Commercial Valuation Confusion

[Bethany Fannin]

I am relatively new here, and I am in the process of reading Brandon Turner’s The Multifamily Millionaire vol. I (it’s also credited to Brian Murray, but it seems that Brandon has mostly written vol. I and then Brian might be more involved with the writing of vol. II).

In Chapter 9: The Multifamily Millionaire Model, Turner explains how you can use the cap rate formula to increase your ability to make wealth.

He explains cap rate and how it is related to NOI and property value, which all made complete sense to me and was incredibly interesting (I love numbers).

However, he starts to talk about how you may sometimes overpay for a property because you are not necessarily worried about what the property is worth today but about the “long-term play.” This is what he says verbatim:

Notice that, based on a 5 percent cap rate, the property is worth only $1,228,600. Then why would you consider paying $1.3 million for this property - $70,000 over value? Because of the long-term play. You know the property can be improved. You don’t care as much about today’s value, because today’s value doesn’t tell you about the property’s possibilities. Some investors might think you were crazy for buying this deal for more than it was apparently worth. You’re not worries because you didn’t buy it for today.

This doesn’t quite make sense to me, because why would I pay someone else for the value that I am going to put into the property? Perhaps it is different when it comes to commercial real estate versus residential, but if you are going to renovate a SFH or even a MFH, you wouldn't pay more for it because you plan to improve it - if anything you pay less?

When I searched the BP Forums for "commercial valuation" and "commercial value-add" I saw some information about people finding deals where the seller wanted to sell a commercial property for when it was "Stabilized" - but this seems slightly different than making improvements that go beyond filling vacancies.

Obviously I have far less experience than Brandon Turner! And, to be honest, I am not even in the process of looking for a 4+ unit property (yet), which is what this section is referring to, but it drives me nuts when I read something I cannot understand.

[Henry Clark]

He is referencing value add.  Realize that would be based on your efforts, versus the current sellers, but you would be willing to pay above market if you plan to make a lot more by doing the value add.

I prefer to pay below market, but if the zoning is hard to find, if the potential value add is great, or the finance deal is wonderful, then I would pay above market.  If I pay $70,000 above but can make $400,000 more in both cash flow and value appreciation it's a great deal.

1.  Let's say it's a house sitting on 20 acres.  You can cut the house off on 5 acres and sell for a little less than you paid for the total ($150,000 less).  But you can subdivide the remaining 15 acres into 3 lots and sell each one for $200,000.

2.  Church- who wants to buy a church?  All of BP and other investors are looking for a nice 3/2 they can do a quick fix up and either flip or rent out.  You might be able to split into 4 rental units.  Rent out parking.  Sell off lots. Rent out space annually for $30,000 to Firework tents.  Etc.

3.  Nasty- I like nasty properties, because there is less competition to buy and more money to be made.  Not referring to clean or dirty.  The church above is a nasty property because most investors can't get their heads around it.  Could be a low spot or swamp area.  You put a sign up and contact dirt contractors and tell them they can drop off "Clean" dirt there.  Years later you have a great location worth a lot of money.  Or you buy a property nearby with a hill.  Make money leveling the hill, but also filling in the land with the low spot at the same time.

4. Look at MLS. Look for the Oldest (Nasty) listings first. Let your creative side figure out how to make value out of it.

Thats what he is referencing.

[Bethany Fannin]

So he's not saying to pay for all of the value you will add - simply that you might pay a bit more than it is worth today because you know you will be adding much more value?

I guess I would think you would always want to fight to pay as little as possible? Or is this a situation where you would do this only if you would lose the deal otherwise?

[Henry Clark]

Correct.  Only if you would lose the deal or could not find a similar deal priced "correctly" to your expectations.  

Right now, for example there is a town on a $300,000 property let's say that is zoned correctly, I would pay $400,000 for it.  Because I can't find property for sale in that zoning.  I am willing to pay more because in 2 years, I can add $1mm value add on that property.

We just sold some properties.  The buyers and we the sellers both got what we wanted.  They will be able to increase their value by $500,000 in 1 month just by sending out a rent raise letter of $10 per unit per month.

Do this. Look on your local MLS. Sort on the oldest SFH listings of 6 months or more. Anything with 10 acres or more. Go to your county or City Planning and Zoning website and see to what degree you can subdivide. Then make a post here, give the details and do a deal analysis on how to make value add money out of that situation. Your tag line says Raliegh, NC; thus, should be some high-priced real estate in that area.

Also look for a church or daycare for sale that has been listed for 6 months or more.  Do a deal analysis on them.

