evaluation of multifamily property

19 Replies

Hi BP!

I am an investor from Israel and recently had an offer to join a syndication for a buying of a multifamily unit in NJ. The offer sounds tempting since  the group has to finance about 3M$ (the rest comes from a bank with a low interest) and the building is bought about 1.5M below value, so when we sell we should expect a 50% return when selling which should be 3 years from now.

The thing that bugs me is the way the building value was evaluated, i am copying a section from the presentation:

"Market activity has shown similar properties consistently trading in the 4.75-5.25% cap range (refer to “Comparables” slide for specifics). Using this approach, keeping with

conservative rent growth and vacancy assumptions, and factoring in the fully matured real estate tax amount post-abatement, the Y1 projected cash flow of $570,561 ($670,561

adjusted down $100,000 to account for the fully matured RE taxes) would value the asset at roughly $11.4M at a 5% cap - a substantial savings from our purchase price of

$9.8M. This evaluation is further supported by a recent CBRE pricing opinion of $11.5-12M"

What they done is evaluate the price by assuming the return is 5% annual. From everything I know about US RE the returns should be much higher, but maybe certain markets has lower returns. What do you guys think?

Isaac:

A broker's job is to sell a property quickly at the highest price possible.   Their pro-formas will almost always try to show what a great deal you are getting and suggest that if you don't hurry you will miss out on the opportunity of a lifetime.   

Don't believe it.  

Pro-formas are also often wishful thinking. I've seen too many deals that look great in the pro-formas but when you dig into the actual performance and real comparable data you can see you would be overpaying.

Unless that deal is a pocket listing or other kind of off-market deal, the property has been exposed to the market so its current value is exactly what you are paying for it, not a penny more.   I would be very surprised if you could immediately resell this property for $1.5M more.

You may want to learn how to do a ground-up evaluation so you can really understand if you are getting a good deal or not.

The cap rates are likely as compressed as they'll be during this real estate cycle at least. So if they are basing their sale price off of the current 5% cap rate then they will likely be disappointed when they end up selling at 6% or more in 3 years. If that's what they claim to be conservative I would caution you to review all their other numbers carefully.

@Isaac Geller Well, real estate is regional. I’d imagine that a 5-cap is horrible in Ohio but would be awesome in Manhattan. Here in San Diego I’ve seen projected financials that yield a 4-cap. And projected financials are usually projected by the listing agent. So even that 4-cap is a little “ambitious”. Consequently, it’s hard to know the reasonableness of the investment if you don’t know the area. In a syndication (especially if you’re not in the country) you’re somewhat dependent on the lead to figure it out.

Here’s where I see the fly in the ointment. The purported “fair value” is $11M. The purchase price is $9M. If you take a low annual ROI but think the fund has $2M in equity (recognizable on the exit) it could still be a great deal. But the “price opinion” was done by CBRE, are they the listing agent? If $9M is the best offer they have then it’s not worth $11M. If it was (being a free market) someone would have offered $10M to capture that $1M in purported value. Okay, that last sentence isn’t iron-clad but it’s more likely that $11M is too rich, $10M is fair market, and $9M is a reasonable deal.

Again, I know nothing about the property, this syndicator, etc. I’m just theorizing.

@Isaac Geller the disconnect here is that you are confusing concept of "return" with "cap rate".  The two are not the same. 

Income real estate is "valued" by cap rate, which in the simplest terms means you take the net operating income, divide it by the purchase price, and that is your cap rate.  In this case they are saying that "similar properties (are) consistently trading in the 4.75% to 5.25% cap range", which, depending on the class of property and the market in which it is located, could be true, or at least in the ballpark.  Only the comps will say for sure.

Nevertheless, the cap rate doesn't equal the return to the owner or investors.  No, not even if you are paying all cash like some people would incorrectly say.

It's entirely possible to earn a double-digit IRR on a 5-cap property. It's even possible to earn a double-digit cash-on-cash return on a 5-cap property (although less likely in the early years of the investment). 

