Broker providing different cap rates. Which to underwrite with?

Question

Hey!

I'm trying to underwrite some properties and a broker often sends info like this:

Currently 65% Occupied. The  Projected Net Annual Operating Income at 100% Occupancy with units  leased at market rates is $109,500 or a 17.5% Capitalization rate at  the asking price of $626,000.  The 2019 Projected Net  Annual Income based on 62.5% occupancy is projected to be $35,896 or a  5.73% Cap Rate.

Is he trying to say the cap rates for comparable properties are 5.73% or 17.5%? What would I use to underwrite the sale of this once stabilized? I'm assuming the stabilized cap rate is somewhere in between there?

Thanks for any help!

Chase Louderback · Answer

@Nick Brown

The broker is projecting that if you lease all units to his interpretation of market rates and are at 100% occupancy then it will be equivalent for 17.5% cap.  He then follows up with the 5.73% cap rate assuming you do not gain occupancy and probably don't increase rents.

5.73% sounds like a high cap rate for a property that must be so distressed that it can receive a yield of 17.5% upon completion of a reposition.  You will have to connect with other brokers to see what the current market cap rate is for a similar product in order to determine your stabilized cap rate.

Ask the broker for the T12 and RR to determine what the actual NOI has been the past 12 months and what the story of this property is.  Then you can determine what the upside is based upon lease up, bumping rents, renovating units, etc.

Sounds like it is overpriced, but if you are interested in the property you can do the legwork and then have a strong basis for a lower offer.

Theo Hicks · Answer

17.5% = $109,500 / $626,000

5.73% = $35,896 / $626,000

Neither of these cap rates should be relevant to your underwriting. Determine how the property is currently operating, how it will operate once you take over and stabilize, the costs to bring the property to stabilization, and how long it will take to stabilize the property. The output should be a yearly budget with a yearly cash flow. Then, thru an iterative process, determine a purchase price that will meet your return goals.

Immanuel Sibero · Answer

@Nick Brown

...Is he trying to say the cap rates for comparable properties are 5.73% or 17.5%?

Neither. Those cap rates are calculated using numbers specific to the property being offered for sale under various different scenarios. The broker is just showing you that he can do math.

I would ask the broker what he thinks the prevailing "market cap rate" is for the area for the type and class of property being offered for sale. I would also verify this market cap rate with other brokers/investors in the area. The prevailing market cap rate for a particular area is the average cap rate of recently sold properties that are comparable to the property being offered for sale (i.e. comps).

I encourage you to do a search on apartment underwriting right here on BP. There are some very experienced apartment syndicators that you can learn from. Among several important steps in underwriting is start with accurate, actual financials... so ignore "proforma" or "projected" numbers.

Cheers... Immanuel

Gwyeth Smith · Answer

@Nick Brown it looks like the broker is trying to give you a stabilized CAP rate (17.5) and an actual CAP rate (5.73).  Neither of those are the market CAP rate for the area.  IMO, CAP rate is of little value when analyzing non-performing assets (occupancy less than 85%).  In a situation like this you want to find out why the occupancy is so low and what needs to be done to get it to appropriate levels.  Figure out how long that will take and at what cost.  Then run your projected numbers and calculate other metrics like cash-on-cash return.  You can then use the market CAP rate (which he has not provided) to figure out how much equity you will have created in your project.  I'll second what others have said here.....Don't trust the brokers numbers.  Always verify yourself.

Chase McArthur · Answer

@Nick Brown

Disregard his numbers. I assume that CRE isn't this brokers full time gig. If so, he should reconsider his specialty.

Truthfully, given the 37.5% vacancy rate, the property's cap would be my last concern.

The property is grossly over priced for starters. If my calcs are right, rents are currently around $300 and market is around $537. If that's right, then why are vacancies at 37.5% when the GPR is over 44% below market?

The asking should be set based off of comps and T12 data, not proforma. Let's safely assume a 12% cap, at 62.5% occupancy with rents at $400 your looking at an asking of $425k. I highly doubt this property is in any position to set the market, so he is way overly optimistic with that kind of asking.

PM the address I'll pull some Research for you.

What part of Ohio is it in?

Bjorn Ahlblad · Answer

@Nick Brown relying on cap rate in that situation would give you a limited or false picture of what is going on. How do we know what numbers the broker included or where they came from-never assume broker/seller numbers are accurate. I would look at everything else..............what are comparable rents for that building and area. What is the building like and what is the tenant class. You can do taxes from the municipality or county website, water and sewer from the city. etc. If you get serious about the deal explore further.

Nick Brown · Answer

@Immanuel Sibero Thank you, I just sent him an email asking his thoughts on the current prevailing market cap. It did seem extremely arbitrary for him to include the cap rates which don't really mean anything.

@Julia Bykhovskaia Totally agreed, not sure what the point of even including those caps are. It's a C class property in a C class neighborhood, 17 units. The 62.5% occupancy is the current occupancy.

@Bjorn Ahlblad Thanks, I'm just doing a surface level valuation and haven't dug into the nitty gritty. I'll definitely be asking more than 1 broker for the area cap rates, thank you!

Julia Bykhovskaia · Answer

Such an odd way to present the info. 17.5% is crazy high for a stabilized property. Tell us more please - what's the area like (average or median household income?) how many units and why is he assuming occupancy drops to 62.5% this year (from a 100%) and STAYS there the whole year?

Broker providing different cap rates. Which to underwrite with?

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