What am I missing in my analysis?

Question

Hi BiggerPockets community - I'm in my education phase of real estate investing, and have been working hard to learn the details of financial analysis. I’ve done a fair bit of web research, and am also part to most of the way through a couple books (both recommended by BiggerPockets). I’m trying to validate my understanding of how to analyze the financials of a potential real estate deal, and am hoping someone can answer a few questions. To test my understanding, I went to the Redfin website, found a 4-plex, and worked out all the key numbers I’ve been reading about. I did all the math by hand to make sure I understood it, then I tried plugging all the same data into the rental calculator on BiggerPockets (fortunately I got the same results in both cases). Here are what I believe to be some of the key numbers:

• The property was listed for $625k
• NOI is $28,188
• Assuming a 30 year mortgage at 6.5% with 20% down and typical closing costs, cash flow would be negative $867 per month. Additionally, the debt coverage ratio would be 0.73.
• Assuming an 8% cap rate (I don’t actually have any idea what it is for the area), the property would be valued at $352k

Since I got the same numbers from doing the math myself and running the data through the BiggerPockets rental calculator, I’m assuming the math is correct. If this is the case, then I’m left confused about several things:

• This looks like an utterly terrible deal. There is negative cash flow and even with the principal being paid down, it would never break even (if the cap rate for the market is more like 4.5%, then it would be more highly valued but would barely break even after 5+ years). Am I missing something?
• Would any lender even be willing to loan money at a debt coverage ratio of 0.73?
• Why did this deal go pending after being listed for only a couple weeks? If you could increase the rent by 50%, you might end up with a valuation of around $615k (again making assumptions about cap rate), positive cash flow of around $866 per month, and a debt coverage ratio of around 1.28, which sounds much better. Is it likely that a buyer thought they could increase rent by 50% without putting much more money into the property?

I’d love to hear some thoughts on whether I’m analyzing this correctly, and also why this property looks like it is going to sell very quickly at price that does not seem to be indicative of a remotely good deal!

For reference, here is the listing for the property: https://www.redfin.com/WA/Everett/7801-Timber-Hill...

Thanks!

Ryan

P.S. Can anyone tell me if it is possible to edit the title of a post so I can fix my ridiculous misspelling of the word "analysis?" :/

John Leavelle · Answer

Howdy @Ryan Tremblay

This is not a commercial property. Therefore, as @Brent Coombs stated, you do not use Cap Rate to determine the property value. 2 - 4 unit small multi family properties are valued the same as Single Family Residence (SFR). That is by using recently sold comps.

Let me give you two "Rules of Thumb" to quickly determine if you should be interested in a property. First use the 1% rule. The monthly Rental income should be 1% or greater of the purchase price. In your property we get $625,000 * .01 = $6,250. The current rental income of $3,825 is only .6% of the purchase price. This is not even close to being a good deal. To go even further we can check what the average rental rates are for similar properties on Rent-o-meter.com ($1,336 for 2 bedroom). That would be a total of $5,344 per month for the 4-Plex. Still to low for the purchase price.

Let's say the purchase price was $382,500 (meeting the 1% rule). Then you would use the 50% rule for further evaluation. You multiply the monthly income by 50% to estimate expenses. In this case $3,825 * 50% = $1,912.50 expenses. Your estimated NOI is $1,912.50.

We can now estimate Cash Flow.

Purchase price $382,500

20% Down $76,500

Loan amount $306,000

4.5% APR / 30 years

P & I $1,550

$1,912.50 NOI - $1,550 P&I = $362.50 mo. ($90.62 per unit)

If these were the actual numbers the property would be worth further analysis.

Bottom line: Determine the Market Value/ARV first. Then use the 1% rule and 50% rule to quickly determine if the property is worth further investigation.

Also to answer your other question: No you cannot change the post title. Lol, I've tried.

Brent Coombs · Answer

@Ryan Tremblay, for 4-plexes, Owner-Occupier-Buyers are likely to have one big advantage over pure Investors:- they can borrow at around HALF of your assumed 6.5% Interest Rate (as well as not requiring as much deposit)!

