will be no money leftover for that: someone wanting to make money will have to push the costs up and expenses down just to break even.
It might not happen to all the tenants at once — you might not even see any active evictions/non-renewals to make this happen. With small units in a university-driven city, the new owner might just renovate as folks move out, and accept that they’re taking a loss in the short term.
So, this building today:
- 6 units with happy tenants
- Paying a price that’s $400-$600 below the median of the market.
- Living in relatively newly reno’d apartments with a professional property management company.
This building post-sale:
- Notice to tenants that rent is going up 30% next year.
- Some units converted with some investment so the rent can go up 40% instead.
- Property management company fired/reduced so that new owner can cover their costs.
The person who comes out ahead in this scenario isn’t the new owner (who is barely breaking even!), but rather the landowner who purchased in 2001, and is currently pocketing $60k/year on this investment even after expenses… and has decided that now is the time to cash out on their $1.5M in increased equity. I expect that even telling the tenants that their building is for sale isn’t on the priority list for them.
The current owner isn’t trying to hide this: indeed, it’s one of the selling points of the property in the real estate listing:
“Units are currently leased at below-market rental rates, presenting the opportunity to increase net income with minimal additional capital requirements.” (Emphasis mine.) “Opportunity” to the new investor is another way of saying “displacement and evictions” to the current tenants. Whoever buys this will buy it with the expectation of raising the rents: it’s the financially optimal thing to do, and is necessary to make the investment make sense in the first place!
How To Fix It
This story happens all the time in Cambridge. So, what can we do to fix it? How do we prevent this from happening to the next apartment building… and the apartment building after that?
First, rules like “Tenant Opportunity to Purchase” are valuable. They make it so that tenants can at least have *knowledge* of these things, and a chance to intervene: they get a right of first refusal at the market price on sales of their buildings.
But of course TOP is about a right to first refusal at that market rate ($2.6M in the case above). A traditional mortgage — even if you somehow had a set of 6 tenants that could pool together the necessary scratch for a down payment — still doesn’t leave the opportunity to meet the monthly payments on a mortgage at that price, even if you switch to doing all the maintenance yourself. We need to explore an alternative funding source that can help us lower the financial costs of the purchase.
This is a case where working with a highly financially stable entity — like the City of Cambridge — can be a valuable tool.
Cambridge has the ability to get bonds at substantially lower rates than even the historically low mortgage rates we currently have. While an investment property mortgage might be in the low-4% range, creating a $15k/month cost, a 30 year fixed mortgage at the 2.2% rate of Cambridge’s municipal bonds has a monthly cost that is only around $9k — substantially lower than the market competition.
With money like that, a non-profit could work with the city to put up initial capital, and use the city’s ability to borrow cheap money in place of a traditional mortgage. In exchange, the City could establish an agreement that the non-profit limit annual rent increases — to 1% over inflation absent vacancies, for example — ensuring that the arrangement creates increased stability for tenants.
The idea of investing in real property through non-profits in order to secure better resident outcomes isn’t foreign to Cambridge. They can and do act as a mortgager regularly via the Affordable Housing Trust. And the risk can be relatively low: the city can review the pro-forma on these investment properties and establish a minimum bar for viability before investing.
Using the city’s superior financial position, a non-profit makes a 20% down payment; has a mortgage (guaranteed through the city) at a 1% under prime, which lets them maintain the building at the below market cost, and the tenants get a promise of stability of rent.
When I think about “what could a community land trust actually do?” — this is where my thinking goes. A CLT, with active tenant representation and a small amount of seed funding, could become a revenue-generating entity which could protect the stability — not the costs! — of a greater number of tenants over time, by making these investments, and then using any additional revenue to fund additional purchases using the same set of tools.
The City would act as a funding partner, doing pro-forma reviews of purchases to determine whether they are safe investments from a financial perspective. If they’re not, the CLT could try to get alternative funding, or eventually, they could even pay cash instead of financing if the model was successful.
In this way, you get a virtuous cycle: you protect tenants who are renting below market, giving them a promise of stable rent increases, and any additional revenue from the properties goes back into supporting additional tenants. I don’t think anything here is technically complex. It’s a somewhat straightforward REIT-type setup, where the “return” goes back into the community, rather than to outside investors; and where the goal isn’t maximizing return, but maximizing tenant stability.
Many in the community like to attack renters as transient: but the reason that renters in Cambridge are transient has nothing to do with what *renters* want, and everything to do with the realities of real estate. With financial support from the city, that could change.
In order to maximize the number of tenants such a non-profit could help stabilized, when a tenant voluntarily vacates a property, I support the idea of updating the rent to a fair market rate (ie, vacancy de-control, to some reasonable fair valuation). This theoretical structure is not a housing affordability strategy, which most people seem to focus on for community land trust considerations. Instead, it’s a way to provide a scheme for providing more effective tenant protections and stability than will ever be generally passed into law, by empowering tenants with rights more similar to co-op owners on most elements, with a pricing model committed to by the org running it. On every other element — repairs, maintenance, property management, purchases, etc. — you can imagine having a tenant-directed component of the organization leading the way for protecting their own housing.
People often suggest that “Community Land Trusts are the solution to housing affordability”, but the reality is that the missing component of housing affordability is just “money”. Instead, creating organizations that are focused on tenant protection and stabilization but not affordability can be done in ways that protect an expanding number of tenants in a revenue neutral way, especially if backed with municipal investment supports.