Negative cashflow apartment building. What to offer???

Question

We all know that it is hard to find a great multi-family deal in today's market.  It's better to "make one".  We have bought multiple small apartments 10-20 units, that have had upside potential with room to increase the NOI with increased rents and improvement management, with great success... but they all had a positive cashflow at the time of purchase.  The building we are currently looking at is a little different and I'd love some input on what you guys would do.

We are looking at a 39 unit apartment building in a tertiary market of Minneapolis.  The building itself looks great, it was built in the 1990's and and the city it is located in has had continued population growth over the past 10 years and is next to a  larger city with job growth.

I was so excited about this opportunity until I received the 2019 financials....  Negative cashflow and 20% vacancy.  Here is the question, how do you determine a fair price to offer?  If I evaluate the cap rate at the current NOI and listing price it is 2.1%, which is crazy for a high risk, negative cashflow property.  The cap rate if purchased at a price that would assume the mortgage at 2.4M would only be at 3% (with current occupancy).  The pro-forma cap rate for full occupancy (minus 5% for vacancy) for purchase price of 2.4M would be 6.5%.  Does that seem too risky?  I would hope for a higher cap rate with the risk of buying a building with only 80% occupancy.

Thoughts?  How would you go about analyzing this deal?  What would you offer?

Michael Ealy · Answer

@Karen Higgins,

I don't agree with buying this property based on actuals. In fact, I don't buy properties based on their existing Income and Expense.

Why? Because by the time I buy and operate the property, it's financial performance will be DIFFERENT than how the previous owner operated it. The property taxes will also be different because due to reassessment when the value increase or decrease based on my purchase price.

The right (although complicated) answer is given by @Evan Polaski - smart guy.

Here's a simple way I would calculate it:

Proforma Value less Capital expenses less Holding costs less Your Target Profit = Your Offer

Your capital expenses is what you pay to improve the property.

Your holding costs is your estimated cumulative negative cashflow that you need to factor in during the time you stabilize the property.

Your Target Profit is what you want to get out of the deal, i.e., once you stabilized the property and decide to sell.

Makes sense?

Erik W. · Answer

I'd work the deal backwards, same with a disaster home that needed to be rehabbed and brought up to standards.

What will the NOI be once the property is brought up to standard?

What costs will you spend rehabbing, marketing, holding?

What profit do you desire for the time and effort it takes to get the property up to standard and stabilized?

All of those components are dollar amounts.  Add them all together and work the price backward to find what you are willing to pay.  The good news is you're experienced with apartments, so should have a reasonably good estimation of what this is going to cost and how long it should take.

List price is meaningless.  Find the value the property has to offer you to make it worth your time, then make your offer to the Seller.

Fun story: My boss at my day job (VP of Info Tech at a Fortune 500 company) always negotiated with vendors the same way.  "Let's start at $0 for your product/service and you need to convince me what the value is for our company.  That will get us to a price that works."  He negotiated more "discounts" of the prices than anyone I've ever met.

I would do the same for this apartment.  The Seller may disagree.  Okay....next property!

Michael Ealy · Answer

Karen,

One other thing: you have to look at the T12 - line item by line item to find out why it's negative cashflow. An apartment building with 80% occupancy should still cashflow or at worst breakeven.

Sometimes a building is negative cashflow "on paper" because the owner includes everything in the operating expenses even including 1-time capital improvement items. For example, if they just replaced the roof for the year and spent $20,000 - that amount should not be part of the operating expenses because that's a 1-time capex item. Since the roof has a lifespan, say of 20 years, you should only include $1,000 for that year as replacement reserve amount for the roof. That just adds $19,000 in your cashflow and at a 5% cap, correct accounting increases the value of the building by $380,000.

If the accounting is correct, negative cashflow properties can be filled with a lot of hidden opportunities. If apartment turnover cost is high, that means the current owner/PM is not doing a good job getting the right tenants. If you can get the right tenants who will stay 2 years or longer, your turnover costs will drop significantly. This creates tremendous value especially under our low cap environment.

I literally made MILLIONS buying negative cashflow apartments. Tons of value-add can be created with them.

Bottomline: finding good deals in today's market is hard - you have to be good at finding "the good" in what appears to be a "bad deal" - solve the issues and by doing so, create significant value.

Hope this helps.