Check THOSE numbers into your calculator!

[Even pure Investors can often borrow at significantly lower than 6.5% Interest Rate].

And remember, the value of residential/NON-commercial property is based on sold COMPS, not market Cap Rate. Cheers...

Ryan Tremblay · Answer

Thanks everyone for the detailed and thoughtful replies; much appreciated! I have quite a handful of comments and questions in response:

1. It's interesting to hear peoples' thoughts on using cap rate when analyzing residential properties. The inconsistence of opinions on this is consistent with what I've found elsewhere :). In general, everyone agrees you should use cap rate for commercial, perhaps half say to use it on a 4-plex, a quarter say to use it on a duplex, and a small handful say to use it on a SFH. Really interesting to hear how different people think about this!

2. Really interesting points on how owner-occupied affects the analysis between a significantly reduced loan rate and a negative cash flow justification. I hadn't really considered this because I'm not really considering owner-occupied scenarios for my own investing.

3. I didn't know about rent-o-meter.com - seems like a useful resource when starting research into a market or sub-market! Thanks for sharing!

4. The 1% rule and 50% rule seem like interesting and useful rules of thumb for doing an initial analysis without a calculator. Seems interesting also to note that you can directly relate this to cap rate (perhaps to allow for a more apples-to-apples comparison of a residential investment and a commercial investment). Specifically:

value = rent / 0.01 (estimated via the 1% rule)
NOI = 12 * rent * 0.5 (estimated via the 50% rule)
cap rate = NOI / value = (12 * rent * 0.5) / (rent / 0.01) = 12 * 0.5 / (1 / 0.01) = 6 * 0.01 = 0.06

In other words, combining the 1% rule and the 50% rule is the mathematically the same as assuming a 6% cap rate for residential. Does that sound right?

5. I appreciate the thoughts on potential hidden value. I suppose with enough experience and actually looking at the property, this is something a potential investor could identify.

6. Regarding cash flow being number one priority, that makes sense, but even with good cash flow, overpaying seems risky as it would "lock you in" to the property (it'd be hard to turn around and sell it if you needed to). It also seems like it'd make it a lot harder to get a loan, unless the property actually appraises at the seemingly inflated price. Would you agree?

Thanks again everyone for the replies to this question. Really really helpful as I try to educate myself!

Ryan

Andrew Johnson · Answer

@Ryan Tremblay I think others have hit the nail on the head. Either the buyer is "desperate" to invest of their math is different than yours. When you look at house-hacking scenarios (a definitely possibility) you do run into a group of buyers that will opt to "lose $1,000 per month on a property because it's better than paying $2,000 to rent". Which, by the way, isn't exactly illogical. And if they are going to be an owner-occupant their interest rate isn't going to be 6.5%, it's going to be much lower. You're also positing a valuation based on an 8% cap rate. I've leave the try-not-to-apply-commercial-valuation-methods-to-residential-properties aside but I'd imagine that it's a pretty high cap-rate for a city that still should be able to commute to Seattle (a long commute) from. The rents for Seattle have skyrocketed so I can't imagine cap-rates haven't compressed in Seattle along with anything that's remotely commutable.

This isn't to say that this property or any is a *good* deal but if this mystery buyer gets the property for $600K + raises rates 10% + has a 5% interest rate + doesn't have to pay rent anymore it could be a decent deal for them. Not to mention, if you are going to live in the property it isn't the worse thing in the world to pay a premium (read: get a mediocre deal) to live where you'd like to live. Pure ROI aside, it's not illogical to think: "I'll lower my cash-on-cash return from 10% to 7% to live in a place I want to live".

But, hey, this is all random hypothesizing.

Ben Wilkins · Answer

@Ryan Tremblay - I'm actually going to go the opposite direction from the other two replies (sort of).

While this is indeed a residential property and will be based on comps, I always evaluate rentals as if they were commercial since I will be treating the property as if it were commercial.

@John Leavelle gave the two rules of thumb that I use, although I based the 50% rule on the area. If it's a place with higher taxes or if the property is in a lower-class area, I will up the expenses to 55% or even 60% to estimate cash flow.

