Valuations based on actual vs projected rents

[Steve Miller]

I am reviewing properties for my first purchase. I’ve educated myself here (thank you BP!) for buying a 4 to 6 unit building. My questions are:

The property details list the current rental rates and generously forecast "projected rental rates".These forecasted rates are higher than the prevailing GRM and typically are much more than a 10% increase in the current rates. When you are evaluating a property to determine sales price and valuations, how do you reconcile the current rental rates vs a projected rate?  For the most part, I can see a fair 10% increase, that’s normal and in line with the market place. I’m also one who believes in a happy tenant is a long term tenant.

I would also like to occupy a unit in the building as my residence. Do you still factor in the “rent” of an owner occupied unit when calculating the value and other valuations?

Thank you

Steve

[Joel Owens]

Be conservative not the pro-forma junk brokers and sellers are pushing. If the deal still works it should be a go.

Appreciation and rent growth is icing on the cake. If both are needed to make the cake it could fall flat and you have nothing. When you buy purchase right and plan multiple exits. Begin with the end in mind. 

[Jeff Greenberg]

@Joel Owens is correct. Go on actual numbers. Most proformas are pie in the sky, and a 10% increase seem extreme.  When I get the statement that the rents a $X under market, I asked why has the owner not done that.  I then ask is, have any of the units been brought up to that level.  If any have, what improvement were made to get the addition revenue.  

Those increases are your bonus' if they occur and you should not pay the seller for what they did not do.

I would still consider the rent of a unit that I was to occupy. It would be considered a concession.  When you sell the property you what to make sure that that rent is on the books

[Tony Velez]

Great question

[Account Closed]

Current market rent rates are what you should use. The market GRM's that you will use against that will have the appreciation and rent growth baked into them. Trying to use future rents AND current GRM's is double valuing the rent growth.

That's why you see high teens low twenties GRM's in high appreciation and rent growth areas but sub 10 in less profitable areas.

[Bill Gulley]

Never base a price on the owner's or listing broker's claims. Actually, it is more like their actual numbers less 10% because many pad the books in the expectation of a sale!

Your numbers will never be what the past owner's were, never! 

You can rely on numbers that can't be fudged: Current lease agreements, obtain a letter of verification from tenants prior to settlement. Utility bills. Their property insurance might be assumed, but check with your broker. Licenses, permits and code inspection fees (if any
) will be very similar, same with real estate taxes. Annual maintenance requirements accomplished by third party vendors under contract can usually be very similar. Example: Best Heating and Air Company, Big Green Landscaping Service, Sammy's Snow Removal. It helps to be familiar with vendors too, my rule, ignore small unknown sources for maintenance receipts/charges as many play games, larger reputable companies will have more standardized pricing.

If you can determine vacancies from lease files, good, but still be careful for leases that can't be verified by lease receipts/deposits. A red flag is a start date 1 or 2 days after the prior lease termination, same date is even a bigger red flag. 

Understand the market, the differences between apartment dwellers and single family (1-4 unit) dwellers. 

Tax returns, tax returns. tax returns! Do they match claimed NOI?

Often, small owner's (under say 24 units) won't share much information. If you're looking at a 250 unit complex, you're probably going to get a boat load and actual numbers.

You need to use market rents to buy, not your forced appreciation that you may obtain from your excellent management skills or your fix it abilities. If I fix a toilet, I want the economic benefit of the work, so your buy numbers should be in line with market rates.

Never buy based on income alone, you're buying improvements that have an economic life, maintenance and improvement factors, social and demographic factors. You may have X dollars generated today, that doesn't mean that level of income will remain the same or increase over time. An owner may already know that and begin looking at a gain over depreciated carrying value, need to recognize that as well. (BTW, also a reason owners sell with seller financing).

Consider your financing requirements, your CAP rate will never be the same as the previous owner's. How you leverage the purchase will effect your expected returns and for some time.

If you can't or don't need to flip for a MAI appraisal, ask appraisers for a letter of opinion of the market, they may be very close and at a fraction of the cost. 

Just some thought :)

[Kathy Stewart]

I ignore the pro forma, stated by either the seller striving for a rosy projection that will get your attention or by a broker striving to present best possible numbers to sell this property and move on. Definitely be guided by market rental rates-10% can be a hefty increase that creates tenant exit when 3%-5% could maintain desired occupancy.

[Farakh Zaman]

Just wanted to say as a new investor I appreciated this thread.  Received some rosy pro-forma data on a 10-plex and market rents are about 25% less than pro-forma.  

Again, thanks for the post.