Value of Rental Property: Negotiations to Buy or Sell

Prior posts discussed the income capitalization method of determining the value of a rental property. This post will cover how you use that information to negotiate the purchase or sale of property.

If it works to your advantage, structure the negotiations into a discussion of value based on income capitalization. Because this roughly duplicates the approach an appraiser would take, it has a high degree of credibility.

Choose the most advantageous NOI period. Is it:

• The last fiscal year?  If I wanted this, I would say it is the most accurate from an accounting standpoint, because all the accounting adjustments have been made.  As an example, my monthly P&L might have a "reserve for credit losses" of $1,000 per month on a multi-family property. But, when the books are closed for the fiscal year, we might post actual credit losses of only $6,000 for the year, or as much as $25,000 for the year.  If I did NOT want this, I would say the last fiscal year closed several months ago (or longer) and the more recent numbers are more relevant.
• The last twelve months? This is called the "trailing twelve."  If I wanted this, I would say it is the most recent twelve month period, and therefore the most relevant.  If I did not want it, I would say no accounting adjustments have been made, so the numbers are not as accurate as they could be.
• The twelve months after a sale? This is called the pro forma NOI.  If I wanted this, I would say the purchaser is not buying last year's income, he or she is buying the future income. Last year is history. It can't be bought by anyone.  Only the future income is relevant. If I did not want this, I would say pro forma is just one person's prediction, and I'm not impressed by crystal balls. What is being bought or sold is the proven track record of a property, which is a fact, not a speculation.

Next, examine the operating expenses and income to make sure they are accurate, complete, and do not include items that are not legitimate for purposes of the income capitalization model.  See my prior post for that discussion.

If you are buying, you should try to duplicate the process your bank, or your bank's appraiser, will take. In other words, if the seller self-manages, you still need to allocate a 10% management fee. If there is no expense for credit and vacancy losses, you should allocate at least 5% to such an expense. Finally, if the owner self-maintains, you should allocate a reasonable amount (based on property condition) for annual maintenance and repairs.

Banks do this because they must analyze the property as collateral for their loan. In other words, if they have to foreclose, what will the bank incur in operating expenses? They will not self-manage, the loan officer will not get up at midnight to fix the toilet, and they will definitely have some type of credit and vacancy loss.  Appraisers allocate expenses because the property's value is predicated on purchase by a typical investor. The typical investor does not self-manage, self-maintain, or enjoy 100% occupancy and no credit losses.

If you are buying property, you must argue in favor of those allocations.  "The market" of typical investors will have those same expenses. Plus, your bank will loan money based on value calculated after using those allocations. If you pay a higher price, you will have to come out of pocket with the additional money. This is the time to be humble, and explain that you cannot afford the property unless you get 75% or 80% bank financing.

In negotiating theory, this is known as the only winning strategy in a game called "chicken."  The classic game of chicken involves two idiots racing toward each other in really fast cars. The one who swerves to avoid a collision is considered the loser. The only way to reliably win is to rip off your steering wheel, and communicate that to the other driver. Then, the other driver knows he MUST swerve, because you cannot.  In negotiations, when you tell the other side you MUST do something because of something over which you have no control, you are trying to win at chicken.  Blaming your bank is a classic chicken winning strategy.

Finally, select a relevant cap rate.  Unless a property is brand new, there is some "wiggle room" about an appropriate cap rate.  Brand new apartments with similar amenities will pretty much sell on the same cap rate. Others will fall within a range.

If you are selling, you want a lower cap rate. Lower cap rates = higher values. If you are buying you want a higher cap rate. Higher cap rates = lower prices. A property with an NOI of $12,000 will sell for $171,429 on a cap rate of 7 percent. The same property will sell for $160,000 on a cap rate of 7.5 percent.

Using the tools and advice above, based on principles discussed in prior posts, you should be able to negotiate a favorable price for rental properties, whether you are buying or selling.  If one of you reading this is the buyer, and the other is the seller, then you will probably settle at a reasonable, and realistic, true market value!