PM & CapEx in or out for figuring Valuation???

Question

Hey BP gang,

I'm wanting to step up into the larger multifamily properties and move away from <4 unit buildings. When it comes to running financials on larger properties I know I need to include PM and CapEx expenses on a monthly basis.

However, when I'm reviewing larger properties financials many of them do not include PM or future Cap Ex savings/expenses (saving money back for a rainy day or new roof, or boiler etc...). So i stick them in the financials they provide me for my evaluation of the place.

However, when you add PM and CapEx savings to the Operating expenses it drops your NOI tremendously and then when you multiply it by the Cap Rate you get a much lower valuation of the property than the listing price.

For Example a 12 unit I'm evaluation is listed for $422K, but my valuation without PM and Cap Ex in the NOI makes it worth about $373K. But if I subtract PM and CapEx from the NOI it only values at $324K. This is a 12% Cap place according to the Broker.

Which is the true valuation for figuring out where to start making offers on the place? Do you include PM and CapEx in the valuation or leave it out?

Jeff Kehl · Answer

@Matt Kauffman excellent questions. Especially on the CapEx. Property Management should always be included as an operating expense. On CapEx though, there's a lot of subtlety going on with those numbers that get glossed over but make a lot of difference in the performance of the property.

Ask most accountants or multi-family expert and they will tell you that Cap Ex is subtracted after NOI (or below the line as someone said above) so technically does not affect the valuation. Price =NOI/cap rate is the accepted formula. So why does CapEx matter?

Well, that formula comes from larger apartment complexes where the assumption is that the property has been maintained. And if not, that ALL deferred maintenance will be taken care of by either the seller before closing or providing cash or they buyer in the 6-18 months after purchase.

Lenders on larger properties will require that that happens.

So essentially, if you leave out CapEx on your valuation you have to assume the property is in perfect operational condition. And even then, as you suggested, you need to save up (or reserve) a certain amount each month for future CapEx. Most Proformas will at least have a small CapEx reserve shown.

In this period of rapidly rising rent growth and low vacancy, a lot of this gets glossed over because property appreciation covers any problems.

So, here's what I would suggest. First, always include adequate property management expenses. Second, make sure all immediate capital expense needs are addressed by the seller or that you have the needed funds set aside in cash to make the repairs/improvements. Lastly include a monthly expense to save a fund for future CapEx preferably specifically for the items that need replaced and taking into account their age.

Joel Owens · Answer

You have immediate capex ( deferred maintenance) and ongoing capex.

Just remember most sellers are positioning the property as a (perfection property) meaning they say no deferred maintenance, expenses are low, NOI is HIGH. Great deal buy,buy,buy! LOL

When a buyer digs into the numbers the property paints a different story.

I am not so sure I would want a seller fixing items before closing. Since they are selling they tend to do the cheapest repairs possible and the buyer might end up redoing them later anyways. I also do not like lenders saying they will use a seller credit to reduce the loan amount as that does nothing for me.

I want a seller credit where I have the reserves to pull from and make quality repairs to the property.

Lot's of sellers are selling on bubble numbers the last few years ( 4% rent growth, 35% opex, 3% vacancy). Just remember everything cycles and what goes up generally must come down at some point. On the 10 year cycle average on the curve bottom from  ten years ago is generally higher in value then the last bottom. The key is if an investor has the pockets to weather a full cycle and realize the upside again on the next cycle. In 2007 I saw many get crushed with the last down turn. They were over optimistic on the numbers that a boom period would last forever. The cycle changed and now the numbers were not what they thought and they could not hold on for the next cycle. Lot's of short sales and foreclosures happened.

Funny enough some of the sellers that sold to them on the peak were now flush with cash and buying stuff back from them and others at a discount.

Historically on a broad basis for multifamily over many decades rent growth is about 1 to 2%, opex 50%, and vacancy 10%. When economy goes on a downward cycle residential tenants looks for cheaper options. Vacancy increases and rents flatten or reduce where investors fight for occupancy levels and keeping the properties afloat. If you buy based on perfection happening to make the property work you are setting yourself up for disaster.

I would rather buy NOTHING and wait for the right property then buy just to feel like I am doing something. The doing something you just got saddled with mediocre to bad debt and now it could keep you from owning a great property when it comes along. I saw that in the last downturn when I helped a seller short sale a 70 unit property. They owned about 250 units in one town of many buildings. They bought some right, some were okay, and some were dogs. When the down turn happened the dogs took all the profits from the good ones. So if they only held quality properties they would have done very well no matter the cycle but the marginal to losers were wrecking the returns on the overall portfolio.