[Nick Maugeri]

Quote from @Bethany Fannin:

I am relatively new here, and I am in the process of reading Brandon Turner’s The Multifamily Millionaire vol. I (it’s also credited to Brian Murray, but it seems that Brandon has mostly written vol. I and then Brian might be more involved with the writing of vol. II).

In Chapter 9: The Multifamily Millionaire Model, Turner explains how you can use the cap rate formula to increase your ability to make wealth.

He explains cap rate and how it is related to NOI and property value, which all made complete sense to me and was incredibly interesting (I love numbers).

However, he starts to talk about how you may sometimes overpay for a property because you are not necessarily worried about what the property is worth today but about the “long-term play.” This is what he says verbatim:

Notice that, based on a 5 percent cap rate, the property is worth only $1,228,600. Then why would you consider paying $1.3 million for this property - $70,000 over value? Because of the long-term play. You know the property can be improved. You don’t care as much about today’s value, because today’s value doesn’t tell you about the property’s possibilities. Some investors might think you were crazy for buying this deal for more than it was apparently worth. You’re not worries because you didn’t buy it for today.

This doesn’t quite make sense to me, because why would I pay someone else for the value that I am going to put into the property? Perhaps it is different when it comes to commercial real estate versus residential, but if you are going to renovate a SFH or even a MFH, you wouldn't pay more for it because you plan to improve it - if anything you pay less?

When I searched the BP Forums for "commercial valuation" and "commercial value-add" I saw some information about people finding deals where the seller wanted to sell a commercial property for when it was "Stabilized" - but this seems slightly different than making improvements that go beyond filling vacancies.

Obviously I have far less experience than Brandon Turner! And, to be honest, I am not even in the process of looking for a 4+ unit property (yet), which is what this section is referring to, but it drives me nuts when I read something I cannot understand.

Brandon Turner is a big thinker, which is partly why he's had such success. This question is best answered with a financial approach and hopefully will be super simple. 

Let's say the below 10 unit is being offered at $800K: 

Property: 123 Anywhere, USA

GOI: $75K ($625/month)

NOI: $45K

CAP: 5.6

You love this opportunity because you understand it's potential - more importantly, how to realize the potential. 

Proforma GOI (market): $120K ($1K/month)

NOI: $78K

CAP: 5.6

ARV: $1,392,857

Refinance 70% LTV: $975K loan amount less $560K balance = cash out at $415,000. $415K less rehab costs at $200K (20K/unit) = NET $215K

You would pay a % of the future value in this example, you certainly (and neither would he) wouldn't pay $1,392,857 for an asset generating $75K per annum, understanding that the value therein would be offered at a 3.2 CAP. You pay more because the upside is significant.

Consider also: thinking even a bit bigger - depreciation write-off on a $1.4M asset is now around $30K per annum. A five year hold with the example reflects: 

Cash out refinance (NET tax free): +/- $215K

Cashflow assuming 6% interest at 900K: $42K

Depreciation write-off: $150K

Realized income: $407K ($81K per year)

Now, paying $800K for an asset which might be actually worth $750K (6.5 CAP) seems worthwhile. Ultimately though, if you're financing then an appraiser will/should keep everyone honest regarding value.

[Paul Azad]

Sounds like the author is justifying a reason to overpay for something.

Isn't Brandon Turner the guy from Open Door Capital Fund? Which has now stopped investor distributions? And has many very unhappy limited partners on the syndication threads? From reading some of those threads, it seems like ODC was overpaying for commercial real estate in the last couple of years using floating rate short term maturity debt with limited rate cap insurance, and got caught when 10yr went from 2% to only 4.2%. You may not want to finish reading that book....

[Evan Polaski]

@Bethany Fannin, this the is issue with any "educational" content: university included.  There is the theoretical/mathematical way of doing things then there is the real world.

Most deals are NOT going to be valued by cap rate, at least at purchase.  Cap rate is a valuation at one point in time.  If you think rents are going to grow 20% per year, every year, for the next 5 yrs, you will look beyond today's value, and start pricing in the future value.

Really, most buyers are backing into a desired IRR and/or cash on cash return, and backing into a viable purchase price.

You should understand general cap rates, but again they are not the preeminent valuation tool in the real world.

[Henry Clark]

OP, I would narrow your approach and focus down, otherwise you will go into overload.

1.  Don't answer.  How much money do you have for a downpayment and for repairs?

2.  What is your financing mechanism?  What percentage downpayment will be needed.  

3.  1 and 2 determine your deal size.  Example:  have $50,000.  Will need to put 25% down on a commercial deal.  That means you can do a $200,000 deal.  This helps narrow both your learning and searching, also the people you deal with will appreciate being able to narrow down the discussion.

