market is 8 cap, rent under market price, selling for 5 cap?

Question

Hi all, I am just starting to evaluate multi-family deals and came across a 23 unit multi-floor complex. I received its financials today and upon looking, it's 12-months performance puts it at 5 cap, and factoring in mortgage puts CF negative. Local market for properties around that age and class should be selling at 8 cap. Given the covid situation, a lot of tenants are behind on their rent. I'm guessing some of this is expected since trailing 12 months starts on May 2020 back during the eviction moratorium.

Pro forma shows 8 cap, obviously I am not paying for proforma and then doing the evicting and fixing for free, would it be a reasonable strategy to try to get it at 6.1 cap and then slowly raise rent to 8 to 9 cap or is this not ambitious enough? Or should I stick to 8 cap and move on if the owner won't budge? I know his purchase price and I don't think he would come to an agreement above 6.1 cap.

Thank you all.

Nick Robinson · Answer

@Allen LiWhat @David Brent and @Spencer Gray are trying to tell you is do not take what the brokers tell you as gospel.  Trust but verify.  The other thing is your too concerned with CAP rates.  Brokers are always telling me how great deals are based on CAP rates.  You need to look at the CoCr, total ROI, yearly ROI etc.  You should be offering on properties and offering at prices that make the numbers work for you.  Also just another thing on CAP rates yes you can "make more money" with higher CAP rates but CAP rates also determine risk.  If the CAP rates are super high its usually a riskier investment than a property with a lower CAP rate.

Jeffrey Donis · Answer

As many have mentioned, we are seeing 4-5 caps in our area. 6 caps are rare but we do see them every now and then. 8 caps we have not seen in a long time.

Allen L. · Answer

thanks all, great points. Think less about sales cap rate since the property is not stabilized, instead think about what the projected cap rate can be given my strategy to reposition the building.

Spencer Gray · Answer

I would worry less about what cap rate you're buying at and more what your projected returns look like after implementing your business plan.

Every investor is different, but I wouldn't consider a project if there was strong cash-flow, unless there was an absolute clear and concise plan to quickly stabilize the property and increase cash flow. If you are having to do some serious repositioning, your projected returns should reflect the risk involved.

If your model shows too low of returns, adjust your purchase price. Offer at, or below that purchase price. If it's not in the ball park, then move on to the next.

David Brent · Answer

Just for fun, let's assume this is a "C" class at about $100k a unit and your price at 6.1 cap is $2.5M (NOI = $150k).

To "raise rent" to move it to a 8-9 cap is a big lift.   Take the ((8%/%6.1)-1), and that's 31%.   That means you need to increase NOI by 31% ($150k to $196k).   Assuming T12 has a 14% vacancy/non-payment (trailing 12 mos National Average) and rents are increasing just ~2% a year... even IF you drop vacancy to 7%, it would be VERY hard to see you closing more than 9% of that gap in Yr.1.   And that assumes no increase in R&M or other expenses.   And that gets you to just 6.7%.  But thats a lot of IFs in the first year.   Having purchased my first 24 unit in November, I have learned rather quickly how foolish it is to take broker or proforma numbers with more than a grain of salt.   Even the T-12 can be manipulated with deferred maintenance or even off the book expenses to prep the property.  I'd agree with what Bryan said - ignore a lot of that, and make an offer where even with conservative estimates you get positive CF!

Bryan Hartlen · Answer

You should be making offers at prices that drive cashflow and an overall return that you're comfortable with.  That said, if your return expectations are out of sync with the current market you wouldn't expect many deals to be accepted.

If you don't think your offer price isn't going to work, look for other ways to improve the deal (alternate financing, new income streams, etc) to see if you can bridge the gap between his asking price and your needed returns.

Allen L. · Answer

I was quoted 8 cap from my broker. The local market is closer to 8, it’s one of the highest cap markets with decent population size in the US. Maybe it’s closer to 6 now.

David Brent · Answer

I would REALLY question the proforma math behind an 8 cap.  Things have changed this past year, caps are sitting MUCH closer in the 4-5 range as shown in the t-12...