What are your thoughts about this potential deal?

Question

I'm looking at buying the apartment building I'm currently renting in & potentially the building next door with seller (same seller  for both buildings) holding note @ 7.5%.  The 2 multi family buildings fit together perfectly on side by side lots as if they're one complex with a courtyard.  I have a 762 FICO and can put up to 25% down on both buildings.

Some instant appreciation may be attained by updating the units and a Community Redevelopment Assoc has begun improving the nearby (less tan 1/4 mile) beach access road to attract more businesses & beach goers, which hopefully will also lead to added natural appreciation in time, once completed.

So, am I doing these numbers the right way and what are your thoughts about this potential deal(s)?  Thanks!

BUILDING #1
Built 1969
Current Owner Purchased in 1977 for $142,500
10 apartments; Two = 2BR/2BA, Eight = 1BR/1BA

INCOME APPROACH 
$67,500 PGI x .50 = $33,750 NOI / 0.075 (Min 7.5% CAP Rate Desired) = 
$450,000 Estimated Value

CASH on CASH RETURNS
$67,500 PGI x .50 = $33,750 NOI - $30,206.04 Debt Services = 
$3,543.96 Before Tax Cash Flow / $90,000 Down Payment 20% x MAO = 
0.039 Cash on Cash Returns

---
  
BUILDING #2 
Built 1973
Current Owner Purchased in 1989 for $157,000 
Legal 3 family; Two = 2BR/2BA & One = 3BR/2BA (Currently being rented as three 2 BR's + 1 Effic)

INCOME APPROACH
$31,800 PGI x .50 = $15,900 NOI / 0.075 (Min 7.5% Cap Rate Desired) = 
$212,000 Estimated Value
 
CASH on CASH RETURNS
$31,800 PGI x .50 = $15,900 NOI - $14,230.44 Debt Services = 
$1,669.56 BTCF / $42,400.00 Down Payment =
0.039 Cash on Cash Returns

---

BUILDING #1 + BUILDING #2
INCOME APPROACH
$99,300 PGI x 0.50 = $49,650 NOI / 0.075 (Min 7.5% Cap Rate Desired) = 
$662,000 Estimated Value
vs.
$721,210 Tax Assessed Value

CASH on CASH RETURNS
$99,300 PGI x 0.50 = $49,650 NOI - $44,436.48 Debt Services = $5,213.52 BTCF / $132,400.00 Down Payment of 20% = 
0.039 Cash on Cash Returns

Joel Owens · Answer

Dave how much land are those 2 buildings sitting on??

Older vintage product which would be C and D buildings being by the beach most likely in an A to B location were built on more expansive lots as land was more readily available.

In most area land is now at a premium so things are much more compact and tighter.If you have a bunch of land next to the beach you might have a re-development play in the future.

7.5% CAP rate on that vintage of a building is pretty weak.Most with that vintage want a 9 to 10% return.

To drop almost 133,000 into a property for an annual 5,000 return if everything goes perfect is crazy in my mind.

With that much money you should be able to leverage yourself into a much larger project.

Given the age of those buildings when you re-model you will have to conform to the new EPA lead certification rules and procedures which run the costs up.

What about deferred CAPEX?? If the buildings almost need new roofs,mechanicals,etc. then most of your cash flow projection went out of the window.

Your 7.5% with deferred CAPEX could become 5.5% in year 1 and 2 because of major repairs.It also depends on how long you want to hold it.

Paul B. · Answer

I think your cap rate is way too low. In my mind, your cap rate should always be higher than the cost of the debt, or you are getting debt-like returns for equity-like risk. That makes little sense, at least to me.

Either the cost of your debt is too high or the cost of your equity is too low. I'm thinking the latter.

David Beard · Answer

Has the seller even thrown a price out to you, or are you just working off this $662K number that you came up with.  I assume he did tell you he'd finance at 7.5% for 30 years.

Have you looked at getting your own financing?  It's probably advantageous for him to seller finance, as he can spread the taxes out via an installment sale, so don't pay more because he'll carry the note.  You have good credit and cash, so might be able to get a loan at a local bank.

The 2% rule for C properties (get 2% of purchase price per month in rents) suggests that you shouldn't pay more than 50x monthly potential rent, or $414K.  And if there is immediate deferred maintenance, you would need to subtract that off your offering price (or at least half of it, since you'll have new components).  If you can't get into this ballpark, move on.

Combined with the 50% expense rule, that gives you a 24% gross return and 12% net return/cap rate.  C properties trade in the 10-15% range typically, though you need to run sales comp in your immediate area to validate.

Mark Small · Answer

I'd consider that an ultra low cap rate.  I might consider that type of cap rate if I was 75 years old, didn't want to work anymore and there was a long term triple net lease.

But what happens the minute a heating system goes out or you have a few months of vacancy or some other large expense or decreased income occurs.

If you can't find properties at higher cap rates than that, I'd strongly suggest you either move or at the very least develop a method of investing outside of your area.

It is very easy to think of the town you live in as your world.  There are parts of this country you can conservatively make 20% cap rates now.

What do you think the potential upside is on a property that has a 20% cap rate and sold for more than twice what you're buying it for at its "high water mark" compared to the property you described?

Mark Andrew Small

Dave House · Answer

I've heard of the 1% Rule (get 1% of purchase price per month in rents) so how are the 1% & 2% rules used and where can I find a list of these mathematical guides or rules of thumb & how to use them?  Also, what is a C property?

Thomas Ashton · Answer

Dave,

First, you do not "select" a cap rate.  You observe cap rates in the market place by seeing what similar buldings in the marketplace have sold for recently.  You then ascertain what the NOI is for those recently sold buildings and determine the cap rate.  This cap rate is then applied to the NOI of your potential deal to determine a valuation (NOT investment return!).  When the cap rate is greater then your cost of debt, you will realize increased return with leverage.

Second, debt and equity returns are VERY different.  Debt returns are generally less risky then equity because the debtholder has a legal claim to getting paid back.  For example, if the debtor defaults, the debtholder can sue for whatever collateral is securing the debt, which in the case of mortgage debt is generally the asset (building) that secures the debt.  Equity does not have a legal standing and therefor is riskier.  That is why equity holders are generally wiped out in corporate bankruptcies.  SInce debt holders have a legal standing, they generally become the new equity holders.

Third, equity returns should always be higher then debt returns.  The seller is requiring high interest because one of two, or a combination, reasons.  Either the building is high risk or the borrower (you) is high risk.  In those cases, the cost of equity would also be higher.  If the buidling and/or borrower is low risk, then the interest rate on the debt should be lower since the debtholder is more assured of being paid back.  Likewise, the riskier the project becomes, perhaps because of leverage, then the equity returns should be correspondingly higher.

Hope this helps.

Joel Owens · Answer

Is the criteria you have to live there OR can it be any investment ??

Major maintenance I don't count in the 50%.With major immediate improvements needed your cash flow model will be severely impacted beyond the  normal accounted for repairs.

Example they could have been running 30% total expenses by managing themselves and cutting every corner known to man rigging their property.

Your landlord said he is older and wants to retire from land lording.

Now  you need to check HOW BAD he wants to retire.

Does he want to finance you?? If so what is the lowest price he is willing to take ??

What are your thoughts about this potential deal?

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