4. Then decide on your investment type.  Usually your first investment starting out should someone hinge around your living costs, thus your rent becomes part of the cashflow for the investment.  Realize your saving money right now though.  Then you have to fit to your life style.

5.  You might try to do two types of investments up front.  A.  Cash snowball.  Quick fix/flip or other you sale and make cash.,  B.  Longterm cashflow and appreciation.

6.  Based on 5 above, then start to learn and get experience.  

7.  Luckily you as a new investor have far more strategies and strengths than an existing investor with multiple properties.  Go to a local realtor.  Tell them everything about yourself.  Ask them what kind of programs you can get.  There are actually 0% downpayment deals and lower interest deals out there depending on your locale and situation.  Then come back and make a post.

Key is to narrow down your search and learning.

[Don Konipol]

without getting into the question of any particular real estate 'personality's" success, or lack thereof, I can unequivocally state that the "rules" change in each differing economy.  The "formula" that worked in 2008 doesn't work in 2024.  BUT, there are some BASIC principles that are universal; also, each investor ought to have rules they follow the sum of which will depend on the risk vs return they seek.  

[Don Konipol]

without getting into the question of any particular real estate 'personality's" success, or lack thereof, I can unequivocally state that the "rules" change in each differing economy. The "formula" that worked in 2008 doesn't work in 2024. BUT, there are some BASIC principles that are universal; also, each investor ought to have rules they follow the sum of which will depend on the risk vs return they seek.

[Graham Rider]

Just gonna add my 2 cents. Your basis is forever, when your basis is right even a bad market makes you money. When you overpay, you are only making money in good markets. 

As an investor, you do due diligence to determine the value and risk of the asset. A good way to think about caprates is they quantify risk. The 10Y T-bill is 0 risk, as the risk grows you expect a return reflecting the risk. This can quickly help you figure out if you are paying a premium or a discount for the expected future cash flows of the asset.

When you pay more for an asset, (lower caprate) you assume the risk is lower.  

In my market right outside of DC, often considered recession-proof with some of the best demos in the country, I know of multiple projects where the current owners paid too much have foreclosed, or are bleeding money as they try to get projects stabilized and paying for themselves. Controlling your basis is very important and the quickest way to do this is to not overpay. This allows you more options for exiting, it also means you do fewer deals but they pay more.

[Bethany Fannin]

Quote from @Don Konipol:

without getting into the question of any particular real estate 'personality's" success, or lack thereof, I can unequivocally state that the "rules" change in each differing economy.  The "formula" that worked in 2008 doesn't work in 2024.  BUT, there are some BASIC principles that are universal; also, each investor ought to have rules they follow the sum of which will depend on the risk vs return they seek.  

This is exactly what I was wondering about. I am reading several books that seem to be popular/recommended - of course, I believe they were written by the creator of this website, so naturally they would be recommended by this website - and I am trying to decipher whether they are universal principles or things that worked at that particular time for that particular individual.

As far as @Henry Clark 's suggestion that I narrow my focus to exactly what I can do now - I appreciate that perspective and will not bang my head against the wall about this topic. I am not yet ready for commercial investments, but I will be one day and figured there is no reason not to start learning the basic principles about cap rates today. However, maybe this is something I should set aside for the future so as not to be overwhelmed as you suggested! I appreciate the time you've taken to respond to this and will follow your lead!

[Chris W.]

I don't post here often, but I do like what Henry Clark had to say earlier about choosing properties that have been on the market for a LONG time.

I used that strategy for a 1031 exchange from a small condo to a 6ish thousand square foot commercial office building (no experience). The property had been on the market for 3 years, but was located in a downtown historic district. The owner REALLY wanted to sell because they were retiring, so I drove an aggressive bargain.

2.5 years later a $15 million dollar redevelopment project straight across the street is starting to lease apartments and some 1st floor commercial spaces. My due diligence was EXTENSIVE because I was a newbie. I knew it was only a matter of time for that property to be redeveloped and also where the city itself was focusing their efforts (which my property is on that main street).

Never read a book about it....but that doesn't mean you shouldn't learn or read up before you commit serious funds in the commercial space. In my opinion it has similarities to residential, but also a different monster as the other posters have said. It can move like molasses too, so your asset may take time to sell if you choose to exit.

All this said, and I don't have a single income producing residential property at the moment....something I'm working to rectify.