Help With Offer On First Apartment Complex

[Reggie Youngblood]

I came across a seller that was looking to sell a 8 unit apartment complex out here in Houston. Problem is, I have no idea on how to evaluate the property to make an offer. I have the rent roll and P&L statement, since I know they will be needed. Can anyone here help me with this?

[Ben Reese]

Reggie,

Forgive me if I get too basic here. In buying any rental always keep this in mind: It is only worth the net income it is able to generate. Consequently, a thorough verification of the gross income and expenses is critical. While such a verification is easy in theory, unfortunately many sellers will talk up the income and talk down the expenses.

The data you sent over does not look complete to me and it is difficult to tell if these are actual numbers or pro forma estimates. A rent-roll should show a monthly payment history so that you can see who is delinquent, what rents are in arrears, and which units are vacant. This will assist you in predicting future income. Ask the seller for 3 years of “actuals” for both the income and expenses. And ask him for the full rent-roll, not just a summary. As a crosscheck I always ask to see tax returns to confirm if they are consistent with the P&L. A lot of the time an owner won’t share the taxes, but it never hurts to ask.

Once you have a good history on the income and expenses it’s time to ask a few questions and make adjustments to the numbers so that you can predict the property’s performance. What is the condition of the building and its systems? Are there expenses looming such as deferred maintenance, old roofs, faulty, heaters plumbing and so on. You’ll also want to see if the property taxes will go up based upon the sales price. In some jurisdictions this can be a substantial bump.

When evaluating a complete P&L I make my own adjustments to the income estimate if I see obvious vacancy or turnover problems on the rent-roll. You can do this by coming up with an expected annual loss figure or you can just reduce the income by a expected loss percentage. And I adjust the expenses by removing items that are related to the seller's financing (unless I'm assuming it) such as Amortization and Interest. You'll also want to remove Depreciation if shown, as this is a "non-cash" expense item. Lastly, look at the expense history to see if the seller has expensed what was really a capital improvement. If he has, great, leave it in the expenses as a negotiating item while knowing that it is an expense that won't recur. Adjust the property taxes to reflect the new post-sale amount, add in a replacement reserve to cover things that wear out and you'll have a ballpark figure on what the actual cash expenses are expected to be. Your goal in this is to get an accurate estimate of the property's Net Operating Income (NOI) as this drives the property value based upon your desired return.

The return you are looking for is up to you. You'll hear the term "CAP Rate" which is simply the amount you are earning on your cost of the property. Market CAP Rates vary depending on the quality and type of property. As a buyer I generally want to buy a property so that it produces a 9% or better return. ( A "9 CAP" in other words). My basic return formula looks like this: (Gross Income -Adjusted Expenses) / (Purchase Price + Required Improvements) = Return on investment.

Shortened up: NOI/Cost=ROI

Assuming the building you are considering has no deferred maintenance and assuming the seller's Net Operating Income (NOI) figures are correct then to obtain a 9% return you would want to buy the property for $24,151/9% = $268,344.

If you choose to finance the property then the terms of your loan and the amount of your down payment will determine what your return on your invested cash or ‘Cash on Cash” return is. I can help you with that if you like.

Ben