What's wrong with this Loopnet listing w/ projected 17% cap rate?

Question

Just browsing idly on LoopNet--I know these are the pick-over and overpriced deals--and I was curious about this 3.2 million listing for a 90 unit portfolio in Cleveland with a "projected" cap rate of 17. 27%. Occupancy is at 42%--ouch. What would an experienced investor offer on this? What's going on here?

14100 Superior Road, Cleveland, OH

http://www.loopnet.com/Listing/20057500/14100-Superior-Rd-Cleveland-OH/

14100 Superior Road, Cleveland, OH

http://www.loopnet.com/Listing/20057500/14100-Superior-Rd-Cleveland-OH/

Matthew King · Answer

@Sarah Lorenz  No unicorns and rainbow analysis needed for my listing. The occupancy is so low because more than 1/2 the product needs full or partial renovation.  What is rent ready (43 units) is over 90% occupancy.  50% rule doesn't apply here, most expenses (including heat and water in some) is passed thru to tenant.  I am happy to email you the OM with a YouTube Video of the whole portfolio so you can better understand current condition, occupancy and financials both actual and my pro forma.  Feel free to pm me your email.  I can't however give you any of my unicorns, I keep those for myself.

Tom Mole · Answer

Hi @Sarah Lorenz,

Have you ever looked at a real estate broker's description of a single family home. If it's super small, they call it "cozy". If it covered in overgrown vegetation and original paint and rotted trim, then it's "cute". If it needs a little TLC, then it's a money pit and if it's "investor's delight" then it's a tear-down. Loopnet is like that but on steriods.

The proforma number are pure poop. They mean nothing! Never, ever buy at a price based on what an asset could be. You make your offer on what it is, where it is and in it current state and condition. Ignore entirely what the cap rate would be at 100% occupancy. It never will be 100%. Look to the market where the asset is in order to find the occupancy rate then round down to the lower percentile. (example: the local market vacancy rate for comparable assets is 13%, then your occupancy figure is 80% at full performance.)

Next, even when your occupancy is relatively high, you should figure the turn over rate, concessions and economic vacancies. That is to say, how do you get the occupancy up and how much does it cost to keep it there. If you can rent the units quickly, but the tenants don't stay for long, the cost of tenant acquisition can add a lot your expenses, which can have the same impact to your bottom line that extra vacancies would.

What happens when you rent your apartments out? Do you have to offer inducements, like the "first month free" or "all utilties paid"? Do you have to lower the rents you charge across the board to push occupancy north? Who do you attract when you do these things? Are those tenants going to keep paying the rent once the concessions run out? How many of these folks are you going to have to evict? If these costs were compared to the cost of lower occupancy, would you be better off to let a few units remain vacant longer?

When I look at a Loopnet listing with high vacancy I ask myself why are these units not rented. Often it is NOT due to a lack of tenants, but rather having units that are not in rentable condition. If the vacant unit are not safe, clean and livable, then they are not rentable. A unit I cannot rent is a liability, not an asset. I never pay asset prices for liabilities just because I could make it an asset someday if I put up still more investment. That's like buying a broken down VW bug just because it used to be new and that's just stupid.

Now, that being said, I look at Loopnet from time to time. I agree that Loopnet is where "commercial deal go to die" when they are not good enough to attract buyers in better market segments. Loopnet is the Walmart of the commercial marketplace, but deals can be found at Walmart because there product is priced accordingly. Loopnet has deals for someone who can sort through the fluff and deception to assess the real value in a particular deal, set a maximum allowable offer price and terms and then negotiate to that threshold.

There is great deal more to consider than the occupancy and cap rate, but I ain't writing a book here. This is just the tip of the iceberg. The point is this: a 17.27 cap is pretty good. Now get that number based on a 42% and a $100k in repairs. Your LOI should should offer something closer to $1.35M for the portfolio and then only if everything else is working great. If they won't talk to you at that price point, then sigh a huge sigh of relief, move on to the next property and let a stupid person buying that lousy listing. Never offer to pay for what a property "could" be worth.

Cheers!!

Tom Ott · Answer

I just want to point out this property is actually in East Cleveland. It is its own city, not a neighborhood of Cleveland. I would suggest doing some research on that city before diving in. It is a very risky place for an investment. Unlike the surrounding cities in the Cleveland market, that one has a large set of issues and has even considered merging with the city of Cleveland just to be able to continue to provide city services!

Joseph Gozlan · Answer

@Sarah Lorenz look at the numbers yourself.

for the cap rate to be 17% at 42% occupancy the units will need to bring $543,915 in NOI annually.

Even if you are using the 50% rule it means each unit will need to be rented for over $1,000 per month. Is that realistic for the area?

And due to the fact that this is not really a 90 units complex, it's a combination of 4 different properties, I doubt that the 50% rule is enough.

I think this broker's projections are based on unicorns and rainbows surrounding this deal.

Franco Li · Answer

To be honest, LoopNet is sort of misleading because they never provide you details on their calculations. Also, the agents who list on there tend to overvalue to make it look good.

Nicholas Novak · Answer

I might add the City of Cleveland told them they would not be annexed because of those problems. The city of East Cleveland is notoriously tough to deal with as well with tough Point of Sale inspections. Odds of ever getting this place 85% occupied are seriously slim.

Brian Ploszay · Answer

Properties in Cleveland, especially in lower income areas generally have high cap rates.   Make sure that this cap rate is not a "pro-forma" cap rate.   The description of this building suggests that it needs major capital improvements.  Those renovation costs may not be in the analysis.

Andrew Johnson · Answer

@Sarah Lorenz I think what you're seeing "risk".  Risk in that they are estimated to need between $100K and $300K of renovations.  Their cap rate is based on 100% occupancy and most people would tell you to factor in at least some level of vacancy.  Odds are it's hard to manage 90 units by yourself while managing a $300K renovation project so you'll have to add in a non-factored management fee.  You're going to have significant holding costs and *hope* that renovations won't impact your ability to rent the units that don't need renovations.

To get around optimism I usually ask a logical question:

"Why not take out a $100K loan, rehab the units yourself, get to 100% occupancy and make back you're $100K?"  After all with 42% occupancy at 100% occupancy you'd likely (easily) double you're net income raising it $172K in just one year!  So why not take a $100K loan to make $172K in cash-flow back in 12 months?  It would be insanity not to!   I hard money lender could give them $100K for a predatory 50% interest rate and still make money!  I'm being hyperbolic but you get the point.

Logical answer answer is that the owner/sellers knows there's flaws in those assumptions and risk in doing that.

What's wrong with this Loopnet listing w/ projected 17% cap rate?

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