basing analysis on future rent increase?

Question

I found a 3 unit property in good shape and in a good area near me. Its a for sale by owner and they are not willing come down on the asking price. The issue is that at the asking price and current rents, the cash flow before taxes is only slightly over $100 per month total with approx. 2.9% cash on cash return. A deal not worth doing, right? However, all the leases are on a month to month basis and the rents are about $100 below market rate. So if rents are increased to market rate, now the cash flow is just under $400/month with cash on cash return of 9%. Now its worth considering since its in a good area and I would say lower risk.

My main question is, when doing the analysis, such as using the calculator on this site, do you ever base it on market rate rents if the current rents are below market? Or is that a bad idea and bound to get you in cash flow trouble?

My main question is, when doing the analysis, such as using the calculator on this site, do  you ever base it on market rate rents if the current rents are below market?  Or is that a bad idea and bound to get you in cash flow trouble?

Sean Tracey · Answer

Are all the units currently occupied? Have you factored in any vacancy as a result of pushback from current tenants that wouldn't want to see their rents increased to market rate? That might be additional vacancy to what you would already factor in. Also 9% seems a bit low to me for what may turn out to be a not very passive investment.

Sean Elliott · Answer

Dont be afraid to walk away from deals that dont make sense.

Leland Barrow · Answer

If the numbers are so close that you have to depend on future predictions to decide to buy in a decision then it is probably too tight of a deal. You could use a decision tree to analyze this situation. If you want to keep it simple then don't buy at such tight margins. If you are confident in the numbers that you came up with for market rent then I would suggest using that. I would not calculate it off of current under market rents because that can be due to poor management on the current owners part. I also would not value it off of future rents. Today's market rent would be my choice. You have to be honest with yourself with what market rent is. If rents are lower for any other reason than poor previous management then than calculating an increase would not be market rent. Instead it would be just a contrived number.

Current Rent < Market Rent = Historically poor management = use market rent data

Current Rent < Market Rent= Non-Competitive Property = use current rent

If you are going to value add then adjust for a new market rent.

Gino Barbaro · Answer

@Michael Kissel

The first rule of analysis is to buy a property on actual numbers.  Proformas are great, but they are worthless.  The bank will only lend on actuals.  Get the last 12 months operating statements.  The fact that the rents are below market is where you are going to raise them, force the appreciation and make your profit.  If the seller says they are below market, have him raise the rent and then buy on the new income.

It is going to take a few months to raise rents, so be careful if the property is negatively cash flowing.

Gino

Omar Ruiz · Answer

I never make offers based on future rents. That's what got investors who were buying NY office buildings in trouble. As an investor you decide the risks your willing to take.

Roy N. · Answer

When we are modelling a property for analysis, we use the lower of current rents or the market median rent for the type of unit(s) in the property.   You want to be as conservative as possible when conducting your analysis to ensure the property will perform, or at least carry itself, in adverse market conditions.

Never {well almost never, there are some cases when buying turnarounds that break this guidance} base an offer on the potential of a property ... why would you reward the Vendor for the work you will need to do to realize the potential.

basing analysis on future rent increase?

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