@Nate Wilson -
A few observations about your numbers; especially with regard to your description of the property being "kind of in the ghetto" (I think "D location" when I read that):
-W/S: This seems low for a 7-unit. Are the tenants in some units paying their own? Does the city bill them directly or do you have to back-bill?
-Electric & Heat: These numbers are identical? Seems odd so thought it might be a typo.
-Vacancy: A small multi in a D location is going to have more turnover than just about every other residential asset there is. While they may rent easily, you have to consider the time between tenants. I would consider running my numbers at higher than 5% to account for this, or at least do some more digging: talk to owners of other properties in the neighborhood, review ACTUALS rather than pro forma estimates if you haven't already (more on that later). By the way, turnover cost is going to be a recurring theme in my comments.
-Credit Loss: You don't have this in your list, but you should. This type of property is going to experience some tenants who don't pay rent, and you are going to have the financial equivalent of a vacancy while you evict them. A small multi in a D location is going to have more Credit Loss than just about every other residential asset there is. Whatever amount of rent goes unpaid from when they stop paying until you get a Writ of Possession and have them removed, is Credit Loss (don't foolishly think there is any chance whatsoever of recovering it from them). The time that goes by before you have a new tenant in place, is Vacancy. The money you spend while vacant and fixing the damages they did before the Sheriff locked them out is Repairs & Maintenance. If it's in a D neighborhood, you're going to have more of all of these.
R&M: Again, in a D location, you can expect more than $45/month in average repairs. If not, that's great, but assume the worst when underwriting, and double your current figure at least. Also remember that Vacancy will be exacerbated by the degree to which R&M is an issue caused by tenant quality. The more repairs are needed between tenants, the longer the vacancy drags out. And yes, to be through and consistent, it is my opinion that a small multi in a D location is going to have more R&M than just about every other residential asset there is.
CapEx: Capital Expenditures are big ticket items that degrade over time (roof, heating systems, etc). They are generally not caused by tenant quality issues; however, items such as flooring and appliance replacement certainly can be. 10% seems high, but I don't know the condition or age of the building system components, and hey, at least the pro forma assumes worst-case on this line item. Okay, the "small multi in a D location having more X" thing doesn't necessarily apply here, but don't expect major capital improvements to boost value (and/or rents) as much as would be the case in a better location.
Management: 7%, really? Keep in mind that higher turnover not only means higher Vacancy and Repairs, but it also means Leasing Fees (for a 7-unit, each vacancy resulting in a 1-month leasing fee is equivalent to 1.2% of GSI). If you have a management company that is going to charge you 7% of collected rents, and no leasing fees, I can't decide whether you should jump for joy, or run for the hills because it's too good to be true. Personally, if I were to buy a property like this, where tenant quality is going to make it or break it, I would want quality management in place, and I would be willing to pay for it. In fact, I would try to negotiate a turnover disincentive (for example, they get bonuses based on lease renewals, rather than getting paid more every time someone gets replaced).
As you can see, almost every item above is affected by the fact that your property is "kind of in the ghetto". Usually, D location properties look great on paper but the higher vacancy, credit loss, and repairs keep reality well below pro forma. Furthermore, do you expect value and rent appreciation in this neighborhood?
As far as your question about the money that builds up from Repairs, Vacancy, and Capital Expenditures, it is normal to hold onto the CapEx (that's why it is also called Replacement Reserves). The Vacancy and R&M figures are for underwriting purposes. However, until you have enough in your reserve account to handle a large capital expenditure that might be looming, keep feeding that account. Ask yourself how long the roof has left, the heating systems, etc. I think your $25-30K is probably more than safe.
Another thing to note: Take your mortgage payment out of your expenses. It's not an expense, it's debt service having to do with your financing situation, and it has absolutely nothing to do with the performance of the asset. Taking it out will also allow you to more easily calculate Cap Rate and DSCR.
The Cap Rate on this property (using your numbers), is 8.07%. An 8-Cap in a D location needing renovation of a couple units? I think it's overpriced if the neighborhood is truly how you describe it. I also don't think it's even an 8-Cap because the expense assumptions are too low. Hitting it with a 60% OER gives a Cap Rate of 6.4%. In reality it should be even lower because Vacancy & Credit Loss are NOT Operating Expenses. They come out of Gross Scheduled Income to derive Gross Operating Income. Sure, some would argue that since you have the utilities split off, 60% OER is way too high, but that really all depends on how the tenant quality affects R&M. Let's try this (and I think this is generous): 10% Vacancy and Credit Loss; 50% OER: Cap Rate = 7.25%; CoC = 7.87%. Do these numbers justify a "ghetto" 7-unit that may not appreciate over time but is likley to be a PITA to own?
Of course, all of this is conjecture without knowing what the numbers really are. Have you seen a T-12, or just a pro-forma? Have you told the seller that you intend to see the applicable schedules of his tax returns (K-1 or Sch E) as part of the contract contingency? Did your spreadsheet originate from numbers provided by the listing agent, the seller, or your own due diligence?
A bit of a disclaimer: my experience is limited to direct ownership of SFR, as well as analysis, underwriting, and LP investment in large multi and other CRE asset classes. I have never owned a 5, 7, 10, or 16 unit property because, in case you didn't guess it already, I believe that a small multi in a D location is going to have the most risk and least upside than just about every other residential asset there is.
Please make sure to dig into the ACTUAL numbers before you make any investment decisions. If the seller is unwilling to provide them, walk away.
Good luck and happy investing,
Troy
