How to value negative cash flow

Question

I've had a lot of deals like this come across my desk, they are 5 million dollar and above. These are preforeclosures and REO and they are negative cash flowing usually because there around 50% occupied.

How do I value properties like this
456 units
50% occupied, no deferred maint. but REO
asking north of 9.4million
negative 120,000 per month
potential 364,416 per month

so with those numbers taking 15% vacancy
potential 309,753 per month divide by 2 = 
potential 154,876 per month NOI

10 million @ 7% 30 years = 66,530 per month debt service

so with 85% occupancy potential NOI after debt service
1,858,512 - 798,360 = 1,060,152 per year or just over 88k per month.

but currently around 50% occupancy the property is losing 120k per month.

so how do i value something that has negative cash flows like described above?

Ralph S. · Answer

I'd take Mike's evaluation and take it one step further.  Even if a prospective buyer thinks they have the magic key to turn it around, it's still very overpriced.

Whatever reason for the 50% vacancy, this is a distressed property and the price should reflect performance achieved, not performance AS IF you were able to pull off what the previous owner couldn't.

Seems like selling a building as if value is intrinsic to the building (~$21K/unit), without recognizing it for the failing, distressed business that it is.

Reminds me of those who claim rents less PITI equal cashflow (all the while losing their b*tts), or "rents could be raised," and price a property "as-if" it were true.

If you coulda, you woulda, you can't or didn't, and who's going to reward the seller who didn't with a price as if they did?  The buyer of this property would be exposing themselves to tremendous financial risk, and if they can indeed turn the occupancy around, they should be GREATLY rewarded for their risk taking, hard work and success, and not have to succeed where others have failed, to simply earn a good return.

You'd have to fill an additional +/-200 units while not lowering rents or incurring additional expenses?  Tough nut to crack.  Price as business, not as building or "as if" and only after discovering if there really is a magic key to success.

Owen Hogarth · Answer

Thanks for all the advice guys, Norm Chrostowski was correct I was just trying to figure how to value these but Ralph and Mike laid out some good points about why the property is 50% vacant.

From speaking with the controller *its in receivership*

the previous owners used the complex like a bank and kept borrowing against the property, when the markets turned they lost it, during the foreclosure process the vacancies skyrocketed now its bank owned, they are just holding it on the books.

with that said, the market has been a rental area forever and occupancies hang out in the 90's, in my calculations i did 85 just to be conservative.

Jon Holdman · Answer

I think I might approach it as a rehab.

You say its a good rental area, so that implies it could get filled to a reasonable amount.  Its a big building, so the 50% rule gives you a good best case number.

If its a REO or pre-REO and in receivership you can bet your bottom dollar it has deferred maintenance.  You need to figure out what it's going to take to being it up to the local standard.

Its going to take a while to fill those vacancies.  You could treat it like a new project and use the local absorption rate, if one can be determined.  Otherwise, you're going to have to do some sleuthing.  Are there similar properties nearby?  Do they have vacancies?  How many, and how quickly do they fill?  Are your vacancies 2% or the local units (relatively painless to fill) or 20% (much more difficult)?  Somehow, you need to come up with a conservative estimate of the amount of rent you'll not get while filling these units.

Are incentives going to be required?  In the lower end units around here, a month's free rent or very small or zero deposits are the norm.  You need to figure out what this economic vacancy would be.

Then, I'd use the 50% rule, a reasonable cash flow per unit, and your expected loan rate and term to back into a price.  Assume 100% financing to come up with the price.

Max payment = (gross scheduled rent / 2) - desired cash flow
Max price = PV (rate, term, max payment)

Now, subtract off your costs.  These are the rehab costs, the actual vacancy, and the economic vacancy.  This gets you to a value.

Yes, the 50% rule includes some nominal vacancy, and you're double counting this by subtracting off your actual and economic vacancy numbers.  But these are all just estimates, so double counting makes it that much more conservative.

An alternative is to start with the NOI derived from the 50% rule.  That includes some nominal vacancy, say 10%.  But you're at 50%.  So, instead of expense being 50% of gross rents, they're going to be 90% of gross rents (empty units still incur taxes, insurance, utilities, etc.)  So, take 10% of scheduled rent less desired cash flow.  I'm guessing that number is negative, meaning the property has no value, as-is.

Ralph S. · Answer

Thanks for the vote, Norm, but to arrive at an offer price would come after finding the magic bullet.  This "turn around" would need significant DD that would include evaluations external (uncontrollable) and internal (controllable) to the property in order to simply determine what would be a reasonable occupancy rate, and at what rent level.  To many unknown fundamentals, and too large a project (risk) to apply a valuation based on unsupported or claimed numbers.

Norm Chrostowski · Answer

Vote for you Ralphy-boy. Very good advice. That about sums it up

Norm Chrostowski · Answer

I think what he's asking is how do you figure out an asking price, based on those numbers. Meaning, "I know your asking 9.4m, but based on the 50% vacancy, my offer would be...."

Maybe I'm incorrect ?

Michael Rossi · Answer

You need to understand what is causing the 50% occupancy to be able to determine the value.  If there is just no demand, then the property is worth very little.  If this is simply a matter of totally incompetent management, then it would be worth the asking price minus the holding cost of getting the property back up to normal occupancy ASSUMING THAT YOU COULD AFFORD TO HOLD IT!

So, it's a detective story and the question is WHY IS THE OCCUPANCY SO LOW?  What could you do to fix that?

Mike

How to value negative cash flow

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