Multifamily Property Valuation

[Davit Gharibyan]

Hi fellow investors.

I was evaluating a 88 unit complex and based on T12 financials it runs 69% expense ratio. Based on the actuals it is worth $4.2mm.

Now the property doesn't have a listed price and they are looking for the highest market bid. However they have mentioned they are looking for an offer in $9mm range, which is based on around 50% expense ratio.

The property is obviously mismanaged and has a high expense ratio. The deal is to reduce the expenses to increase the value, and the rents are below market so there is a potential there as well.

How would you come up with the valuation? Based on the actual financials or the story that the broker is selling?

Your feedback is greatly appreciated.

[Brian Burke]

Originally posted by @Davit Gharibyan:

How would you come up with the valuation? Based on the actual financials or the story that the broker is selling?

The answer:  Neither.

Actual income and actual expenses have only partial correlation on how this investment will perform if you manage it properly. And the broker’s proforma has no correlation at all.  But both of them tell a story, and your job is to interpret that story.  Here’s how.

You have to build your own income statement.  And not just a one-year.  You need to go out ten years.

Start with a market study to determine what similar units are renting for in the area, and what condition those units are in (and be sure you are comparing to similar size and vintage as to the subject).  Use that data to build your rent roll and your renovation plan.

Now that you have your target rental income, build in line items for ancillary income such as late fees, application fees, pet fees, utility reimbursements, etc.  Now build in economic vacancy deductions for physical vacancy (using market averages with a cushion), loss to lease, concessions, credit loss and non-revenue units (model units, employee discounts, etc).  

Next, compare your forecast to actuals.  Most likely, if the property is mismanaged or un-upgraded, you’ll notice that your income forecast is a lot higher than what the property is producing today.  This is where your multi-year forecast comes in.  Set year 1 to be roughly equivalent to what the property is doing today. That is the income you will inherit. Set year 3 or 4 to equal your forecast. Set year 2 higher than year 1 and year 3 higher than year 2—this is where you are ramping up from current performance to well-managed, upgraded performance. 

On the expense side, increase the actual utilities and contract services (landscape, pool, trash, pest control, etc) by 3%. Calculate the management fee based off of your management company’s rate and each year’s income on your forecast. Calculate the property taxes based on what the taxes will be after you buy it—not based on what the seller is paying (the number will likely be vastly different).  Get typical expense numbers for advertising, general/admin costs, and repairs/maintenance and ongoing capital improvements from your management company and use the higher of those numbers or the broker’s proforma. 

This gives you a NOI for each year in your 10-year forecast.

Finally, factor in debt service for each year. This gives you your cash flow. Now you set your price to a point where your cash on cash return and IRR are acceptable to you. You can calculate a cash on cash return for each year, and you can calculate a sale price using the NOI in the year you plan to sell, and using the proceeds from sale and each year's cash flow you can calculate IRR.

This is how the pros do it. Those who say to just use actual income and a cap rate are completely missing the boat and are the ones saying that everyone else is paying too much, are crazy, or whatever.  That works for me—the more offers the seller receives for half of the property’s true value the better my offer looks.  :)