For you, as a potential passive investor in a syndicate, you are most concerned with how much money you get back, and when. In other words, your return, both cash-on-cash and IRR. While there are reasons why cap rate is and should be part of the discussion, your return isn't one of those reasons.

What are those reasons?  For one, is the cap rate commensurate with comparable sales for similar properties?  For another, is the investment sponsor forecasting that the exit cap rate (the number they are using to calculate the exit value) is the same, higher, or lower than cap rates today?  (hint, if they aren't forecasting higher, beware).  While on that topic, are they even forecasting an exit value, and are they showing that in their underwriting??  If they aren't, perhaps they haven't thought that far ahead and that's just downright scary.

Your return can only be determined by a thorough underwriting where you see how the cash flows through the deal.  You should see the rent going in, the expenses going out, the debt service being made, capital improvements being made and the waterfall to the investor; and follow those numbers from start to finish.  If there is a break in the flow, watch out.

Other posts have already explained "cap rate". If this is just across the bridge from NYC then that might be an OK cap rate range; if this is across the bridge from Philadelphia (like Camden), then that cap rate range is maybe not so wonderful.

@Brian Burke

Thanks for weighing in on cap rate confusion. Cap rate being defined as some measure of income/return, has been a standard definition on BP. Doesn't help much that investopedia.com defines cap rate as a "rate of return".

https://www.investopedia.com/terms/c/capitalizatio...

Because of this many newbies have no choice but to get stuck in the mindset that somehow "cap rate" is strictly a measure of return and nothing else. I'm a newbie in MF so I know of this confusion firsthand.

I have pointed this out a few times but your weighing in on it sure carries a whole heck of a lot more weight! :-)

Cheers... Immanuel

@Brian Burke Thanks for the informative explanation and for clarifying what are the critical aspects I have to dig into. thanks!

@Andrew Johnson You are very right asking the how is the price so low question. I was also suspicious. The answer was that there are two reasons for the low price: one is that the owner is keeping part of the building and functions as PM what will create extra income for him. The seconds reason is that the purchase is made without agent that usually charge 7% percent and this money is save to the seller.  Seems reasonable. 

@Isaac Geller As a foreign investor I definitely  think that you are on the right track looking at passive RE investing (as opposed to the direct route you were considering). 

Assessing a syndication deal is not rocket science- but on the other hand it is not at all trivial and there is much to be learned.

There  are many factors to consider aside from the proforma figures thrown at you by the broker/ syndicator.

To mention a few:  

  1. Syndicator/Company background/  experience/ Track Record.
  2. Investment Strategy and Process.
  3. Team
  4. Alignment of Interest
  5. Market 
  6. PPM- Fund terms
  7. Waterfall and Fees
  8. Accounting/Valuation/Reporting
  9. Legals

IMHO point 1 above is more important than any of the others and should be the make or break before even considering the specific offering. Take the time to learn the process before getting pulled in and definitely don't get blinded by high flying figures- Excel is easily manipulated.

@Isaac Geller Interesting, I’d be interested in knowing what they think they can do with the property over the next 5-8 years.  If the current owner will still function as the PM: a.) Can you fire your PM if he/she is taking less money for the PM revenue? b.) Do historic financials show a PM fee? c.) A lot of syndications look for value creation through repositioning, professionalize management, etc.

Looking specifically at “c” it’s hard to reposition the property if someone else owns part of the property and if you keep the PM it’s still the same management.

So maybe it’s an awesome building and you’re buying a conservative yield play with the potential to recognize the “bought it right” equity on exit?

@Andrew Johnson the building is new (2017). The idea is to install solar power system on the roof to get extra cash flow and thus to increase value. the bank interets rate is quite low, about 3.86% for 30 years. The first year is interest only to increase the returns in the first year. They are planning to sell it after 3 years when most of the profit will come from the extra 2M of the selling price. The group puts is about 3M so it should be a 66% profit just from the sell.

