Evaluating a rental property

[Account Closed]

Hello everyone. I'm new to real estate investing. I might have stumbled on to my first investment. My brother-in-law's mom owns a hair salon with two apartment units on top. She owns the building free and clear. Her husband has cancer, so she's looking to sell the building to be able to retire, and spend more time with him. I'm interested in doing a seller financing deal with her. Right now I just need help with evaluating the property to determine a sale price. Currently the owner uses that salon for her business, and she rents the two apartments to relatives, who she charges far under market value for. When she sells the building, the salon will be empty and also be another revenue stream. If anyone has some advice for helping me determine the value of this property, I'd appreciate it. Thanks!

[Shane Pearlman]

Hey @Account Closed - that could be an interesting deal. I just finished doing due diligence on a split use building in Seattle (hair salon + clothing shop at street level + 7 apartments above). Here is what I learned about pricing in the process:

Step 1: Cap Rate.

The price of your building is really based upon the annual profits that it can offer an investor.

The location of the building, its state of repair, desirability, and the market conditions define a cap rate range. Start by figuring that out. In the case of Seattle, cap rates are 3.5-6%. That is what the market (body of investors competing against you) will pay, although good luck finding a 5 cap right now. 

Do you know your local cap range? If not, go talk to other local investors, maybe ask on BP, as well as a few realtors.

With the cap rates in hand, then you can use the NOI to determine a price range.

Step 2: Determined NOI

First income. I had active leases on all units, as well as a property manager I trusted to determine the difference between the current and market rents.

It sounds like you probably can't depend on the historic income. You might consider calling a couple commercial retail brokers to find out what rents look like for the lower space. 

The residential should be easier and a mixture of craigslist + pm's can get you an estimate.

You'll also need to figure out what the vacancy rate is like in the area to factor into your equation. If you have never done commercial before, be aware of what can at times be much longer vacancy periods, as well as the costs of tenant improvements.

Second Expenses. There are a million posts and articles on how to determine expenses. Brandon Turner just did a nice one (http://www.biggerpockets.com/renewsblog/2014/12/02...) and ben had an interesting rebuttal (http://www.biggerpockets.com/renewsblog/2014/12/16...). 

The biggest thing I have personally noticed is missing small things that add up. Like an arborist service I have to get once a year to keep a few trees from eating the roof alive ($300/yr I wasn't expecting on one of our duplexes). That and underestimating the impact of cap-ex. The longer I've owned our buildings, the more long term investments I find myself doing (like buying over 10k of washer / dryer + kitchen appliances this year).

Imagine you had 3,000 in rents and 1,000 in expenses, then your NOI is 2,000 / month. Again, no loans go into this.

NOI = Income - Expenses

$2,000 = 3,000 - 1,000

Step 3: Your Price!

If your NOI is 24k for example (2k / month of profit if you own it outright with no loan) and the local cap rate is 5 - 7%, then the price should be between $342,857 - $480,000.

Purchase Price = NOI / Cap Rate

$342,857 = 24,000 / 7%

$480,000 = 24,000 / 5%

If you plan to get a bank loan, then you also need to take their minimum debt service ratio into consideration. If the case of the building in seattle, I need the price to be 50k lower than the seller was willing to go to appease the bank's desire for a 1.2 ratio (or put in another 50k cash). It broke the deal.

Lastly, if you have a loan, then you need to factor it in and make sure the cashflow meets you personal investing criteria. I'd avoid a monthly loss like the plague, and make sure that the cashflow provides enough profit compared to other opportunities. 

Good Luck!!