Price Per Square Foot vs. Cap Rate/Return Metrics on 2-4 Unit Multi-Family

[Roig V.]

Hello All,

I wanted to float a scenario that I found myself in to get some perspective on people's opinions of where $/SF should rank in terms of priority when valuing a 3-4 unit MF property. I recently came across a 3-unit, 2600 SF property that was very attractively priced from a return metrics standpoint (i.e. gross monthly rents were 1.3% of purchase price (slightly above norm for my market), GRM 7, Cap Rate 8.5% (about 0.5% above typical cap rate for the market), Cash on Cash Return over 17%, passed the 50% rule, and cash flowed over $100/unit assuming 100% financing on a 30 year fixed, etc). It passed all of my return hurdles with flying colors and was above what I typically see in my market. All of these return tests used very conservative expenses including a 10% management fee and vacancy. The property was 100% occupied with 2 long term tenants and one new tenant. It was well maintained and recently updated with no deferred maintenance. The list price was $245k ($91/SF), however I think there was a high likelihood I could have tied it up for around $230k ($86/SF). Sounds like a great deal right? That was my thought as well, until I dug into the comps.

There were about 6 MF comparable sales within a few miles of the subject property and what stuck out to me was that all of them sold for around $65/SF. These properties were of similar age, quality, and the samerental market as the subject. I did not have rental figures for the sales so I could not determine sale cap rates for these properties however based on my knowledge of the market they probably penciled out to around 8% sale cap rates (consistent with the subject). There was nothing in the market that supported a subject sale price $86/SF, let alone the seller's ask priceof $91/SF. Basing an offer on the market norm of $65/SF resulted in a value of $174k, a price that would have sent the cap rate and Cash on Cash returns through the roof, and that was well below what the seller would have accepted.

So my long winded question is, in making purchase decisions as a buy and hold investor should primary emphasis be placed on return metrics (ROI, cap rates, CoC, etc), with $/SF a secondary measure, or should it be a prerequisite that the $/SF price be at or below market in order to protect yourself in the case that you need to sell? Obviously as a triplex, this is a residential property so its value is more heavily influenced by sale comparables ($/SF) than return metrics (cap rate, CoC returns). I ultimately passed on this deal as I couldn't get comfortable with the $/SF at the purchase price however I can't help but think about it in the middle of the night and wonder if I missed out on a great opportunity to pick up a very strong cash flowing property that would have required very little maintenance or management effort.

Sorry for the long post here, hopefully you made it through it. Curious to see if any other MF investors out there come across this type of discrepancy and how they address it. Thanks and happy holidays! 

[Bill Gulley]

Actually, you should care about the value of the building that is what you're buying. The building gives you the opportunity to run a business operation, that being leasing. There are two different worlds here.

2-4 family dwellings are under the single family banner, the are not multi-family units.

The property allows appreciation and depreciation as applicable to taxes, these aspects have nothing to do with tenants or cash flow.

As pointed out above, any SF matrix can be misleading, very misleading. If you are looking at two or more very similar properties that may be a fair assessment.

Very similar= same structure, same builder or on who builds at that quality level, same age or nearly so that depreciation can be applied in a reasonable manner, style, amenities and where there is no significant difference due to location.

In my area, we have 2-3 unit dwellings that constitute most of a "neighborhood", they are along one street, built by the same contractor, there are many such neighborhoods. Looking at these properties the replacement method becomes valid with recent sales.

The SF approach is more applicable to commercial leases than sales, a retail space or office space is really on location and the space, then condition is almost the order of importance for a tenant. It's not that valid as a valuation of a residential property.

What the replacement method is showing is what the price would be if the subject property were built and then depreciated as to age and condition bringing that imaginary building back to the same condition as the subject. This is the least weighted method of the three approaches to value.

2-4 family units are single family dwellings, while investors here may not consider living in one unit, you could, it could be an owner occupied property. I mention this because in valuing a property, you need to look at the "highest and best" use, not just your intended use. I won't go into economic valuations and assumptions, but an owner occupied duplex can skew the value, it can be the highest and best use.

We use the SF analysis as a quick "banded" assessment, a 1500-1800 sq ft building, a 1800-2000 sq ft building, It can get you out of the parking lot and into the ball park, it won't get you to your seat.

1-4 SFDs are best valued from a market approach, usually. "Market" you can look up that definition as it requires several aspects to be present to establish a "market" in real estate. Sales activity is key to give most weight to the market approach. The market approach reflects what others are willing to pay, all other factors are assumed to have already been considered by buyers in the market, it also takes much of the highest and best use aspect out of the picture as that too is reflect in the market for similar properties. What the market approach also considers is the income approach, investors' considerations are included in that open market pool along with influences of owner occupied dwellings.

Now, as to the income approach that is of most interest to a single investor. CAP rates for valuations are pretty well assumed as to the "market". To an investor buyer, so long as your requirements that are assumed to be applicable to you, applying consistency, it may give you a basis for your valuation.

Investors here, small investors speaking of 1-4 SFDs, are brought to thinking of a CAP rate from an appraisal aspect to their individual situation. The CAP rate is assumed to be at a rate acceptable to investors when analyzing within the market. Investors adopting that market CAP rate may be in the ball park, might get you in the section, but most likely it won't show you to your seat either.

Bob Bowling's short comment drills to the ineffective use of the investor's CAP rate. Your operation will never be the same as the past owner. In order to arrive at a CAP rate you must determine your opportunity costs and this is something that is practically impossible to arrive at with small properties. The risks are not the same as location has an influence, property condition is never the same, in short, real estate is unique, no two parcels are the same. So, you make assumptions that may or may not be valid in forecasting a CAP rate.

The only CAP rate that is truly applicable to an investor is their historic rate, you won't know what it might be until you have experienced it.

Pro-forma accounting (estimating future cash flow and expenses) is subjective. You use an internal rate of return or your CAP rate to estimate your return on investment and your cash on cash return. This too has flaws. Using a flat vacancy rate for example isn't going to be the reality of your cash flow. 10% of your units are not vacant all year, vacancy could be broken down to days, your loss of rents would be staggered. Another assumption that is flawed is that there is an assumption that cash received is immediately reinvested at the same rate, I don't think any small investor breaks out income at irregular intervals and applies different rates to the stream of income. Too much brain damage and you're probably not going to be correct.

Your best assessments will be cash on cash and net income before taxes (NIBT). Why NIBT? Because that considers income after expenses with depreciation, this is from your income statement, you balance sheet may include principal reduction of debt and appreciation, this is to your net worth. The two reasons to be in business, income and increasing your net worth.

I don't wear my CAP rate, it's irrelevant to my goal of targeting profits and increasing my net worth. It is relevant to market analysis, but not in my personal analysis. :)