@Isaac Geller So it's starting to make sense why you might not be seeing the "returns should be much higher".  You're thinking about investing in a syndication that looks to be buying a yield-play.  It's a 2017 build so (I'd imagine) everything is new.  Over the next three years you likely won't hit any big cap-ex bumps.  Maybe some appliances will break but exterior repaints, roof, parking, etc. are all shiny and new.  Maybe what doesn't make sense to me is (if all variables are equal) why you wouldn't install solar, get 12 months of financials to show the benefit, and resell it.  The money (it appears) is in the flip rather than the cash-flow.  You won't pay down squat in terms of mortgage principal in the three years.  I haven't put pen-to-paper on the numbers but it would appear that each year you keep the property the more "modest" cash-flow the overall rate of return would decline.   If all of the numbers show up as stated I'm not sure why I'd hold onto the property for more than, what, 18 months?

@Andrew Johnson I think the answer to the 3 years question lies in the new tax laws. Some investors may not want to reclassify "carried interest" from lower taxed cap gains to higher taxed ordinary income. In order to qualify for the lower capital gains tax rate on “carried interest,” investors will now have to hold their assets for three years instead of the former one-year holding period.

@Isaac Geller When you say "Grand Street" as the address, I'm assuming you're referring to Jersey City. Keep in mind, while the place is evolving, there're still some pocketed areas to be avoided. Feel free to PM me to discuss a specific area of JC or another town where this property is located. Being from NJ, I can try to help you determine the area stats.

Also, from personal stand point, as an MFH investor, I don't like to bet on appreciation. Unless I know that the property is going to cash flow, I would not even consider it. But then again, everyone has their own preferences. 

Definitely consider all other important factors stated above by others!

Happy to help in any way I can. Feel free to PM me.

Best!

@Alina T. I know carried interest "loophole" would benefit the GP but if I'm an LP why wouldn't I want money returned quicker in this scenario? The vast majority of the return appears to from the sale "at market value" rather than holding, repositioning, etc. that might take years to complete. It appears to me (what do I know) that the play is "slap solar on the roof to lower utility bills, nudge up NOI, bump the value a little, and sell at a fair market cap-rate".

@Andrew Johnson You might be right on the money with the play. In terms of the three years, since the rules in the partnership are dictated by the GPs, they are potentially making a decision on the terms of the holding period. Again, this is pure thinking out-loud. The owners may have the three year term in mind for a totally different reason.

@Andrew Johnson the subhect you broght up is very interesting, I am guessing that this firm wants to establish long term relationship with investors. It is true that the return would be higher when selling quicly but the investors would expect to make huge profits in short time, and that is not the case. This opportunity is uniqe and not common. If the firm produces an overall return of 20% annual for 3-4 years then investors woud be happy and will continue to invest in long term deals. It's only a thought but I know that the hardest thing for an investing firm is to get finance, and it is done by building trust with investors

@Isaac Geller I couldn’t agree with you less 😊 The way to establish a long term relationship is to honor my money. Keeping it tied up, lowering my effective return, all so the GPs can get a tax break isn’t honoring my money. If I know that GPs respect my money and investment *more* than their tax consequences I’d be 100 times more likely to reinvest in a subsequent deal. Lowering an effective annual return because you don’t want me (as an investor) to “get used to” an above-average return treats me as though I’m an petulant child and that I’m too foolish to see that it’s for the benefit of the GP’s tax rate.

Again, I don’t know this deal from a hole in the ground, haven’t see the pro-forma, etc. so it’s all just speculation given what’s here. And this doesn’t mean you shouldn’t do the deal or that the returns don’t merit investment. I’d just want a GP that put the investor first. Purposefully diluting annual returns is absolutely not the way to establish a long term relationship.

Free eBook from BiggerPockets!

Ultimate Beginner's Guide Book Cover

Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!

  • Actionable advice for getting started,
  • Discover the 10 Most Lucrative Real Estate Niches,
  • Learn how to get started with or without money,
  • Explore Real-Life Strategies for Building Wealth,
  • And a LOT more.

Lock We hate spam just as much as you

Join the Largest Real Estate Investing Community

Basic membership is free, forever.