Analyzing an existing/inherited rental property?

Question

Disclaimer: I'm a newbie, just learning the ropes here :) Apologies if these are "stupid" questions, but after some fruitless BP searching I have to ask for some help...

I love all the resources on BP for learning how to evaluate a potential investment property before you buy. But does anyone have guidance for how to analyze a rental property that you already possess or have inherited, to determine how much sense it makes to hold on to it, vs. trying to sell it? How similar/different is this kind of analysis to what one would run on a potential investment property?

My family owns a 3-unit rental property, bought decades ago and currently owned free & clear. As far as my generation (who will inherit it eventually) is concerned, no cash has been invested, so the cash-on-cash return would be essentially infinite (right?), and therefore seems like a useless figure. Does it makes any sense to calculate the cap rate based on the original purchase price back in the day (1985)? Or should I be basing it on the most recent tax assessment, estimated market value based on similar properties, ...? Or are there some entirely different number(s) I should be looking at?

Thanks in advance for any advice you guys can give me!

Fay Chen · Answer

Cap rate is more commonly used for commercial investments and multi-family properties (4+ units). It's how other investors & lenders value the investment/property. Say your Net Operating Income (NOI) is $30K. In a market cap of 10%, your property will be valued at $300K. But you have a triplex, so your property will be evaluated by market comp. If Joe down the street just sold a few similar triplexes for $250K, your triplex will likely be valued close to $250K.

I don't find cap rate practical since I have a single family home on mortgage. Cap rate is unlevered, pre-tax, before depreciation... For all those reasons, it doesn't paint the whole picture for me. Cap rate, ROI, ROE, COC are all different ways to measure the performance of investments. I like to change things around (such as modifying the ROE in your case) so I can compare apple to apples. If you are preparing a formal report to other investors/lenders, you might want to leave out the modified equations. Otherwise, you can choose the equation that makes the most sense to your investment.

Fay Chen · Answer

Anytime! And to clarify, I meant to say "more than 4", so 5 units and above. A triplex and 4-plex would both be "residential." 5 and above would be "commercial." Good luck! Keep us posted!

Fay Chen · Answer

I can think of 2 ways to do it:

1). You can calculate the Return on Equity (ROE). I would use the market value of the property for equity. Then you can compared it to the market CAP rate. But since it's 3-unit, I'm not sure how much this will help you.

2). You can deduct closing, tax and commission from the market value, and get the total expected equity. Use the expected equity in the denominator to get a return on expected equity. Then you can compare that to the Return on Investment (ROI) on your future investment.

Anjana Vakil · Answer

@Brandon Hall Thanks for the input! I think you perfectly expressed the goal I didn't know I had (as @Gilbert Dominguez pointed out, it probably wasn't clear in my original post): my goal is to determine if it makes sense to keep the rental property, or sell and reinvest the money elsewhere. I hadn't really thought much about refinancing but it sounds like that might be a good way to go, sort of a best-of-both-worlds scenario.@Gilbert Dominguez Thanks for your tips. If I do determine that it makes sense to hold on to the property, I'll look at ways to improve the cash flow. Talking to a realtor is a good idea, I should probably do that no matter what. Thanks again for the advice everyone! I'll keep you posted (ha!) when I crunch the numbers and figure out whether the property is a keeper or not.

Gilbert Dominguez · Answer

You want to compare apples to apples and oranges to oranges. Cap rate usually will not apply to simple residential buildings as they are valued using comps and commercial residential buildings are valued based on the income generation, historical or capacity for income.

If you concentrate on Income generation which would be one concern you might have then I would research what similar units in your area are renting for. I am sure you can think of what sources to look for to obtain this information.

As to whether you have a legal 3 unit or 4 unit building a simple examination of a few documents such a deed, tax records, and assessors records could probably discover this for you.

You say your building has been well maintained so that you can more safely count on the valuation being in accordance with current comps. You might also obtain the opinion of a local real estate agent who has been selling or has sold similar properties in your area.

One thing to consider when determining and deciding over rents is to weigh the benefits of long term tenants vs dealing with vacancy periods, upgrade cost if any, and dealing with the unknown from any new tenant. It is usually easier to increase rents and get new tenants in your building that are used to the rental amounts from the start rather than increasing the rents on existing tenants for obvious reasons.

At this time you are probably aware of what your taxes are on the property and insurance costs, maintenance cost etc. so that you can determine what your net income or cash flow is. Do you want to improve those figures, is there room to get the building to perform better I do not know what your goals are or if you are simply conducting an exercise on determining a valuation of your building from a financial stand point.

Do you want to optimize what your building would appraise for. A consultation with a local appraiser might be in order. He or she could make recommendations to you as what could be done to optimize the appraisal value of your property and then you can determine if there is anything you want to do about it or care to if any thing.

Evaluating a property pre-investment and evaluating a property after you already own it are just two different things.

Brandon Hall · Answer

Great question - what you will be looking to understand is the opportunity cost of the equity in the property, meaning, if you pulled money out of the property and invested it elsewhere, would you earn a better return? Basically, if the inherited property is paid off and worth $100k and generates a net income of $6k per year, then your return is 6%. You will want to understand what happens if you refinance the property, or sell the property, and apply that capital to other investments.

Say you refinance the property at a 75% LTV meaning you pull $75k out of the property. Now your return is 24% ($6k NOI/$25K equity left in the property). You are still generate the same NOI, however now instead of using $100k to generate $6k, you are using $25k to generate $6k. Then the question becomes: what will you do with the $75k you pulled out of the property?

From a cash flow perspective, leveraging properties will provide for better returns.

As far as my generation (who will inherit it eventually) is concerned, no cash has been invested, so the cash-on-cash return would be essentially infinite (right?), and therefore seems like a useless figure.

Nope - the figures will not be useless. You need to treat the property as if you invested the cash (even though you didn't) to determine how the asset is performing. Similar to what I said above.

Anjana Vakil · Answer

@Fay Chen Ah OK that clears it up, and that's what I had understood previously, that commercial properties are 5 or more units. Thanks again!

Anjana Vakil · Answer

Thanks very much for the clarification @Fay Chen.  I've seen cap rate used as a metric for comparing different potential purchases apples-to-apples as you say, independent of the financing terms (which would affect COC but not cap rate, if I'm not mistaken). ROE is a new one to me but it definitely sounds like a good number to look at for this type of situation. I also didn't realize that there was a difference between 3- and 4-unit properties in that sense. Actually, it had previously been divided into 4 units, but for the past several years two of those have been rented out as a single unit.  I've been wondering is whether it would make more sense to separate them again - in addition to looking into the legal details, sounds like I also need to do some homework on how it would affect how the property is valued.Thanks again for the tips!

Anjana Vakil · Answer

Thanks for the tips!@Michael Noto Good points, and definitely ones that have been on my mind. The property has been well maintained, but I'm pretty sure that it could be bringing in more rent - one unit could even be split into two relatively easily, which I think would increase the rent substantially. But for now I guess I'm just trying to establish a baseline.@Fay Chen Thanks for your suggestions - I hadn't thought of deducting the selling costs but that definitely makes sense to me. One question, could you explain what you mean when you say in point 1: "But since it's 3-unit, I'm not sure how much this will help you"? Maybe I'm revealing my ignorance here but I didn't get it - do you mean that this approach would work better for a single-family or something like that?

Analyzing an existing/inherited rental property?

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