Buying on actuals vs pro forma

[Barri Griffiths]

I've always heard and believed that you should only buy on actuals. But I've been hearing more and more of the experts buying at a low cap rate(5-5.5 and even lower)

Therefore I'm assuming they're buying on what the property can achieve in the future. 

There is a property that I've been looking at that have rents that are $100-125 below market.

 And I believe I could comfortably get $75 more per door without having to do any improvements.

A lot  of the tenants are month to month, so I could implement this pretty quickly.

How are these experts buying at such a low cap, and still giving their investor a good rate of return?

And is it unreasonable for me to buy on what I believe I can get the NOI to pretty quickly?

[Andrew Johnson]

Barri Griffiths It's hard to know motivations for investors. You have to balance cap-rate against location. A 5.5 cap in San Francisco is insanely good. A 5.5 cap in urban Memphis is likely insanely bad. So you *might* be seeing investors taking appreciation gains from SF/NYC/etc. and putting them into *less hot* (but still good) markets. There's also an argument that money is still cheap and interest rates will rise. In short, there are a ton of potential reasons. And we are nearly 10 years into a housing recovery, you can't expect cap rates to stay idle during a decade long appreciation market. Banks are also becoming a little more lenient than 5 years ago so that helps market competition. People that walked-away or short-sold their home 7 years ago have had 7 years to rebuild their credit. Again, increasing competition. But now I'm rambling...

And banks still pay squat in for a checking/money market account and very few people want to lock their money up in bonds... 🤷🏻‍♂️🤷‍♂️

[Darryl Dahlen]

CAP rates are all over the place in some markets and the affect is bleeding into the lending aspect. I closed a Class C property in Dallas that had a CAP rate in the 5s, but that's only because the price/unit is so high there that it's driving down CAP rates as most multifamily properties there are at or near market rents.

As far as using actuals vs proforma, you want to buy on the actuals and use the any financial upside as your "meat on the bone". The lender will use actuals and any future financial gains, whether they be through made through rehab/upgrades or through increasing the NOI, are speculative.

[Jeff B.]

IMO, an investor does not buy because a neighborhood or City has this or that CapRate (unless they are wet behind the ears). Especially in MFUs, the REI is purchasing a cash-flow stream. Therefore knowing FMR for the area and getting the rent-roll are paramount to understanding what day-1 ownership will look like AND how much better it can get with forced appreciation.

RE Agents quickly quote pro-forma but these aren't worth the ink to download and print.  Always require the rent-roll, 2 years of Sch-E and PnLs

[John Barrows]

pro-forma is a view at a possible future price and not what you should pay today. Like buying a business, would you pay for future sales or what sales are today? Now, with that said, let's make the case. If you rare buying a multi family unit with very low rents but, with very few issues (no maintenance issues), the roof has been replaced etc.... then that might be a buying opportunity especially if the rents can be raised to MEET THE MARKET rents. 

Let's say your exact property one block away is renting for $1000.00 per month and yours is renting for $750.00 per month, that is instant equity that a good manager can recover for instant income. Also, if the owner is paying for utilities, that can give you INSTANT INCOME by using the RUBS SYSTEM (RUBS)= Ratio Utilities Billing System, which is legal in most any state.. Do your home work and (YOU GET THE REWARDS)......

[Karen Schimpf]

@Barri Griffiths,  

I agree with @Darryl Dahlen and @John Barrows Prior to 2008 Financial Collapse, lenders accepted pro forma, but since than, lender only base the numbers on actual.  Since lenders will be using actuals, why pay more for a property (or business) based on pro forma?

[Andrew Johnson]

Barri Griffiths On a side note, I always think it's a little dangerous to assume management incompetence. You did say you think you could raise rates without repair. That implies that the property is in good condition today. If an owner or PM is keeping up the property they probably care about it. If they care about it they likely track the market and know appropriate rent levels. It might be a different story if the property was in disrepair, mismanaged, had large vacancies, etc. In short, you could see material evidence of mismanagement that would make you think you could correct that and get an increase in top line revenues. But, as others have said, you don't pre-pay for potential or you efforts (unit turnover does require effort). And getting to that greater topline revenue costs money: turnover vacancy, getting units rent ready, potentially a leasing fee to a property manager, etc.

