How do you underwrite an apartment complex with a negative NOI?

Question

Need some help from the community. I'm meeting with a broker to walk an off-market apartment complex here in Cincinnati. The property is in a downward spiral, so I think this could be a fantastic deal with great value add/upside potential.

The problem: I just got financials today, and P&L from 2015 and YTD 2016 shows a negative NOI. Since rule #1 of multifamily investing is to buy on actuals, and NOI/CAP = value, how should I go about calculating the value of this property? The asking price is significantly overpriced (priced off stabilized/proforma numbers), so I want to be able to rationally/credibly defend my valuation and potential offer price. Any advice is greatly appreciated...thanks!

Anthony Chara · Answer

Hi Chris, there are 2 ways you can evaluate the property in its current condition. First off, since you have a negative NOI, I'm assuming the property has high vacancy. Only other explanation would be that they cannot charge enough rent in that area to offset the Operating Expenses. Either spells potential disaster.Valuation #1 is just like a SFH. The appraiser would use the Comparison Approach. What did other properties in the area in similar condition sell for on a per unit basis.Valuation #2 would be just like doing a Fix & Flip. Start with the ARV. Use proforma GPI (assuming all units are occupied and everyone is paying rent), then, subtract out the market vacancy and add in any Other Income the property would generate from things like laundry, storage, parking, pet fees, etc. This will give you your EGI or Effective Gross Income. From that, subtract out market rate for Operating Expenses (Taxes, Insurance, Management, Maintenance, Utilities and Repairs/Reserves). You should be able to find these amounts by talking to PM's in the area that manage similar properties. This will give you your proforma NOI. Using this proforma NOI you can now divide it by your Market Cap rate (NOI/CR = Value) to come up with your After Repair Value (ARV). Once you have your ARV, now the fun begins. The questions you have to answer is, "Why is the property the way it is and what needs to be done to it to get it to produce income based on these market numbers"? Let's say it's under performing due to it needing extensive rehab. Great, figure out your rehab costs, add in holding costs while you're making the needed repairs (taxes, insurance and mortgage costs) during that same time frame and then subtract that from the ARV. You should also subtract out a 'fudge factor' to be conservative. Next, subtract out what you think is a fair profit for the money you're putting into this deal and the risk you're taking in order to turn it into a performing property and you now have the Maximum you should pay for the property 'as is'. If you've never done a Fix & Flip or Fix & Hold, I would suggest you partner up with someone in your area that has a great reputation for doing them. Someone who's good can estimate rehab costs within a few percentage points of the final costs as I've outlined above.Good luck to you Chris!

Chuck Stagliano · Answer

Chris,You are buying the property today, so pro forma means nothing. Asking price means nothing. Find out what the average cap rate is in this neighborhood for similar property sales. Not listings, or pendings. Sales. Then use that cap rate as the key to determine the as is value today, based on today's true NOI. That's your absolute max price, but that will be colored by your risk tolerance and your realistic evaluation of your ability to orchestrate a turn around. You have to structure the risk away as much as possible. Once you close, the clock will be ticking on your cash burn, so know those numbers cold, and always assume that you made a 10 % mistake. Have a plan, the personnel and the capital to begin the turnaround immediately. If using private capital, have the sources and uses carefully planned. Do not overpay, regardless of what the agent tells you. As an adviser of mine says, be cynical at best and paranoid at worst.

Tyler Weaver · Answer

@Chris Washington Why is it negative? Lets assume its because poor repair. Did the owner defer all the maintenance, including turning around units? Or did the owner defer maintenance because his model was broken and he was losing money every time he fixed up a unit to rent out again to have the tenant cost him money and get evicted.. I would underwrite a negative NOI property almost the same as a completely vacant property. Basically you take the pro forma, but not theirs. You make one based off of conservative rents, and conservative figures of where the building should be. Figure out a very conservative cap rate for the neighborhood based on sales. Thats the ARV, then work backwards. Subtract out construction and holding costs. I would price it at the rate a company that does a project of that size every month, not once or twice before. For the holding costs I would calculate it based off of the market's highest rates for private lending, even if you are going to qualify for a lower rate commercial loan of some sort. This would be the calculation I use to defend any offer I made. Then I would do the same calculation for internal use. Rather than looking at all the numbers 100% pessimistically I would look at them realistically. Try to calculate out my construction costs accurately, and cost of capital with my required IRR for funds and my investors/lenders rates/expectations. My IRR would have been based off of a value add on a pre-stabilized property though, so I would also add in an extra margin to account for the risk of this project. I would want to see at least double the returns for taking on this kind of risk. Hopefully these 2 figures make sense and you end up with a starting point to negotiate from and a ceiling of max to pay. I would only use the replacement method in a neighborhood where you could conceivably want to build a new multifamily. Here is why, if there is a 10 unit building in say Avondale, that would cost 400k to build new, but is currently 100k and has 50k in deferred maintenance and would stabilize at 200k. The spread between the 150/200 and 400k is a risk, not equity. The capex doesn't care that the building is worth less than it costs to build it, or rebuild parts of it as things break down.

