Analyzing Multi-family's

My long term goal is to purchase 4-8 unit mult-family's at a discount. Next step is too upgrade the property by rehabbing the units at the end of the lease and raise the rents.

When analyzing those properties I can imagine that the 50% rule wont be met. Especially in the bay area, california with 4% cap rates. But if their is still room to raise the rents by another 150.- then my guess would be their is still a opportunity to make money.

According to the cap rate formula: (value = increase in net operating income / Cap rate) the increase in value with a 8 unit multi family when increasing the monthly rents 150,- will be 240.000 dollar (at a 4% cap rate)

Every time a multi family gets analyzed here I almost never see the strategy of adding value being discussed here.

A bay area property will not cash flow, be the property can still be undervalued compared to similiar properties in the area. Yet if you post the deal here it would probably be advised as a bad investment. I was wondering if someone could give me an opinion about this.

Second Question: Who in the right state of mind purchases multi family's at a retail price with a 4% cap rate without any upsides? Sounds like an awful investment to me.

Third Question: How do you analyze a value add property? I have learnt that during the renovation you will sometimes have to deal with a vacancy rate of 40% or more. So Deep Cash reserves are required. Sounds like Analyzing such a project will be pretty hard and depend on many assumptions.

Anyway thanks all in advance for helping me out. If been a big fan of this site altough I never post. People Like Jon and MikeOh have given me an incredible amount of real estate wisdom and knowledge :D Thank you

Edited: 06/26/2010 at 10:19AM

Jon Holdman

Real Estate Investor · Denver, Colorado

11853 posts
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Icon_minipost Oct 31 '09, 02:42 AM

Thanks for the compliment.

You are essentially talking about a fix and flip sort of approach. Buy a property, increase its value, then resell it. With income properties, that's purely a matter of increasing the income. You've identified a couple of ways to do that - increase occupancy and increase rents.

Keep in mind, though, that especially for quads, the property may also be valued using comparables.

Why buys terrible rentals like this? For one, naive newbies who really don't understand the business, but want to invest in real estate. Apparently that's a pretty good market, but I personally have qualms with exploiting it. Another is someone who's speculating. They're hoping for appreciation and then reselling at a higher price. Certainly that was a good strategy from about 2000 until about 2006. To some extent, what you're relying on is the "greater fool" theory.

I'd approach this like a rehab, and consider the costs associated with fixing it up, filling vacancies and the cash loss while you own it all as part of your "rehab" expense. This is a bit riskier than a SFR because your pool of potential buyers is much smaller.

Edited: 06/26/2010 at 10:19AM

Jon Holdman, Flying Phoenix LLC

Vikram C.

Real Estate Investor · Phoenix, Arizona

1457 posts
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Icon_minipost Oct 31 '09, 03:25 AM

Musa, Jon's advice, as usual, is fantastic. Look at it as a fix-and-flip project and work the numbers.

Your idea about increasing values through higher rents is definitely a valid one and has been discussed here in BP several times. Particularly by Jim Johnson in his discussions of mobile home parks.

I think the reason people here don't like the low cap rates of the Bay Area is that the same approach of upgrading and increasing values can be done elsewhere as well and without having to put up with the low cash yields.

But if you have the right kind of property in the City, for example, you could very substantially increase rents by upgrading it although your upgrade costs will probably be quite high. Also watch out for tenant "protection" laws.

BTW, Steve is going to point this out anyway, so I might as well beat him to it. The 50% rule says nothing about cap rates and prices. It simply says that the long term expenses on a property will be roughly half of GSI.

Edited: 06/26/2010 at 10:19AM