How To Write LOI that Holds Seller to Cap Rate

Investor · Member since 2018 · 259 posts · 74 votes

Hello!

We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.

Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).

They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)

We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).

Has anyone ever written an LOI that says something like this:

Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.

Any ideas? Best way to handle this kind of situation?

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Greg ScottPro Member

Rental Property Investor · SE Michigan · Member since 2014 · 4k+ posts · 6k+ votes

While I understand the concept, how do you decide what is the "true" NOI?

I could see arguments ensuing about whether an expenditure is a capital improvement that goes to the balance sheet or a repair which hits NOI. If the seller stops taking a management fee and the NOI goes up, can they force you to pay more? Seems like there would be too much opportunity to play games.

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Greg ScottPro Member
Rental Property Investor · SE Michigan · Member since 2014 · 4k+ posts · 6k+ votes
3y
While I understand the concept, how do you decide what is the "true" NOI?
I could see arguments ensuing about whether an expenditure is a capital improvement that goes to the balance sheet or a repair which hits NOI. If the seller stops taking a management fee and the NOI goes up, can they force you to pay more? Seems like there would be too much opportunity to play games.
3 Reply
Al Boettger
Real Estate · Southern New Jersey · Member since 2014 · 78 posts · 31 votes
3y
Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

0 Reply
Al Boettger
Real Estate · Southern New Jersey · Member since 2014 · 78 posts · 31 votes
3y
How about something along the lines of “… The price tendered is subject to revision pending receipt of actual cash flow information”?
0 Reply
Don KonipolBusiness Member
Investor · The Woodlands TX / Avon, CT · Member since 2009 · 6k+ posts · 10k+ votes
2y
Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?
Theoretically, it can be done, BUT, to be effective you’d have to agree upfront to a third party deciding what “true” net is. I don’t see anyway around the “regrading”; which probably occurs in many commercial deals. I just sold some land I own that, while doing their do Dillinger the buyer and I discovered an unknown under ground steam that was flooding a large portion of the property rendering over half the property unbuildable, with a very costly remedial procedure. The buyer offered a new contract with a 50% price drop; I was willing to drop 40% and the buyer accepted and we closed. New information = new price.
My suggestion is that you make the offer based on the best information available; you can state in the offer than you’re basing your offer on the advertised 7.5 cap rate and that if due diligence shows that the net income is lower you will adjust the offer based on the resultant 7.5 cap rate. This does 2 things. First, if the seller accepts he is acknowledging that the final price is likely to be lower than the original price offered; second, if he’s “playing” games he’s likely to reject the offer as a “waste of time”, thereby ensuring that you don’t waste your time.
There is also a strong possibility that the seller doesn’t even thing about the cap rate; he just wants a certain price and the broker “messaged” the p and l to show an acceptable cap rate. It’s know as “recasting” and is commonly done and in my opinion complete bs.
I will also tell you (you probably already know this) that sometimes a listing needs to “season” before the seller is willing to accept reality of property value. Ninety percent + sellers think that their real property holdings are worth more than they actually are. Sometimes by crazy multiples. Being a buyer usually means shifting through lots of overpriced crap to find the “doable” deal. I look at 50-100 deals to do 1.
This brings up another issue. Most brokers place a property on the nationally advertised websites for sale before obtaining a title report. Many times either the title is “clouded”, there’s additional undisclosed liens against the property (especially IRS and property tax liens), the survey or legal description is deficient, the seller doesn’t hold title to all the property he thinks he does, there are easements which negatively affect property use and value; the property is not in zoning compliance, the property was inherited but never went thorough probate, or their are “missing” heirs that may hold an interest in title.
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2 Reply
Russell BrazilBusiness Member
Moderator
Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
2y
Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

So are you willing to pay the $138k more if the mistake is they reported the income too low?
[email protected]301-893-4635 Podcast Guest on Show #192
District Invest Group546 Reviews
Website View Page
1 Reply
Kim Hopkins
OP
Investor · Member since 2018 · 259 posts · 74 votes
2y
Quote from @Greg Scott:

While I understand the concept, how do you decide what is the "true" NOI?
I could see arguments ensuing about whether an expenditure is a capital improvement that goes to the balance sheet or a repair which hits NOI. If the seller stops taking a management fee and the NOI goes up, can they force you to pay more? Seems like there would be too much opportunity to play games.

