Transitioning from SFRs to Small Multi's

[Matt Inouye]

Hi BP Community,

I am starting to look into multi-families as the next phase of my REI journey. (just some back history - I have a few SFRs and a duplex as buy and holds but am becoming interested in slightly bigger deals). My question is two-fold:

1 - I was hoping to receive some guidance in figuring out a "prudent" way of valuing a 5-10 unit property.  I live in a crazy-stupid expensive area of the country so I have to stress this is not a discussion of Good vs Bad deal... but rather potential ways to come up with valuation(s) based on what the market's willing to accept.

2 - If anyone invests/speculates down in Orange County California, is a 4.5% cap about the going rate for the county? or are there more specific cap rates as you drill down.

Current Scenario:

Asking: $1,000,000

Current Rents: $50,000 (ttm) - owner is under market

Expenses: $10,000 (ttm) - low prop taxes, bought in 2011

Actual NOI: $40,000

Cap Rate for Property: 4%

Potential Future Scenario:

Potential Market Rents: $70,000 (conservative... utilizing numbers 15% below what rentometer.com says is average for area)

Expenses: $20,000 (higher prop tax)

Potential NOI: $50,000

CapEX: $100,000 (to bring units up to current rent)

Avg. Cap Rate For Area: 5%

My (VERY LIMITED) attempt at trying to calculate a valuation:

If I back into this with average area cap rates (5%)  and actual NOI ($40K) I get a valuation of: $800,000 ($40,000/5%)

If I back into it using "potential" future numbers I get: $900,000 => $1,000,000 ($50,000/5%) - $100,000 CapEx

It almost seems as if the owner is trying to achieve a valuation for potential market rents without having first pushed the rent increases through.

Any thoughts on different ways to value an under-rent property in need of some capex?

Thanks in advance

Matt

[Judth Felker]

Hi Matt! I've purchased several books/programs sold by "gurus".  I know a lot about buying multifamily RE, but haven't pushed through my fear quite yet (lost over $400k in the housing downturn). I'm getting closer since finding a way to identify rapidly appreciating markets.

One thing for sure, Matt, NEVER figure the current value of a property based on "pro-forma" (what it will do in the future). Work only with the ACTUAL numbers in current time.  The owner needs to give you two documents: P & L (profit and loss) for the past 12 months (the "trailing 12"), showing you all income coming in monthly, and all expenses per month. Will the owers be completely honest about the numbers? Not to worry. After you have a signed Purchase Agreement with the owner,  your "due diligence" period begins, and the owners will give you receipts to verify their numbers. It the numbers are different from those first given to you, you change your offer accordingly (in your favor, of course).   

Once you have the P & L statements, subtract annual expenses from annual income , that number is your NOI (Net Operating Income) . Don't yet figure in the cost of money, but do figure, monthly, about 10%, or more, of the income for "Reserves" (maintenance that will someday be necessary over and above the monthly costs).

Maybe you know the formula: NOI divided by the CAP Rate (check out Loop Net to see what the going cap rate per unit is in your area) = Value of the RE you're interested in.

Ask the owner (or owner's agent if there is one), what the "deferred maintenance" is, and the approximate cost of each item. Subtract that number from the "Value" number you just discovered.

That's the offer you make.

The second document you'd require from the seller upfront is the trailing 12 "RENT ROLL" which includes the move-in date for each tenant, as well as actual rent paid, and rent owed, if any.  That lets you see if there are long-term tenants,  if some tenants just moved in, if some are nearing the end of their lease, and if there are vacancies.   Your "expense" column should provide for a small percentage of vacancies, even if now its 100% occupied. If it's 60% or even 70% occupied, I suggest you pass, because it will be hard to get that many new renters right away, and you'll be short of income.

Quick rental turn-overs are expensive because you will need to "make (the apartments) ready" each time someone moves out. I also google the address of the property to see what current and past tenants are saying about their living experiences at the subject property.  If there are complaints, you can figure whether or not a better manager (you, or someone you hire) can correct the problems, and how quickly it can be done.

Once you have your offer number (start a little low, yet don't insult the owner), subtract your cost of money. Subtract your down payment 10% -20%), then,  find out what interest rate you can get on that property. Always ask if the owner would like to keep on receiving a check after the property is sold. If that sounds interesting to them, ask for seller financing on some, if not all, of the remaining cost of purchase. Negotiate the price. If the seller wants something more of you than you're offering,

ask for something (in equal or greater value) from the owner in return.

Matt, It was fun writing this. It'd make my day if you let me know this is helpful to you! I'm also open to working with you. If you'd like to explore the option, kindly call or email.

Best of good luck!

Judith Felker