Phil Christian · Answer

Cap X upfront:

$$$ based on immediate work you would like to do initially after closing add that cost to your basis then math out your Cap Rate (yield on cost / forward cap).

Cap X "as-needed when needed... but maybe":

For underwriting the Cap Rate put it below the line. This $$$ you may or may not do so it will negatively effect your underwriting and business plan if you unnecessarily budget.

Cap X Lender Required Reserves:

Below the line in the form of $250 a month (for 12 units).  You're Cap Rate will still look healthy but your Return on Equity will be reduced by the $250.

Ken P. · Answer

Matt, that depends on the buyer's plans for the larger multifamily asset.  If the business plan calls for spending $4,000 per unit for new flooring, paint, vanity, appliances, etc.,  allowing the investor(s) to raise rents and make a certain return, then the lender will require the funds for those upgrades be part of the initial funding, either in the capital raise or as part of the loan package.  For a smaller complex not financed through agency debt, you have more freedom to fund upgrades organically through cash flow; i.e, pay as you go.

We took the pay-as-you-go route and, while it is what allowed us to get started in multifamily investing, this route has substantially reduced cash flow for a number of years.  That's worked out OK in the early years, because I didn't need the cash flow, but patience and taking the long view is definitely required!

Matt Kauffman · Answer

@Jeff Kehl This was most helpful as I'm trying to figure some of this stuff out. This is the direction I was leaning on what to do. I did not know that the Seller would be providing all money necessary to remedy the deferred maintenance.

Just to be clear, deferred maintenance in larger multifamily properties would have more to do with roofs, windows, doors, (entrance ways, common areas), parking lots, garages, hvac, appliances etc... as opposed to units needing flooring and paint and new vanities in bathrooms?

Matt Kauffman · Answer

@Phil Christian - That's how I've viewed it but the question remains, do you include Cap Ex as part of the Valuation when determining how much money the property is worth?

@Hadar Orkibi Thanks for the input. You use some similar numbers as I do. I ran numbers on another 36 unit property that had $3500/yr of maintenance and no PM cost. The broker said the maintenance and PM was done in house as the Seller owned the PM company that did it. I say "So What", money still has to go somewhere, someone is getting paid to do a job somewhere.

@Bill Keast From the appraisal side it would make sense to include it, but when it comes to making offers when those values aren't included the true value of the property is greatly decreased.

I'm just trying to figure out where to start making offers so that I can get a contract. Once there I know that after due diligence there will be CapEX expenses discovered that need to be addressed in the negotiated price. But I want to try to anticipate those values ahead of time so we're not trying to renegotiate a bunch. No one wants that.

Hadar Orkibi · Answer

@Matt Kauffman  i always put 10% for PM, 7% for Capex, 7% for maintenance, and 8-10% for vacancy. all for rainy day. this money is actually transferred month in to saving account with the reference RESERVES.

Some banks will request that you do that anyway.

It is VERY common that P&L's don't have anything showing for the above, OR showing at a ridicules lower rate.

It is also common that some of the Capex been added to the R&M so the owners can deduct them as an expense in the financial year and Not depreciate the cost over few years.

Matt Kauffman · Answer

This thread has been incredibly helpful as I've been trying to understand all that is involved in valuing an apartment. One I'm looking at would be a great property due to its location, but due to super low maintenance, no PM, and a lack of CapEx the deal sits about $550k more than what the numbers really say it's worth.

Thanks everyone. I've revised my spreadsheet to reflect the input on CapEx and PM from everyone on how to value these properties.

Andrew Bosworth · Answer

@Joel Owens

Your post is spot on.

Here's an example…  An 8 unit property in my target area came on the market unexpectedly last week. I say unexpectedly because I have had my eye on this property for a while and have reached out to the owner in the past (via mailers). The property checked every box for me, and as a bonus, the seller was even willing to offer financing. Only problem was that his numbers didn’t account for management, capex and sufficient maintenance costs (note, there is a big difference between looking at the prior year’s maintenance expenses versus an average year’s expenses – especially when the property is about to be sold!). When factored in, the price of the property was simply too high. The realtor tried to convince me that it would be a great investment, but despite REALLY wanting this property, I had to walk away.

Had I ignored these expenses and not properly underwritten for management, capex and maintenance, I would have potentially been in a bad place down the road when a major item came along, like the HVAC, roof, etc.

Moral of the story is to know your numbers and stick to them…no matter what.  Like you said, better to buy nothing and wait for the right property instead of buying just to feel like you're doing something.

Chris Collins · Answer

@Jeff Kehl and @Ken P. man, this thread is super valuable. Thanks for your abilities to clearly articulate these nuances.  Really helped my understanding of this line item and how it works.  Love this community!

PM & CapEx in or out for figuring Valuation???

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