Scott Lewis · Answer

I've priced a decent number of complex deals, with one catch. they weren't for real estate. they were mainly for various types of complex financial derivatives that were unique and so you could not use a comparative approach (cap rate based valuation is comparative, imo).It sounds like you are going to repair the asset so it no longer loses money (duh!).after you have repaired it, what will it be worth? whats a similar unit going for in the area. you can use comparisons for that. (stabilized value)then what does it cost to fix up the complex so it is stabilized? (repair-cost)your taking a chunk of risk that there may be much worse problems than you anticipate. you need to get compensated for that. how much is fair for that? (repair-risk-compensation)next you are spending your time on this project. you need to be compensated for that too. how much is fair for you? (time-compensation)next it seems like you may have a lot of risk of having to deal with stressful situations. maybe evicting people that haven't been paying rent. maybe worse stuff. you need to be compensated for that (stress-compensation).and the last item is opportunity cost! if you do this deal, are you going to be less able to another similar deal? if yes, than you need to be compensated for that too. if not, then i wouldn't include it. (opportunity-compensate)so if we do: (stabilized value) - (repair-cost) - (repair-risk-compensation) - (time-compensation) - (stress-compensation) - (opportunity-compensation) = indifference pricewe get your indifference price. this would be the value that you would be indifferent if you got or lost the deal. lets say the stabilized value is $1M. and the sum of all your decrements was $500K. gun to your head you would do the deal $499K and would pass $501K. not you have to try to maximize your excess value.lets say you think a $480K offer has a 100% of being accepted. a $450K offer has a 50% chance of being accepted and $400K offer has a 30% chance of being accepted. what do you offer?480K gives you 20K excess value. 450K gives you a 50% at $50K excess value, which is worth $25K to us (.5 * 50K), and $400K gives you a 30% shot at $100K of excess value, which is worth $30K to us (.3*100K). in this little play example, i set your offer at $400K and hope for the best.anywho, again, no experience valuing multi-family units, but i do have some good experience valuing stuff that is difficult to value.

Derek Carroll · Answer

Chris Washington great questions and of course it's all negotiable. You'll get more data the more comps you can get. Call some brokers and appraisers and they might give you a few minutes on the phone. Maybe you'll get enough data where you can do a weighted average. Or back to your original question if you don't get the comp data that you need to adequately value the property then you could use a gross rent multiple on potential and actual rents for your valuation. That should make it easier to compare different unit types. Now once you do come to a value conclusion then my approach would absolutely be to only pay for the rentable units. In fact I'd probably use that as a starting point because if a substantial number of units are down then there's likely deferred maintenance on the common areas and exteriors as well. Now all that said Multifamily is hot right now even though many experts are saying that we're at a peak. You might find that others are willing to outbid based on the above analysis. Sophisticated investors will consider all of the above but not as strongly as you might think. They're simply going to look at a transaction, how much capital they are deploying and what the expected return would be based on projected income streams. If the Expected returns are above their required minimum then they will pursue the project. With yields on other asset classes so low right now some investors are willing to accept very low returns on real estate which is why prices have been bid up. You could do the same type of analysis as another data point to evaluate if it makes sense for you. Figure out a return that you'd be comfortable earning for this project and its associated risks (see cap rate derivation explanations if you want to know the particulars of how to determine this) and make sure that you don't pay over that amount. It also should be in line with the analysis that you did in the first exercise above.

Derek Carroll · Answer

Chris Washington I absolutely would not use replacement costs as a valuation metric. In fact if you look at any large Multifamily appraisals and they don't even factor it in as it is almost irrelevant. I would use comps on a per unit basis as a starting point for a max value and negotiate down from there. No way seller can expect you to pay for value that you create. If they do then you likely don't have a deal.

Anthony Chara · Answer

Hey Chris, here are answers to your questions above:1-You just use the average 'Per Unit Price' just to get you in the ballpark. However, you can talk to Commercial Brokers or Appraisers in the market to get a much better feel for the per unit price. And, yes, you are correct. If the average price in the area is $25K per door and your subject property has all 1 bedroom units, then your Comparable price would be lower. Again, you're just using this information to get you in the ballpark. Assuming you get it under contract you will still need to have an appraisal to confirm or disprove your assumptions.2-I personally don't know any good GC's that don't over-charge for their services. That's why I suggested you partner with a good rehabber in your area. They usually already have their own crews lined up to do work at reasonable rates. On the other hand, using a GC that will give you a very high estimate is extra ammo for you to knock your offer price down.As far as what you can and can't do before submitting your LOI, that all depends on the seller. Some sellers prefer that you walk the property before putting in an offer. Some won't let you on the property until you have a signed contract. Either way is fine, but you don't want to take too much time before going under contract doing 'Due Diligence' work and end up losing a great deal, because you tried to analyze the deal to death before putting in an offer.Lastly, I'll be in Cincy this coming week speaking at REIAGC. Perhaps I'll see you there?

Roy N. · Answer

@Chris WashingtonYou've received some poignant advice from Anthony and Derek.One additional caution I'll pass along is to make certain your pockets are deep enough. Turn-arounds often become more complex once you start digging into them. They can also take far longer to stabilize than you think - particularly if this is your first kick at a broken apartment complex.If you can find an experienced local partner with a few of these under her/his belt and deeper pockets, your chances of a successful, timely, turn-around would be greatly enhanced. You may get a smaller slice of pie in the end, but the education will be worth it.

Tyler Weaver · Answer

@DL Martin You might be able to weigh in here.@Chris Washington I have not closed a deal like this before. But from the research I have done, I would say there are commercial banks that would approach such a loan. They are going to want to see substantially more skin in the game than something with a positive NOI, it will most likely be a short term note, they are going to want you as the borrower to be strong, they will want to see that you have been involved in deals like this in the past successfully, or you have done business with them in the past and this is a logical next step.

Chris Washington · Answer

@Anthony CharaThank you VERY much for your detailed response. Those are great suggestions. Couple of questions:1. For the valuation #1 approach, how do you account for a variation in unit mix? for instance, if the comparable sold at $25k per unit, but contained 1, 2, and 3 BR units, I imagine you wouldn't want to pay $25k/unit if your target property is only 1 BR, right?2. I will see the property tomorrow, but I believe it's got a higher than average vacancy rate and a few down units. Is walking the property with a GC the best way to figure out rehab costs? Should this all be done before or after submitting an LOI?