What are we missing?

Question

I am an agent in NJ. Here are the basics of a deal that I recently discussed with a client.

The asking price for a 9 unit, mixed use property in good condition is about $1,500,000. Gross income is approximately $150,000. A broker-provided offering memorandum, which was unusually thorough, included a broad array of expense items the net of which was an NOI of approximately $110,000, a cap of just under 7%, and cash-on-cash of about 8.4%. Not bad at all.

However, the offering memorandum was incomplete in the following ways. There were no vacancy allowances assumed for any of the 9 units, 4 of which are commercial, with 3 of the 4 having leases expiring in 2023. There is also a vacant office space. The NJ Mansion Tax, which is 1% of the contract price, was not taken into consideration. Neither were closing costs, which represent a very sizable cash expense.

So, when underwriting the property, we applied a 5% vacancy allowance to all units and added nearly $58,000 to cash (which included the Mansion Tax) to account for closing costs.

The results. NOI dropped from $110,000 to about $95,000, the cap rate fell from nearly 7% to 5.8%, and cash-on-cash collapsed from 8.4% to 4.8%. My client passed on the deal.

However, THIS PROPERTY WILL SELL AT OR ABOUT ASKING. What are we missing? Is this a market where an investor should be content with a 4.8% return on cash and an overall 5% return on investment?

Taylor L. · Answer

One thing missing is potential upside. Someone is buying at X valuation, but does their underwriting and business plan push them to Y valuation, which justifies X valuation to them?

It's important to bear in mind that while we may miss something that others see in a deal, we may also see something they don't and/or have different goals for our investments. Maybe the person who buys it is okay with a 4.8% cash on cash. Or maybe they missed the various factors you mentioned. Or maybe they see something you don't on the positive side, like upside in rents that change their projections to a higher number. It's hard to say!

Brian McCabe · Answer

Indeed, there are plenty of factors that come into play. In this case the residential rates are relatively close to market, and the same can be said of the commercial rents, so there's not much upside on the income side. Also, there's a lender's interests to satisfy. If the goal is a no-recourse loan then it's been our experience that the lender wants to see solid numbers right out of the box. Is that how you see it, as well?

What are we missing?

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