Cap Rate Based On Pro Forma NOI?

Question

Hello BP community,

I'm starting to look for larger multifamily properties.

A common (surprising) trend I'm seeing is that people are selling their properties based on future (proforma) NOI.

How does that make any sense?

Here is a real example I'm looking at now:

A 10 unit property has a current NOI of $84,000. After some upgrades it will have an NOI of $100,000.

Sellers will price the property at the $100,000 NOI rather than the current $84,000 NOI. How am I supposed to make money on a value add property when they are selling the property at the price I'd get after adding the value?!

Is this common or am I just seeing this because this is an on market deal? Should I expect them to sell at current NOI or somewhere in between?

Thank you all.

Percy N. · Answer

Underwrite it to your proforma, not the broker's or seller's proforma.

Mike Dymski · Answer

Welcome to commercial REI (and excessive government actions)...you summed it up well!  Need to find opportunities that are not in the $100k.

Mike Dymski · Answer

Need to find value above the $1,100, not the $750...or purchase at a price based on rents between those two rental amounts.  I'm a value investor and have never purchased a property that did not have built in gains.

Paul Moore · Answer

Hi @Matthew Masoud when properties are selling for a price that includes future improvements and appreciation, you know you have entered a speculative market, it is not true investing.  Investing is when your principle is safe and your cashflow is secure, and you expect to make a return from your improvements.  Speculating is when your principle is not safe, and cashflow and value are based on future appreciation which is not guaranteed.  Hope is not a good business strategy and neither is this.

I wrote a book on multifamily investing and committed to only investing in apartments for the rest of my career.  But issues like this one caused me to look outside of multifamily to self-storage, mobile home parks, RV parks, etc. The speculation in future value was just too risky for me. I recommend looking for asset classes that have a lot of mom-and-pop owners that don’t have the desire, resources or knowledge to upgrade their assets, increase income and maximize value.  Though there might be a little speculation involved because of the fact that you are counting on your ability to make these value-add improvements, you are generally counting on the current cash flow to derive the underlying value and thus the price.

I have written several BP posts on this topic, including this one: Attention, Multifamily Investors: Why You Must Raise Rents 33% to Break Even (Part I).  Happy investing!

Chris Collins · Answer

@Matthew Masoud you can actually use this situation as a good jumping off point to negotiate.

Say they are using their $100k NOI and a price guidance of $2,000,000.

That equates to a 5 cap

You simply reply:

Hello, I see that you've valuing your property at a 5 cap.  Based on your T12 NOI of $84,000, I have a value of $1.68M.  Happy to write up an offer, etc.

So you get to 'almost' / 'kind of' use their numbers against them/as a jumping off point.

HOWEVER: As others have said above, there is some value in using future numbers, I think what would be more prudent is to use a T3 or T6 actuals and project forward based on that, since those are reasonable numbers to achieve when you take over the property.  So you'd kind of split the difference between their quoted T12 and their projected NOI.  Great job being out there looking at properties!-Chris

Alex Forest · Answer

@Mike Dymski

That makes perfect sense and resonates with me. Thanks!

Account Closed · Answer

@Matthew Masoud I am currently doing financials for properties I am selling and looking to by. Here is how I look at it: as a seller, it doesn’t  make sense to value a property on last years NOI. Cap rates are a measure of risk, so if you use last years numbers, the risk is zero. At minimum, the sales price should be based on next year’s projections and the probability that those predictions are correct (I.e., the cap rate). As a seller, it is reasonable for one to do 5-year projections to determine how much the buyer’s rate of return is. As a buyer, I would do the same thing. If the value ad is large, it may make sense to pay 100k for the property. Buying low is hugely important, but a seller is not being unreasonable capitalizing of potential value add.

In other words, you can

Vince Turnbull · Answer

1st BP post here! I'm a new investor ... question to @Chris Collins and all - where / how do you keep tabs where cap rates are (especially for a market you're just starting out in)?

Chris - I was thinking of your example above. The seller could get to  $2M using with T12 $84K NOI and 4.2% cap rate, just as they may have with their projected $100k NOI and a 5% cap rate.

If I was a new buyer and didn't know where "fair" cap rates for a market I might've fallen for the $84K at 4.2% !

Any thoughts on this?

Alex Forest · Answer

@Paul Moore @Mike Dymski @Matthew Masoud @Percy N.

Im curious to get your take on this...probably same as above responses...but with rents having increased in many areas by 20 plus percent, there are multis with baked in existing leased rates that quickly became under market.  Im seeing a few ten unit type properties near us that have 2 bdm leased rents at $750, with market rents legitimately at $1100, and of course the proformas are using market.  And the asking price, similar to the original post is based on the proforma.  It is work to find new tenants with turnover, etc but also not large capital intensive renovation costs to get the rents up, it is just adjusting to market rents and dealing with the turnover.  Just curious, do you all still see this in the same light, using actual to price (after all, they could have raised rents and delivered it in that state for a sale, but they didn't) or slightly above actual (but not all the way up to proforma rent assumptions) considering the low capital costs involved?

Matthew Masoud · Answer

It was a great read.

After the past few weeks of looking for large multifamily I'd feel comfortable purchasing, I'm fairly discouraged.

I'm going to have to start focusing on off-market deals or potentially start looking at other kinds of assets as you mentioned.

Cap Rate Based On Pro Forma NOI?

Most Popular Reply