Evan Polaski · Answer

@Karen Higgins offers based on actuals work better for stable or light value add deals.  As do cap rates.

For a deal like this, you are getting into closer to a development model of underwriting. I.e. the NOI on land is negative, so the seller has to pay you to take it.  But clearly that is not how it works.

I would use a discounted cashflow model.  So you will need to forecast and have some sense of certainty what the deal is worth when stable and the NOI.  Then start placing in your costs and outflows and timelines to get it there.  You apply a cost of capital for you, say 15 or 20 or 25% (this is accounting for your risk tolerance) and it will land you on a present value and that would be your offer.

Greg Dickerson · Answer

I am referring to the brokers proforma. You need to base your assumptions and future values and performance on your numbers and the actuals not what the broker is representing. We are saying somewhat the same thing with one exception, I do not pay seller for future value. I use future value and work it backwards.

Ben Leybovich · Answer

Interesting. I see some of what I think great comments and some that completely miss the mark, in my opinion.

@Greg Dickerson says - you need to buy on actuals, not pro-forma. Let's think this through:

If the building is not performing and you make an offer on actuals, it's going to be a low offer that won't get you the deal. And if the building is performing great and you make an offer on actuals, then you'll have to pay a lot and there won't be any value left to capture.

So, it's kind of neither here nor there...

Paying valuations consistent with actual T12 doesn't work in the current cycle. The fundamentals are strong for multifamily and this reality has not escaped the sellers. Regardless of whether the building is performing or not the sellers want part of your future value.

Now, can you afford to give the seller part of your future value? Depends. Think of it this way:

You buy at 4% cap. Naturally, you can't cash flow that. But, if you can fix the occupancy and renovate units to improve rents by $300, then upon your basis you may be at 7.5% cap in 2-3 years. First, you can cash flow 7.5 cap. More importantly, you've created a lot of value.

So, aside for the reality that while buying on existing financials worked 10 years ago but doesn't work today, underwriting what is currently there may be completely missing the opportunity, which brings me to the comment by @Erik Whiting, which is, in my opinion, the right way to think. So please refer to it.

Now, we have to preface this by saying that it's all about the location. Tertiary markets are dangerous, specifically this late in the cycle. And, anything under 100 units is challenging. But, all things considered, this should offer some food for thought.

Good luck!

Luke Miller · Answer

@Karen Higgins you shouldn't focus on going-in cap rate for something like this. This is a value-add play that should yield you a NOI delta that you would be comfortable with. In other words, I would be okay paying a 2.1% cap rate (if it was necessary to get the deal), but the value needs to be there.

I think that's what @Ben Leybovich was trying to say, but he over explains things to seem like an expert.

Negative cash flow might only be important to you, the owner likely is just tired and has stopped trying on the property.

@Greg Dickerson is right though. I would focus on pricing based on actuals to start and only come up as the competition grows or you think there is better offer. Assuming this deal is off-market, you're going to have less competition and the seller will likely need to make the same concessions with any buyer. Your biggest risk, at that unit count, is a 1031 buyer coming in and over paying so don't compete with that.

Jacob Sampson · Answer

Couple of random thoughts.

1.  I'm not interested in negative cash flow.

2.  I would be interested in selling at a 6.5% cap rate but not buying at that.

3.  It's tough to not get excited about deals but emotion is for friends and family not for investing.  Emotion, excitement or fear, skews how you analyze a deal.

4.  I would have to dig into why the vacancy is so high.  I might interview the tenants, ask the seller.  But ultimately, my offer would be low enough so that the property cash flows based on the data I had.  Maybe you will manage it better and drive down the vacancy rate, but maybe not.  Maybe it is out of your control.  Either way don't pay for potential, pay for what is.

Greg Dickerson · Answer

Michael - you would use the actuals to formulate your offer on this particular building. It’s 80% occupied so you would take the actuals and use that info to make your assumptions and build your proforma to formulate your offer as you describe.

Cory Carlson · Answer

@Karen Higgins

Unless you’re coming under leveraged or all cash the lender is not going to lend on it. Use that in your offer and work closely with your bank on how they will underwrite it. Use the financing to your advantage. If it doesn’t cashflow then the Debt-service-ratio will not meet the 1.2 required. Use 70% ltv as the baseline and work backwards use an expense load that the underwriter would use.

Negative cashflow apartment building. What to offer???

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