Why You Should NOT Buy Based on Actual Income of the Property

Question

Real estate gurus teach: Only buy rental properties based on actuals (actual net operating income) not based on pro-forma (or projected net operating income).

Although it sounds good and reasonable, after doing this since 1999 and having bought more than 1,000 apartment units, I have NOT bought a property based on the actual income the seller is getting (or has gotten while he/she owns the property) ever!

Here are 2 reasons why:

1. The income and expenses of the property will be different after you buy it vs. what they are today

2. How you operate the building will be different than how the current owner operates it

Here's an example of the first one: the property taxes after you buy it will most likely be different that what it is currently.

For example, I just saw an 88-unit building for sale for $4M with a cap rate of just under 7%. The property taxes is only $17K/yr and when I check the assessed value, it was assessed for $580K. Once you pay $4M for it, the property taxes WILL INCREASE (once it's assessed) to more than $100K!

If you followed the gurus' advice, you just lost over $83K/yr in income - which, at a 7% cap, you overpaid for the property by more than $1.185M. Ouch!

Here's an example of the second one: repairs and maintenance.

I see newbie investors shy away from properties that have high repairs and maintenance. But if the repairs and maintenance is more than $60/month per unit, I can smell a potential opportunity. When I buy the building, I put in the necessary replacement and renovation upfront so that the on-going maintenance goes down to $60/month per unit or even less. In other words, I can operate an apartment building so that my repairs and maintenance is $60/month per unit while the current owner might not be able to do that.

Now keep in mind the $60/month per unit is more for apartment buildings and that's the number I can get my buildings to operate at.

So what about the more experienced landlords - what other examples can you cite where you do NOT buy a rental property based on actuals?

Kenny Dahill · Answer

Here I thought buying off a proforma was common knowledge...

Actual's do provide great insight into the property.  If analyzed and assessed properly, it can validate your ultra-conservative income and expenses.  Or provide you the proper insight for expected CapEx.

Aaron K. · Answer

@Michael Ealy totally agree especially with the first point in California with prop 13, there a lot of agents who don't understand the implication of the sale when they are listing (or they don't care).

Also there are many times that rents are under market and can be raised, or utilities can be submetered easily.

However to caution the newbies while you might not want to base your decision on actual expenses you certainly don't want to use the seller's pro forma numbers, as those will paint the rosiest of pictures, use your own numbers to evaluate always.

Nik Corbaxhi · Answer

@Michael Ealy,Totally agree with your point of running the numbers and anticipating what comes with the investment, rather than what someone else trying to convince you whether a property is worth it or not.

There is also a human side to being a landlord and not everyone is cut for it. Unfortunately, most see it as strictly a business with no feelings involved.  As a landlord, one rule that I don't break is being ethical. I always do what is the right thing to do and not cheap out on stuff that needs to be fixed, regardless of the cost. I am not writing this up so other people can read it, but because I truly believe in it, every day. How do I know if it is right or wrong? I quickly put myself on my tenant's shoes and ask myself the question. If a property is not good enough for me and my family to live in, it is definitely not good enough for any of my tenants. So far, in my 6-7 years of dealing with tenants in multiple properties, I am still to have 1 tenant that is not satisfied. My consciousness does not allow me to cut corners for a couple of thousand dollars more in my pocket, knowing that I wronged someone to get it.

Dylan McCabe · Answer

@Michael Ealy I agree with you 100%

We purchase 200-500 unit multifamily properties in Dallas TX and surrounding submarkets.

We Always buy based on proforma, not actuals. Everyone from the lender to the buyer is using the proforma, sales comps, rental comps, and true value add strategy to form their valuation in this market.

Our number one goal is to find true value add with a clear upside. That often means the current cash flow is poor due to various reasons:

• Loss to Lease
• Vacancy
• Poor management
• Over-spending on renovation
• Not charging fees to residents
• etc...
•

As long as the upside is there and the story is good - we are interested.

I'm with you -there are several "thought leaders" saying you buy based on actuals - but it really depends on the market and each case by case situation. A sophisticated buyer with experience looks for opportunities. The actuals matter, but they only tell a part of the story.

Adam Leitman Bailey · Answer

I agree with these points. You should write an article on this

Dylan McCabe · Answer

Of course! We run our own model to analyze our deals. I have about five different models I've gotten from large lenders to Michael Blank, to the one we use in-house.

Michael Ealy · Answer

That's exactly right Nik. What you mentioned about being ethical and putting yourself in the tenants' shoes is basically following the GOLDEN RULE: do unto others what you want others to do unto you.And the golden rule has made me "gold".

I rehab my properties to be at a level higher than the market where it is at. For example, when I buy a building in a "C" area, I renovate it to "B" or even "A" level quality. The tenants were so surprised that three things happen:

1. They are willing to pay a higher rent;

2. They will not leave because all the other buildings look "crap" compared to my building - so my turnover is very low; and

3. The word spread around in the community and I get the best tenants attracted to my properties - increasing my occupancy

All 3 combined made me MILLIONS - hence, the golden rule will make you gold.

JD Martin · Answer

I can't speak to MFH as I don't own any but on my SFHs I always exceed what the previous owner was getting, sometimes by double. This is typically because the previous owner was unwilling/unable to make any improvements to the property.

Michael Ealy · Answer

But be careful as to whose pro-forma you're using.

You can't use the broker's pro-forma and definitely not the seller's.

You have to come up with your own analysis and your own pro-forma based on your analysis.

As always "Buyer's beware" and be careful who you listen to.

Andy Freeman · Answer

@Michael Ealy The point about the property taxes is huge. A lot of these apartments for sale have no prior history of being sold and are sitting on an assessed value of only a couple thousands higher than what it was 20 years go. I like your point about running your own pro forma. I'm all for using caution when running the initial numbers (50% for expenses, 90% occupancy if they are saying it's 95%. etc.), but you also have to look at how many value add plays you have. If the owner is stating expenses of 40% or more, there's likely a lot of cleanup and cost savings you can do once you get in there. I think I'd prefer to have higher stated expenses from the seller, rather than a seller claiming to only have 20% expenses per year, as it just adds more upside to the deal if you know what you're doing.

Why You Should NOT Buy Based on Actual Income of the Property

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