Every property that I plan to rent out will be evaluated based on cash flow rather than market comps. Cash flow is what I need to continue to grow, so that is what I focus on. I have a minimum per door that I aim for, and that's what I negotiate for. If I have a solid plan to increase cash flow (a way to increase income or decrease expenses), then I will be able to add value to a property in a commercial mindset.

The chances are pretty good that the buyer has a plan for how to improve the property or they have a separate plan for how to use the property in a different way other than purely as a rental.

Brent Coombs · Answer

@Ryan Tremblay, yes, "combining the 1% rule and the 50% rule is mathematically the same as assuming a 6% cap rate for residential" DOES sound about right - for large swathes of middle America (ie. older homes, in "C" neighborhoods).

The trick is to find those sort of deals where the "cap rate" would normally work out to be LOWER than 6% (ie. not so old homes, in "C+/B" neighborhoods). But as you're now realizing, they'll be harder to find, because you'll be competing against owner-occupiers (ie. emotionally attached, getting lower interest rate, so will pay more) in those markets.

Always keep in mind though that a pro forma cap of 6% for residential property will NOT assure you of a good "deal".

Rule of thumb: WHATEVER the market value is carefully worked out to be, offer no more than 70%, maximum!...

John Leavelle · Answer

@Ryan Tremblay

Good to hear things are sinking in. I know it can be very confusing. The primary reason for using sold comps verses Cap rate is that is what the Bank appraiser will be using in most cases when dealing with 1-4 unit residential properties (at least that has been my experience). Using the Cap rate and COC ROI to compare deals may be useful when looking at multiple deals.

Using Rent-o-Meter or other websites like craigslist are good to estimate rents. A better source is to contact different Property Managers to see what they are charging in the area.

Just remember all markets are not the same as well as each deal and property being unique. You need to take all variables into consideration before making the purchase.

John Leavelle · Answer

@Ben Wilkins

Totally agree. Cash Flow is number one priority for me too. I actually use 55% for expenses in my cash flow analysis. I also take other variables into consideration. Such as rents below market, single building on large lots, or other value add opportunities. In fact I purchased a fire damaged Duplex that was on a 1 acre lot. I will be building additional units and possibly subdividing. It was part of a Two for One deal. Two properties for one low low price. Win win win.

Robert Plumpe · Answer

Hey all:

I've seen "deals" like this from time to time and have even talked to a couple of investors in "deals" like this.

There is a chance that there is some "hidden" factor that might not be readily apparent just be looking at it on the interweb. There might be additional land that might be used to build garage/pool/something else that might make the rents higher or the property more desirable. Maybe the building can be expanded/subdivided to further increase it's value?

Maybe there is a good chance that the property lies in an area that is going to be redeveloped or taken by eminent domain?

Could be something else entirely?

OR

It could simply be a bad deal. I would guess that most investment properties offered up are probably fair to bad deals if you really dig deep.

I once asked an investor that bought a negative cash flow apartment building (he knew it would be cash flow negative before purchase) why he did it and he said that it was a combination of four factors:

A). The area was a nice area that he wished to work in. He presumed that the "value" of the property & market would go up in the intermediate & long term.

B). The rents were slightly below market and the quality of the tenants was somewhat better than average. He presumed that he could raise rents somewhat over the short & intermediate term.

C). He had some $$$$ burning a hole in his pocket and in retrospect he admitted that he acted too quickly and paid too much. He had owned the property for about 2 years. It was not terribly cash flow negative...and was not a catastrophic bad deal, just not a good deal. He stated that in hindsight, he probably would not do the deal again.

D). In that area and in that period of time, this was the "least bad" of the deals that he looked at. At that point the market was definitely a "hot" market and ALL comparable properties like this were cash flow negative. He had some real estate and wanted more...so he bought the best deal he could at the time.

So perhaps the property you are analyzing is in a "hot" market and everything comparable is cash flow negative? If that is the case, it could be the "top" of the market?

If the deal doesn't make sense and doesn't clear your required returns, I would probably pass on it.

What am I missing in my analysis?

What am I missing in my analysis?

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