[Austin Fruechting]

Originally posted by @Barri Griffiths:

 I believe I could comfortably get $75 more per door without having to do any improvements.

And is it unreasonable for me to buy on what I believe I can get the NOI to pretty quickly?

 Here's what I would say: Let's say current rents are $600 right now. Rents could be $675 without any work other than implementing the increases and a little turnover.  If the price is representative of $625 according to your criteria, then I would say it's not unreasonable to go ahead and give the price, even though at current rent for the price it is a little below your criteria.  If the price is representative of close to the $675 according to your criteria then I probably would not.  

Edit to add: I am in this situation currently and  under contract with 32 unit portfolio.  Based on the portfolio I would normally want to be around 1.7% rent/purchase.  It's only at 1.6%, but without having to upgrade anything they will be at 1.85-1.9%.  

[Kevin L.]

@Barri Griffiths great question!

I am working on a deal right now and we put together current financials AND a proforma for the banks, but banks really only care about the current financials (although it does give them more confidence to see that you have a plan for the future).

Have a hard target in mind for your ROI on this type of deal. If your projections hit your required ROI then it is not unreasonable for you to buy the property.

[Austin Fruechting]

Originally posted by @Andrew Johnson:

Barri Griffiths On a side note, I always think it's a little dangerous to assume management incompetence. You did say you think you could raise rates without repair. That implies that the property is in good condition today. If an owner or PM is keeping up the property they probably care about it. If they care about it they likely track the market and know appropriate rent levels. It might be a different story if the property was in disrepair, mismanaged, had large vacancies, etc. In short, you could see material evidence of mismanagement that would make you think you could correct that and get an increase in top line revenues. But, as others have said, you don't pre-pay for potential or you efforts (unit turnover does require effort). And getting to that greater topline revenue costs money: turnover vacancy, getting units rent ready, potentially a leasing fee to a property manager, etc.

 This is good advice.  Dig into everything.  It could be management, or their could be market reasons the rent rate is what it is.  Assume first its the market and figure out for certain if it is, but it could just be renting low. 

In the ones I'm buying, they are using a professional management company too. The owner has had them for a long time and just hasn't raised rents very much over time. Their strategy was to rent below market, have long term tenants and little/no vacancy. 

[Andrew Johnson]

Austin Fruechting Yup, you're right on the money. Trading raising rents 7% for 7% vacancy leaves you (give or take) in the same spot at the end of the year. I have one tenant who asked for the paint color we use in a unit because he wanted to do some touch-up himself. He also replaced his own garbage disposal because "he broke it". So, for that tenant I could argue my "below market rent" (by maybe $20-$30 per month) is more than made up for by reduced expenses and (better) upkeep. Now that could all change tomorrow but, for the moment, I don't want to spook him with a rent raise. The challenge is this so much of this stuff isn't even in the *actuals*. I'm rambling (bad habit) but until you own the property it's not quite so easy to get the full benefit of rent increases. You also have to figure out if those higher rents come with the owner paying some (or all) utilities. Make sure it's an apples to apples scenario.

[Austin Fruechting]

@Andrew Johnson - yeah, I have a lot of rentals about $25 under market for that exact strategy. Either because it's an amazing tenant or just to limit vacancy. It can often provides higher NOI.

The portfolio I'm buying now though, everything is 20% under market rates which is crazy, but great for me!

[James Wachob]

@Andrew Johnson well said. We are seeing 7.5-9% cap rates on fully TurnKey properties in the desirable rental areas of Memphis. Higher cap rates are achievable in lesser desirable areas or with homes that are not fully TurnKey renovations. The key is to find a great team! Ideally you would find a company that has everything under one roof. Acquisitions team, renovation crews (fully licensed and insured), Property Management, and a Real Estate Investment Brokerage in case you ever decide to sell.

By teaming up with a solid firm you can mitigate your risk and have some "boots on the ground" that have your best interest in mind.