I agree. Not to mention, what NOI are we looking at? 2023 prorated? 2022? The intent of what I'm getting at is trying to make an offer based on stated numbers that I think are low. Any ideas on how to structure it better to avoid the issues you describe above?
1 Reply
Greg ScottPro Member
Rental Property Investor · SE Michigan · Member since 2014 · 4k+ posts · 6k+ votes
2y
The seller is not interested in obtaining a certain Cap Rate; the seller is interested in obtaining their price. The seller is going to be suspicious if you try to base the price on a mathematical formula with variable inputs.
I think the best strategy is offer what you think it is worth and if during due diligence you find it is worth less, explain to the broker why you must retrade.
3 Reply
Shafi Noss
Lender · Nationwide · Member since 2018 · 571 posts · 310 votes
2y
@Kim Hopkins Is there a 3rd party property manager who's been handling the accounting? I am wondering why he needs it under contract before showing you the real numbers.
0 Reply
Ronald RohdePro Member
Attorney · Dallas, TX · Member since 2016 · 5k+ posts · 2k+ votes
2y
Quote from @Greg Scott:

The seller is not interested in obtaining a certain Cap Rate; the seller is interested in obtaining their price. The seller is going to be suspicious if you try to base the price on a mathematical formula with variable inputs.
I think the best strategy is offer what you think it is worth and if during due diligence you find it is worth less, explain to the broker why you must retrade.

Agreed with this. Seller will do their best to justify the price based on NOI, but if a buyer disagrees with the NOI, just re-trade. If not, terminate.
No one does this in CRE with a binding legal clause that is highly unpredictable.
0 Reply
Kim Hopkins
OP
Investor · Member since 2018 · 259 posts · 74 votes
2y
Quote from @Don Konipol:

Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?
Theoretically, it can be done, BUT, to be effective you’d have to agree upfront to a third party deciding what “true” net is. I don’t see anyway around the “regrading”; which probably occurs in many commercial deals. I just sold some land I own that, while doing their do Dillinger the buyer and I discovered an unknown under ground steam that was flooding a large portion of the property rendering over half the property unbuildable, with a very costly remedial procedure. The buyer offered a new contract with a 50% price drop; I was willing to drop 40% and the buyer accepted and we closed. New information = new price.
My suggestion is that you make the offer based on the best information available; you can state in the offer than you’re basing your offer on the advertised 7.5 cap rate and that if due diligence shows that the net income is lower you will adjust the offer based on the resultant 7.5 cap rate. This does 2 things. First, if the seller accepts he is acknowledging that the final price is likely to be lower than the original price offered; second, if he’s “playing” games he’s likely to reject the offer as a “waste of time”, thereby ensuring that you don’t waste your time.
There is also a strong possibility that the seller doesn’t even thing about the cap rate; he just wants a certain price and the broker “messaged” the p and l to show an acceptable cap rate. It’s know as “recasting” and is commonly done and in my opinion complete bs.
I will also tell you (you probably already know this) that sometimes a listing needs to “season” before the seller is willing to accept reality of property value. Ninety percent + sellers think that their real property holdings are worth more than they actually are. Sometimes by crazy multiples. Being a buyer usually means shifting through lots of overpriced crap to find the “doable” deal. I look at 50-100 deals to do 1.
This brings up another issue. Most brokers place a property on the nationally advertised websites for sale before obtaining a title report. Many times either the title is “clouded”, there’s additional undisclosed liens against the property (especially IRS and property tax liens), the survey or legal description is deficient, the seller doesn’t hold title to all the property he thinks he does, there are easements which negatively affect property use and value; the property is not in zoning compliance, the property was inherited but never went thorough probate, or their are “missing” heirs that may hold an interest in title.

Lots of great insights here, thank you! I like the idea of putting in the LOI that the offer is based on the 7.5% CAP rate. At a bare minimum, this gives just a little ethical coverage in the case that the numbers turn out to be B.S. ("wow, no repairs ever?!").
0 Reply
Kim Hopkins
OP
Investor · Member since 2018 · 259 posts · 74 votes
2y
Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

So are you willing to pay the $138k more if the mistake is they reported the income too low?
No, why would I? It's their mistake. Only should pay for your own mistakes.
0 Reply
Kim Hopkins
OP
Investor · Member since 2018 · 259 posts · 74 votes
2y
Quote from @Greg Scott:

The seller is not interested in obtaining a certain Cap Rate; the seller is interested in obtaining their price. The seller is going to be suspicious if you try to base the price on a mathematical formula with variable inputs.
I think the best strategy is offer what you think it is worth and if during due diligence you find it is worth less, explain to the broker why you must retrade.

