Need advise... Using CAP rates to sell SFR?

Question

A friend of mine bought an SFR in an "A" neighborhood somewhere in Los Angeles. He did some $100k rehab renovations, and somehow turned it into a four-plex, two units without permits. Here are the numbers:

Gross Rental Income: $4345 per month
Estimated Expenses 25%: $1,086 per month
Net Operating Income (NOI): $3258 per month

Current Cap Rate in this Area: 3.90%
Market value using CAP of 3.90%: $1,002,692

He wants to sell it for a higher CAP at 4.25% to compensate for the units without permits. At 4.25%, the value is at $920K.

... Versus residential comps for this SFR is probably around $700k - $725k.

Does anyone know at what price is this home going to sell for realistically in LA? I would think the buyers pool is limited because it's considered a non-conforming multi-family. Appraisers will only appraise this as an SFR, and not an MFR. On the other hand, a lot of people in LA have cash who's willing to take it.

Owner still thinks he can get $920k for it... is he wrong? What should I advise him?

Thanks in advance!

Joseph Ball · Answer

I would not touch this with a measles-vaccinated iron crowbar.

Roy N. · Answer

@Benjie DeVera Three rather large, warty, and unpleasant possible issues come two mind:1) The partition of the house into four units was done w/o permits - this means there is no verification that the work was done correctly and in compliance with building an fire codes {are all the units separated with an appropriate fire break}?2) Because there is no "official record" of the conversion into a quadraplex, the property will be registered as a SFR in the land titles system (or whatever the local equivalent is in Cali), lenders will only lend on the property as if it were an SFR. If they learn the truth, they may not lend at all.3) You made no mention of zoning in the neighbourhood where the house is located. There is a strong possibility that zoning will not allow the property to be converted into a quadraplex. In this case, buyers will be scarce as they run the risk of being compelled to restore the building to a SFR.In short, your friend will likely encounter a stiff headwind selling this property.

Eric Zunkley · Answer

As someone who has represented buyers, generally they want to avoid an unpermitted situation at the risk of having to remove it. As an investor you run a big risk if something goes wrong in an unpermitted unit. That being said it's ultimately up to the buyer and if they are willing to take on the risk, you need to properly disclose all known information. Appraiser will value the property with the three methods of appraisal; Income, Relative value and Replacement Cost. I believe they are going to find the most accurate value by going with Relative Value. Are there any other similar Income properties in the area?

Fred T. · Answer

Should have asked for your advise before he went off and change the use of the property illegally. This could be a major pickle and the value could actually be less than a SFR. Even cash Buyers have some common sense and have to recognize that, unless they are tearing it down to do a rebuild, that somewhere along the way their capital is at risk and would not get involved in it.If I were you, I'd just say I can't help you with this one and move on.To answer your question though, if it is zoned as a SFR, if it has a CO as a SFR, appraises as a SFR, has a utility set-up as a SFR, then one should value based on the Sales Comparable Approach and not an Income Approach. Appraisers, Lenders and True Investors don't like non-conforming properties...especially illegal ones.Lesson to be learned by those in this community...do your projects the right way the first time around..lol/

Leonard L. · Answer

most people above point out danger of lack of permits, but I see part of the problem as lack of seasoning. I have bought units that I knew were of questionable providence from a permitting standard. Since I am an all cash buyer, I don't have a lender to deal with. I just pay what I think is fair. In one case, there were 3 units but city (not LA) had already issued a code enforcement action claiming 2 were illegal. So I bought with worse case scenario - that I would have to tear 2 down. And in fact that was how the story ended. I ended up with one unit on an oversized lot, but that it how I priced my deal anyway.However, that was during the dark days of 2010. I suspect if that same deal came to the market today, people would pay for at least 2 units if not 3. There is just a lot of cash chasing deals.The amount (or cap rate on total income) a buyer would pay in turn depends on a risk analysis. If these 4 units had been operated for no problem for, say, 5 years, people are going to see the risk as a lot lower than if this is a rehab and flip with little history.

Manolo D. · Answer

This is an accident waiting to happen.

Chuck W. · Answer

Unless you are paying cash, you will need appraisal. The illegal unit conversions will never get past appraiser period end of story.

Eyal B. · Answer

Buyers WILL buy on cashflow in LA, even on fourplexes. Legal fourplexes. Nobody is going to pay anywhere near market CAPs on a property like this. A neighbor complains to the city about too many people coming and going and the owner will be paying 10-20K per unit they are forced to remove from the market (assuming this property ends up falling under rent control), deal with multiple evictions and potential compensation for landlord breaking a lease, plus all the work to convert back to SFR. That is easily 100K+ of work to just go back to a SFR, while the city makes your life miserable. You better be getting a great deal to take on a six figure risk like that. Your friend also made it way more expensive for a developer to purchase the property for new construction (because of relocation costs).

Chris Soignier · Answer

sub-5 units generally get valued by comps, not cap rates.