How to analyze a deal for multi-unit?
Hawthorne , CA · Member since 2015 · 34 posts · 11 votes
Hello everyone, I'm sort of new in buying multi-unit properties. My client is looking to widen his portfolio in real estate and love the idea of multi-unit, considering that he will just rent out the units and not stay on the property. He not necessarily concerned with a huge return on rent, as long as the rents are covering the mortgage. With that being said, what should I be looking for when searching the MLS? I've noticed a few in the south bay, but want to make sure the deal is good before we submit any offers.
50% rule has always seemed reasonable to me as a first cut.
You as his realtor should be doing a normal CMA for him, and a rent CMA for properties, as well as asking for what the units currently rent for when you ask for the seller disclosures. You also need to know about rent control laws in the areas you're checking out for him.
You want this property to be a huge money making success for your client, because then he will get the "Real Estate Bug" and come back to you to purchase future homes. This isn't one where you think of selling a home, this is one where you think of setting your client up for as much financial success as possible and truly adding value to his life. That very well might mean you tell him "bad idea" on the first 3 homes he wants to write offers for $X on - tell him to either not write the offer, or to write the offer for much less than his $X. These investor types are huge freaking money makers for you, **if you help them make money** in turn.
For owner occupied FTHBs, you nudge your clients to make higher, more 'serious' offers. For these guys, it would be OK if you wore your wrist out from making so many vaguely lowball just to see if any stick. Don't get stupid with it, but find the balance.
Investors are about 5x as much work for you per closed transaction, if you're doing it right. But they pay better in the long run, so this is opportunity knocking.
You aren't selling a home, you're playing kingmaker and setting your client up for an empire.
@Myles Allenf I was your client and you found me a small multi with a current GRM of 12 (that I could get closer to 10 with some improvements/mgmt),
Justin, can you give an example how you would change the GRM from 12 to 10?
Sorry, I didn't speak precisely. I was trying to describe the difference between Actual and Projected income from the property.
In my current market, if the broker came with a property with an actual GRM of 12, but a reason he thinks income could rise so it'd be closer to a GRM of 10 within 12 months, I'm interested.
You and I sing the same song on evaluating properties in this thread and others - I think the main point is that CAP rate is not a measure of whether something is a good investment. It's an attribute of the current market. People try to use it as a synonym for their profitability, which it is not.
I didn't read the link, but Stephan really hasn't gained $1.1M until he sells. And if his rents haven't doubled, then he is perhaps allowing that capital "bank" to be underutilized since it's just sitting in the property. Let's turn this example around (not for you, Bob, but for others struggling with this concept like I did)...
Jack and Jill both start with an investment account containing $900K. After five years...
Jack's account still has $900,000 in it. He makes $90,000 a year off the investment in the form of dividend payments (it's an example).
Jill's account is valued at $2.1M. She makes $90,000 a year off the investment from dividends.
If Jack and Jill were both looking to maximize their income, then Jill is not utilizing her money as well as Jack. She should look to sell her current portfolio and buy a different one that can earn her a higher dividends.
If Jill's account after five years is only worth $450K and she's still earning $90K/yr, she has to ask herself how long can that return be sustained? Can the underlying companies in her portfolio sustain those large dividend payments when the value of their company has dropped so much? Or are those companies in an investment cycle where they are simply undervalued?
In my Jack and Jill example, Jack would be synonymous to a real estate investor in the steady markets like Ohio, Indianapolis, etc. while Jill might be in California, New York, or some other cyclical market.
So Cap Rate is just one tool in your belt that you can use to while reviewing your portfolio to see if you should take some of the gains or not. It can also help you understand if you have some bad eggs. Finally, it can give you a general idea of the day-one returns you would expect but doesn't do much for predicting the future.
Let me assist some of the folks here.
1. Most most local markets in California will give you a 4-6% cap rates, if you are cap rate is less than 8%, it will be very hard to generate any cash flow from the property unless your LTV is over 30%.
2. If GRM is over 8, it will generate negative cash flow. According my research, cities like Los Angeles, San Francisco, San Diego, Orange County, etc has GRM of 10 and above.
Hope this will help some folks.
This post makes the assumption buyers reading this forum are buying deals at retail. I would hope this not to be the case...
@Myles Allenf I was your client and you found me a small multi with a current GRM of 12 (that I could get closer to 10 with some improvements/mgmt),
Justin, can you give an example how you would change the GRM from 12 to 10?
Sorry, I didn't speak precisely. I was trying to describe the difference between Actual and Projected income from the property.
In my current market, if the broker came with a property with an actual GRM of 12, but a reason he thinks income could rise so it'd be closer to a GRM of 10 within 12 months, I'm interested.
