How do you overcome inflated purchase prices?

[Joseph Cornwell]

My fellow BP'ers,

I am running into a reoccurring issue lately. For a little background, I am located in the Cincinnati, Ohio market. I am looking for a 2+ multifamily property, the amount of units does not really matter to me, as long as the numbers work and it is in my target area (C to C+ area). I have now sourced 5 off market properties from different owners and have ran into the same issue. On 2-4 unit properties, they want a purchase price that typically results in zero to negative cash flow, and typically the comps in my area are showing a value above where anything makes sense at market rents, based on what sellers expect to sell for. I understand the sellers position somewhat on these 2-4 unit properties, because if others have overpaid and set the market values above what makes sense to buy at, they are hoping for another seller to come along to make the same mistake on their property, and they have the comps to support their position. 

However, I am running into the exact same issue on commercial properties, 5+ units. The past two deals I have worked on, the owners set an arbitrary asking price. I run all the numbers, income-minus expenses divided by cap rate = current market value right? Often times the actual valuation is 25-40% lower than their asking price. If someone paid their asking price with standard financing they would be losing money. When you demonstrate why your offer price is what it is, they get offended and say they would never sell for anywhere close to that price. Of course, my valuation is based purely on the financials they are providing. Even when I factor in value add opportunities by renovating units, raising rents, reducing expenses, it still would not make any sense at their asking price. 

Is this something everyone is dealing with? Am I approaching these sellers in the wrong manner? Has everyone just lost their mind and we will not be able to buy anything until the market crashes? I am honestly just trying to put myself in their position, and if I understood how real estate math works, and I knew anyone buying at this price would lose money every month, how could I possibly think I would sell the property at this price? Additionally, this particular sub market has very little to no appreciation, so it is not like someone can buy these at zero or negative cash flow and make 10% in appreciation every year. 

I would love to hear any suggestions, or from others who have dealt with the same situation. 

[James C.]

Joseph,

Welcome to real estate market cycles. We are on an upswing (some say at the top).

Here are a few things that you should know.

1) Your numbers are your numbers. You have a business plan (or should) that defines your parameters under which you will purchase. You find properties that fit that model. Anything outside of that model is a non-purchase. This is what folks mean when they look at the deal funnel, and say it takes 1000 leads to give me 100 properties to look at, which gives me 10 to offer on and 1 to buy. You can adjust your model, but always keep profit as your goal.

2) 1-4's are financed via conventional loans, based on market comps, NOT cashflow. I have yet to meet a single family that cashflows properly. Forced appreciation can work, but if you figure 10% vacancy, 10% CAPX, 10% property management, it's a tough go. 2's can work, but again, they are usually bid up to the point where they don't. Typically, 1's &2's aren't held by investors, but investor wannabes. 3's and 4's tend to cash flow better, since your buyer pool is slightly smaller and more business savvy, but depending on location they might be bid up as well, since the financing is easy.

3) 5+ units are commercial financed. Right now, there is so much money in the system, and interest rates are so low, that to have a 5 or 6 cap is great if you have (or can get) a bunch of cash. Heck, if you are making 1% (1 cap) in the bank, property at 2-3 cap sounds great. If you have a cap rate that approaches the "real" or "average" risk adjusted rate, then you won't be competitive in the market. Junk bonds are only paying 5% or so... FOR JUNK BONDS! The risk has been removed from the system by the government QE programs, and nobody wants that party to end (Actually, I would like to see it end, and it should have never started IMHO). But it will have to end, or we will go the way of Japan, stagnation and deflation, with overpriced assets (i.e. all risk removed from the market) propped up by the central bank. A risk-less market ain't good for anyone.

4) If your one trick pony is not doing it's trick, find another horse to ride, but keep training the pony. Right now, you are focused on MFR rentals. That trick pony is about tricked out. Find another horse to ride; Fix/Flip, wholesale, Air BnB, new construction, affordable housing, or something else. You need to learn how to make those horses do their tricks. Another analogy: right now you have a hammer, and you can't find a nail to save your life. Go figure out how to use a screwdriver, and go find some screws to turn. No screws? Get a drill, and go drill some holes. No holes that need drilling? Get a saw and cut something. You get the point.

You aren't insane. What you are seeing is normal for the market we are in. Could you use some polish on your approach? Yep, we all can. Get better at what you are doing, and find some different things to do, it will come. 

Also, you aren't putting yourself in the sellers shoes, you are putting your shoes on the seller. You are approaching an "irrational" market where "anything goes" in a very logical, rational (and correct, I would submit) way. If a seller can ask for and get a 3 cap, a seller will ask for 2.5 cap (and probably get it.) Stick to your model, modify as needed, and see if you can find another way to make some cash in this market. 

Hope that helps,

Good Luck!

Jim