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.

[Alina Trigub]

@Omar Khan perhaps you can make recommendation to @Davit Gharibyan

[Robbie Reutzel]

@Davit Gharibyan

Always based on actuals. I would call the broker and explain your rationale. You’re probably not going to get the deal but it’s better not to overpay. This is not always the rule, if the property is massively inefficient and you can still do a cash out refi or sell on your planned exit timeline it can sometimes make sense.  For the vast majority of deals just do your valuation based on actuals, present your offer and let the chips fall where they may. 

Don’t be too discouraged. We recently had a similar situation. We underwrote a 120 unit property at $8M and verbally presented our offer only to be told they were expecting something in the $14M range. They are under contract for $13.5M. Somebody overpaid by a lot. Don’t be that guy. 

Good luck!

[Omar Khan]

@Alina Trigub Thanks

@Davit Gharibyan Actuals unless you own units in the market (i.e. inside knowledge) or have a ton of experience with these types of projects. 

Easy way: NOI / Market Cap Rate

Hard way: Deep-dive analysis accounting for the past as well as  looking at, potential, upside in rents and downside in expenses. 

@Robbie Reutzel is right. You probably will not win the deal. But, at least, you can start a conversation with the broker. Don't be the dumb money in the deal and overpay.

[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.  :)

[Robbie Reutzel]

@Brian Burke, understood. I assume you were referring to me when you commented about offering half the true value. You obviously have a ton of experience and I won't begin to questions your expertise but this particular property is substantially cash flow negative at 80% of the seller's ask. We obviously do run projections and base our exit strategy on IRR but this was not a case of a workable deal. It's under agreement at a 3 cap.

Totally with you on looking at projections, where we are in the market cycle and value-add potential. 

[Brian Burke]

@Robbie Reutzel I wasn't meaning to call you out!  What you posted is a very common belief and something I hear many many times from many many people and see posted on the BP forums quite often.  And there are certain cases where that approach is very true and I'm 100% on board with you.  My post was to counter that very common approach and give the budding investor (and experienced alike) reading the BP forums another tool.  

That said, in a broad sense most real estate is worth the true picture of it's potential rather than a capitalization of the previous 12 month's of the current owner's failures.  Don't get me wrong--if I can get a deal at a 6, 7, or 8 cap on trailing actual income (which is artificially grossly depressed as a result of bad management or whatever), I'd be thrilled!  But that is the unicorn.  It happens, and every time it happens someone writes a post or book about it and then everyone reading thinks that's what happens all the time.  Then you start seeing posts about "why can't I get a deal, everyone is overpaying!".

To that point, I've bought deals at 3-cap on actuals and made a killing and I'm sure everyone else thought I was crazy--until I sold it.  And after the sale all you hear is "how did you get such a great deal?".  Ugh.

On another interesting note, I recently sold a property in Texas.  I had 13 offers.  One was around $6-1/2 million.  Ten of them were over $9 million.  Five of those were over $10 million.  The one guy at $6.5 was underwriting only to actual, or so I would guess.  But a property is worth what a willing buyer will pay and there were five people willing to pay over $10 million.  I'm sure the $6.5 guy (who was all alone way down there) was saying that whoever bought it was crazy, didn't underwrite correctly, used broker proforma, or whatever.  He just missed the point.

[Davit Gharibyan]

Brian, this is great information. I am underwriting this property and doing different scenarios for the next 10 years. The property has very high expenses (supplies, utilities, etc.). As a general rule if I hire a property management company, would I have to pay the management company fee, the manager's and caretaker's salary and repair costs? Or does the property management fee includes the salaries? I understand that the I have to cover the repair costs. Can you please share your ideas?

Thank you again.