You and I sing the same song on evaluating properties in this thread and others - I think the main point is that CAP rate is not a measure of whether something is a good investment. It's an attribute of the current market. People try to use it as a synonym for their profitability, which it is not.
One person does not change the Market GRM. If you bought the property at a 12 GRM based on market sales at that time and you increased the rents over time but the GRM was still 12 then your VALUE would change NOT the GRM.
Now if you can improve a property to the point that the GRM comps are more desirable properties and your property is now comped to them then you'd still want HIGHER GRM (the market will now pay you 14 times your gross rents instead of the 12 times you paid).
It can get confusing because 95% of the people here use it backwards.
@Account Closed So you're basically saying GRM is just like CAP rate - most people use the terms as a metric for a particular property, but the "right" use of both (at least as it applies to commercial properties) is as a market characteristic.
In other words, a property with a given level of desirability and offered at a GRM of 10 should be compared against other properties also offered with a GRM of 10. Comparing a GRM 8 property and a GRM 10 property (or a CAP 8 and CAP 10, for that matter) is really comparing two different asset classes.
Does that sound right?
@Account Closed So you're basically saying GRM is just like CAP rate - most people use the terms as a metric for a particular property, but the "right" use of both (at least as it applies to commercial properties) is as a market characteristic.
In other words, a property with a given level of desirability and offered at a GRM of 10 should be compared against other properties also offered with a GRM of 10. Comparing a GRM 8 property and a GRM 10 property (or a CAP 8 and CAP 10, for that matter) is really comparing two different asset classes.
Does that sound right?
@Justin R You've got it exactly right except backwards. There is no cap rate or GRM on a specific property until a sale is closed. Oops, that 's too late. If Class A office properties (NOI) are selling at 5% cap rate then offer prices mean nothing. A buyer will go into the market making 5% offers {trying to negotiate a higher cap rate but why would a seller sell for less money than marker?) So you go into the market and EVERY Class A office is a 5% cap. See how you can't screen based on cap rate? See how NO ONE has stepped up to my challenge to show how they use cap rates to screen or predict profitability) If someone is trying to sell for over market (say 4.5%) then they have to find a uneducated buyer or they are not in the market to sell.
@Account Closed I thought I was on the same page, but now I'm not so sure. :|
Let's say Class A office properties are selling at a 5% cap rate. Tom owns a Class A office building (it has all the physical attributes that make it "Class A") and his company manages it. But, Tom is a mean person and tenants keep leaving, leaving Tom with a higher-than-average vacancy rate and gross rental income last year of $800,000. Tom's NOI last year was $300,000. Tom puts the building on the market.
There just so happens to be an identical neighboring building that also just went on the market. It shows gross rental income last year of $1,000,000 and an NOI last year of $400,000.
Joe is looking to buy just such a building and sees both listed.
What are each of these buildings likely to be listed for? What language should Joe use to describe these two purchase opportunities? And, assuming Joe purchases one at a moderate discount to listed price, what can he saw about the GRM or the CAP rate in this situation?
Thanks to entertaining the question - I'm trying to be sure I understand the subtlety in both these terms in the commercial arena.
@Account Closed I thought I was on the same page, but now I'm not so sure. :|
Let's say Class A office properties are selling at a 5% cap rate. Tom owns a Class A office building (it has all the physical attributes that make it "Class A") and his company manages it. But, Tom is a mean person and tenants keep leaving, leaving Tom with a higher-than-average vacancy rate and gross rental income last year of $800,000. Tom's NOI last year was $300,000. Tom puts the building on the market.
There just so happens to be an identical neighboring building that also just went on the market. It shows gross rental income last year of $1,000,000 and an NOI last year of $400,000.
Joe is looking to buy just such a building and sees both listed.
What are each of these buildings likely to be listed for? What language should Joe use to describe these two purchase opportunities? And, assuming Joe purchases one at a moderate discount to listed price, what can he saw about the GRM or the CAP rate in this situation?
Thanks to entertaining the question - I'm trying to be sure I understand the subtlety in both these terms in the commercial arena.
Great question Justin. First let's take your properties and show why a cap rate is necessary for this type of commercial property. Lets assume both properties are operated by the same company and have the same vacancy rates. The only difference is that the NOI's are drastically different because leases were signed at different times so the lease rates are different. Building A would sell for $5,000,000. ($300,000 NOI/ 5%)
Building B would sell for $8,000,000! Both building leased up to 95%, expenses the same but because of the timing of the leases one building has higher rents and would sell for a much higher value. Of course a buyer will adjust their offer based on the strength and length of the leases.
