How to underwrite an apartment building that's unoccupied?

Question

All,

I need some advice from the community. I'm in the early stages of analyzing an apartment complex for sale in my target area. It's currently unoccupied so I'm at a loss as to how to underwrite it properly. It may be too much of an endeavor to remodel, but that has yet to be determined.

There is an interesting back story: the current owner sold the property about 14 years ago to another investor after remodeling the entire property (he described it as being in  "immaculate" condition at the time). The new owner proceeded to neglect the property to the point where the roof was actively leaking into many parts of the top floor. The township shut the building down and forced the owner to have all the tenants vacate since he couldn't afford to fix the roof.

The property went into foreclosure and the previous owner purchased it back. He got an estimate to put on a new roof, but hasn't provided it to me yet. I think he got involved in franchise investing and no longer wants to go through the hassle of dealing with another remodel of this building, so hes trying to wholesale it.

Its a 20 unit brick building that is 100% vacant. He says many of the units are in good condition and that hes not aware of any active mold or structural issues (needs verified obviously). The roof was fixed in a temporary manner to prevent further damage and active mold. He said the roof needs repaired, the top units need remodeled, the building needs cleaned. Then it should be able to go back on the market once the township approves.

Although this is a lot of work, if there are units in good shape that can be immediately occupied once the roof is fixed, I would be willing to take on this challenge for the right price - hence why I haven't been scared off yet. Hes asking around 450k. I ballpark a new roof to be somewhere around 100k. At the time he sold it, $650 was the average rent - which have since increased.

I dont know how to underwrite it since there is no income currently being generated and I dont understand what comps could be used. Comps from other buildings would be based on income, so aren't they essentially irrelevant? Should I take $/ft^2 from single families in similiar condition and extrapolate it to the square footage?

Thoughts?  Thanks!!!

Nick B. · Answer

Use rents not sale prices from the nearby apartments as your proforma rent comps.

Use expense budgets provided by a few management companies that manage similar size properties as your proforma expenses.

Once you have these two numbers find out your stable value as:

value = ((proformaRents * economicOccupancy) - proformaExpenses)/marketCapRate

Economic Occupancy is maximum potential rent minus physical vacancy and loss-to-lease.

Discount this value by your expected profit and by immediate capex and transaction costs. This is your maximum offer price.

Brian Burke · Answer

@Nick B. nailed it, but I’d add to his last sentence. If your intent is to flip it, you should also subtract holding costs.  Don’t forget loan interest, utilities, insurance, security patrol, grounds keeping, etc.

If your intent is to hold it, follow Nick’s advice above, then create a pro forma income statement for however long you intend to hold it and then forecast your exit price using the formula that Nick outlined using the forecasted income in the year you plan to sell.  Next, ramp up the income over the first year or so as you lease up.  Then you should be able to calculate your IRR and set your acquisition price at a point that allows you to achieve the IRR that you feel is a good return for the risk.

The challenging part in either of these scenarios is estimating what the utilities and service contracts (landscaping, trash, etc) will cost because you don’t have the benefit of historical financial data. I suppose you might be able to get what the seller’s expenses were back when he owned it the first time and apply a growth factor.  That’s probably as close as you’ll get.

Todd Dexheimer · Answer

As @Brian Burke said, make sure you add in holding costs and then some. I know from experience that holding cost can become very large with a vacant 20 unit. You will have all the regular expenses with no income. Then when you start to rent it, you have leasing fees as well. If the renovation is estimated at 6 months, then budget for 10 months of holding costs.

Joseph Sangimino · Answer

@Nick B. @Brian Burke @Ryan Cox @Todd Dexheimer @Yousif Abudra

I very much appreciate the guidance and advice. That’s the beauty of Bigger Pockets – decades of wisdom in a matter of hours on a complex deal for someone like myself.

This would be a long term buy and hold for me. I didn’t properly account for the holding costs at first – which are staggering for this building (particularly insurance).

I’ve considered the collective advice in my analysis and am going to need to cut his number way down. The next step is to get a better grip on the rehab numbers – most importantly how many units can be occupied with only minor repairs. After walking the building, I’ll need to approach the township for their input since I imagine they have a laundry list of required repairs (since they shut it down).

He’s an experienced investor and seems willing to work with me on it. If anything comes of this deal in the near future, I’ll fill everyone in on the details and numbers. If I need to walk away, I’ll walk away.

Thanks for giving me the confidence to move forward.

Yousif Abudra · Answer

@Joseph Sangimino  The answers above are all correct.  Analyzing vacant, value-add properties such as this is much more difficult because you need to do a thorough analysis on market rents and market costs.  Not to mention estimates of rehab costs.  As @Brian Burke correctly pointed out, the holding costs are likely to be significant, especially if the property is located in a small town.  It takes a while to fill a vacant building, sometimes your best strategy is to offer discounted rents/incentives to get it filled, and then bring up those rents to market over 12-18 months.

Ryan Cox · Answer

@Joseph Sangimino  I would make sure to walk the property and each unit to assess the definition of "good shape"  There are a couple of method's that you could use to determine the value of the property which is currently unoccupied.  The replacement cost method & the net present value method.

(Replacement) The rule of thumb is to be a buyer of real estate when prices fall below replacement cost, and a builder of real estate when prices rise above replacement cost. Therefore, replacement cost is the line in the sand — the base line to assessing potential value creation opportunities.

The NPV method determines a real estate investment asset’s intrinsic value by finding the present value of future cash flows.

Future sales price. Use a capitalization rate appropriate to the asset’s location, class, and product type that conforms to trending market conditions. Forecasts for capital markets, the local economy, and real estate fundamentals should reflect a safe cap rate when modeling future sales prices.

Income and expenses. Forecasted income and expenses should be reasonable and supported by factual data. Forecast lease-up absorption on vacant properties using market standards. Also, use industry standard expense benchmarks in model assumptions.

Discount rate. The discount rate should reflect market conditions. An increase in the discount rate from 7 percent to 13 percent would reduce the NPV

Investment strategy. Modeling a stabilized property versus a high-vacancy property requires different forecasting assumptions. Use worst-case scenarios to offset potential forecasting and assumptions errors, especially on properties without a consistent operating history.

Because NPV involves future cash flow, it is critical to forecast accurate assumptions when modeling a property investment.

How to underwrite an apartment building that's unoccupied?

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