evaluation of multifamily property

[Isaac Geller]

Hi BP!

I am an investor from Israel and recently had an offer to join a syndication for a buying of a multifamily unit in NJ. The offer sounds tempting since  the group has to finance about 3M$ (the rest comes from a bank with a low interest) and the building is bought about 1.5M below value, so when we sell we should expect a 50% return when selling which should be 3 years from now.

The thing that bugs me is the way the building value was evaluated, i am copying a section from the presentation:

"Market activity has shown similar properties consistently trading in the 4.75-5.25% cap range (refer to “Comparables” slide for specifics). Using this approach, keeping with

conservative rent growth and vacancy assumptions, and factoring in the fully matured real estate tax amount post-abatement, the Y1 projected cash flow of $570,561 ($670,561

adjusted down $100,000 to account for the fully matured RE taxes) would value the asset at roughly $11.4M at a 5% cap - a substantial savings from our purchase price of

$9.8M. This evaluation is further supported by a recent CBRE pricing opinion of $11.5-12M"

What they done is evaluate the price by assuming the return is 5% annual. From everything I know about US RE the returns should be much higher, but maybe certain markets has lower returns. What do you guys think?

[Brian Burke]

@Isaac Geller the disconnect here is that you are confusing concept of "return" with "cap rate".  The two are not the same. 

Income real estate is "valued" by cap rate, which in the simplest terms means you take the net operating income, divide it by the purchase price, and that is your cap rate.  In this case they are saying that "similar properties (are) consistently trading in the 4.75% to 5.25% cap range", which, depending on the class of property and the market in which it is located, could be true, or at least in the ballpark.  Only the comps will say for sure.

Nevertheless, the cap rate doesn't equal the return to the owner or investors.  No, not even if you are paying all cash like some people would incorrectly say.

It's entirely possible to earn a double-digit IRR on a 5-cap property. It's even possible to earn a double-digit cash-on-cash return on a 5-cap property (although less likely in the early years of the investment). 

For you, as a potential passive investor in a syndicate, you are most concerned with how much money you get back, and when. In other words, your return, both cash-on-cash and IRR. While there are reasons why cap rate is and should be part of the discussion, your return isn't one of those reasons.

What are those reasons?  For one, is the cap rate commensurate with comparable sales for similar properties?  For another, is the investment sponsor forecasting that the exit cap rate (the number they are using to calculate the exit value) is the same, higher, or lower than cap rates today?  (hint, if they aren't forecasting higher, beware).  While on that topic, are they even forecasting an exit value, and are they showing that in their underwriting??  If they aren't, perhaps they haven't thought that far ahead and that's just downright scary.

Your return can only be determined by a thorough underwriting where you see how the cash flows through the deal.  You should see the rent going in, the expenses going out, the debt service being made, capital improvements being made and the waterfall to the investor; and follow those numbers from start to finish.  If there is a break in the flow, watch out.