Now to your example as is. Building A is NOT performing to market but has the potential to once Tom is gone. Tom is not going to discount his price based on the capitalized value of his underperforming property. An investor will use the market cap rate against the potential of the property. Let's say building B is performing at market with market rents.
An investor will capitalize the potential NOI ($400,000) and determing the same $8,000,000 value of the property. THEN he will subtract the costs to get to market performance. These are called below the line adjustments and include lost rent over say 2 years as anticipated to lease up the property, also leasing fees and a component for the risk. But also he will account for LESS variable costs while his building is under tenanted.
So you see just taking underperforming NOI will result in a much lower price when it may only take say $1,000,000 to get the value to $8,000,000, You will still be negotiation with the seller over how long it will take to lease up etc. plus the value of the risks.
This is a very brief overview of the capitalization process. You can spend months of education just to learn how to analyze expenses which is just a small component of the entire process. For people calling expenses 50% of income and claiming that to be NOI is just plain ignorant. The same for people calculating a cap rate using an asking price.
@Account Closed Makes sense, mostly.
You're saying, though, that Tom will list his building at the same price as Bldg B, even though his NOI is dramatically lower? And expect the buyer to negotiate the purchase price down?
I would think that Tom would offer his property at, say, $6,500,000 because he thinks it'll take $1.5M to get it to market rents. The buyer would then see two properties on Loopnet:
Bldg A (Tom's Bldg): $6,500,000 - 4.6% CAP
Bldg B (Other Bldg): $8,000,000 - 5% CAP
I think this is where it gets confusing - Loopnet is basically saying: "This is a 4.6% CAP property," and that's what people on BP then say in their posts. Nevermind, for a moment, that if it'll actually cost $1,000,000 to get Bldg A stabilized at market rates, the listing on Loopnet with the lower CAP rate is actually the better deal.
@Account Closed Makes sense, mostly.
You're saying, though, that Tom will list his building at the same price as Bldg B, even though his NOI is dramatically lower? And expect the buyer to negotiate the purchase price down?
I would think that Tom would offer his property at, say, $6,500,000 because he thinks it'll take $1.5M to get it to market rents. The buyer would then see two properties on Loopnet:
Bldg A (Tom's Bldg): $6,500,000 - 4.6% CAP
Bldg B (Other Bldg): $8,000,000 - 5% CAP
I think this is where it gets confusing - Loopnet is basically saying: "This is a 4.6% CAP property," and that's what people on BP then say in their posts. Nevermind, for a moment, that if it'll actually cost $1,000,000 to get Bldg A stabilized at market rates, the listing on Loopnet with the lower CAP rate is actually the better deal.
Forget LoopNet. The cap rate is set by the market by actual sales that have been ANALYED by a third party. They will determine what was paid for NOI and adjust for what was needed to arrive at that NOI if the property was not performing to market. Here BOTH properties have a potential NOI of $400,000. One is actually performing and sells at market cap rate of 5%. Lets say building C is performing to market at $300,000 NOI but has no upside. ($300,000 / 5% = $6.000.000) Excuse my incorrect earlier math. I spent 6 HOURS for dinner last nite with an 8 course wine pairing! Still recovering. So building A has the same NOI as C but has upside of $100,000 in NOI. Those properties would not sell for the same. A and B both have potential of $400,000 NOI and that NOI would sell for the same market cap of 5%! But A is not getting $400,000 so AFTER you capitalize AT MARKET you deduct from the capitalized sales price the costs AND risks to get there. Any one ONLY looking at the final sales prices would assume they sold at different cap rates. That is why I keep telling people that if you do not have all the information on a sale then you DO NOT have a cap rate comp so anyone telling/selling you at a 5% because they say a property sold for X with X NOI then they are trying to fool you unless they can show all the calculations and conditions of the sale.
Think of two houses 1000sf that one sold for $100sf= value $100,000. One house sold for $80,000 but needs a new roof for about $20,000. You don't know about the roof but the guy is trying to get you to sell your house to him for $80 sf based on this sale when in actuality they both sold for $100 sf.
@Account Closed Ok, I'm on the same page with all of that, and think I can accurately represent your point about correct usage of CAP rate and GRM. I think I'll act and speak more credibly next time I'm talking shop with a commercial broker.
That said, I guess my only observation is that the usage of grammar and meaning of words changes over time and, if 95% of people really do use the term "CAP rate" to mean something different, at some point it ... well ... it does mean something different. When you use the term, I now know what you mean. When most others use it, I'll have to substitute "an NOI number for the property divided by the offering/purchase/value price of the property at some point in time." More than a little less precise.