I agree. This makes the most sense. Sounds like I need to lighten up on the "thou shall not re-trade" commandment.
0 Reply
Russell BrazilBusiness Member
Moderator
Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
2y
Quote from @Kim Hopkins:

Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

So are you willing to pay the $138k more if the mistake is they reported the income too low?
No, why would I? It's their mistake. Only should pay for your own mistakes.

Because you are the one who said you wanted to make an offer based on a certain cap rate. If you make that offer and they accept, if the cap rate leads to a higher price, youre the one who asked to pay based on cap rate.
[email protected]301-893-4635 Podcast Guest on Show #192
District Invest Group546 Reviews
Website View Page
1 Reply
Ronald RohdePro Member
Attorney · Dallas, TX · Member since 2016 · 5k+ posts · 2k+ votes
2y
Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

So are you willing to pay the $138k more if the mistake is they reported the income too low?
No, why would I? It's their mistake. Only should pay for your own mistakes.

Because you are the one who said you wanted to make an offer based on a certain cap rate. If you make that offer and they accept, if the cap rate leads to a higher price, youre the one who asked to pay based on cap rate.
I mean, it just is an absurd proposal. What if the NOI turns out to be 3x? Is a purchaser going to buy a $30m property?

Anywho, send the price, justify a retrade based on cap, but just start talking!
0 Reply
Russell BrazilBusiness Member
Moderator
Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
2y
Quote from @Ronald Rohde:

Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Quote from @Russell Brazil:

Quote from @Kim Hopkins:

Hello!
We have a great prospective property we're looking at. The broker OM says they're selling it at a 7.5% cap rate and $5.7m purchase price.
Based on our experience, We are pretty sure their expenses are understated (they're at 23% of gross income and almost always are closer to 30%).
They also have a sloppy typo where rent roll totals $410k on the rent roll page but is shown as $420k on the page where they use it to calculate NOI and purchase price (which would make a huge difference in offer price!)
We want to tie up the deal and show them that we're willing to do it at a 7.5% cap rate on the correct numbers, but we can't get the correct numbers until we're in contract and we don't want to retrade If the numbers were misstated (that never goes well in our experience).
Has anyone ever written an LOI that says something like this:
Buyer and seller agree that the purchase price is calculated by applying a 7.5% cap rate on actual annual income and and expenses and any decrease in NOI actuals from the OM will be reflected in an adjusted offer price.
Any ideas? Best way to handle this kind of situation?

So are you willing to pay the $138k more if the mistake is they reported the income too low?
No, why would I? It's their mistake. Only should pay for your own mistakes.

Because you are the one who said you wanted to make an offer based on a certain cap rate. If you make that offer and they accept, if the cap rate leads to a higher price, youre the one who asked to pay based on cap rate.
I mean, it just is an absurd proposal. What if the NOI turns out to be 3x? Is a purchaser going to buy a $30m property?

Anywho, send the price, justify a retrade based on cap, but just start talking!

That is exactly my point, that making this offer would be absurd. The buyer would never agree to it, so why would the seller?
[email protected]301-893-4635 Podcast Guest on Show #192
District Invest Group546 Reviews
Website View Page
0 Reply
Kim Hopkins
OP
Investor · Member since 2018 · 259 posts · 74 votes
2y
Quote from @Russell Brazil:

I didn't come up with the cap rate. They did. They said it's a 7.5% cap rate. They said the NOI is a specific number. I'm simply asking if there's a way to hold them to the cap rate they're marketing.
0 Reply
Tim Bratz
Developer · Charleston, SC · Member since 2015 · 100 posts · 91 votes
2y
First off, great question.
I think the solution is great in theory, I just don't know if it's the easiest solution to solve what you're trying to achieve. Why not just address those discrepancies now?
If somebody puts that in a LOI, to me, it would raise a bunch of questions as to what this person was trying to accomplish. I would try to hit it on the head from the outset. Otherwise, it feels like you're trying to go about this deal in a roundabout way, and kind of plants the seeds of an ulterior motive right up front.
If you're planning on putting this in an LOI, and then you find out these things aren't accurate, and then you re-trade (when an LOI isn't binding) then you're re-trading anyway. Why not just hit it in the head on the front end? I think you'd be saving yourself and the seller a lot of time.
There's two perspectives: some people tie up the property with the intent of re-trading, which can create some animosity. Or, just have full transparency on the front end, and by shooting straight, you're more likely to get the contract anyway.
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