How do you value unused space when analyzing/making an offer?

Question

I will do my best to give a brief description of a property I looked at.  My question is to how determine a fair offer?  The building at one time was utilized as a rooming house, with an attached bar, and attached storefront.  The current owner made a huge 3000 sq ft+ owner's suite on the first floor.  He is renting out the rooms above him, which share a kitchen.  The addition on the back was where the bar and kitchen was, and there is an addition on the side that had a storefront.  Above the storefront he framed out two apartments and roughed in electrical and plumbing.  The building is over 14,000 sq ft.  There is also a huge barn in the back with 4 oversized garages that could produce income.  I walked it twice with my contractor and with my lender.  I wanted my lender to see what needed to be done as far as improvements.  It's a big project, but can easily be done in stages.  My plan would be to walk off a few areas, knocked down a few walls, and convert it into 9-11 apartments.  It would require approval from the Zoning Board, but I've dealt with them on my current project, and I have a good relationship with them.

Let's say the asking price is in the $200,000 range.  However, if I strictly take his income and stated expenses (unverified), I get a value of around $100,000 at an 8.5 CAP, which is what my bank uses when appraising.  For the sake of my question, let's assume I can get zoning approval and rehab costs will be $175,000.  I can generate 700-800 average rent per unit, per month.  At the above numbers, if they hold true, I can make it work at asking price.  But I'm not sure how my bank will value it, based off of current NOI.

So, with roughly 11,000 sq ft currently bringing in $0 income, as well as the garages bringing in $0, how would you value a property like this?  NOI only?  Do you consider the value of the unused structure at all?

Thanks in advance for your insights.

Jason Krick · Answer

@Michael Seeker

Thanks for your insight.  I'd most likely do a Construction Perm loan.  It's hard to describe without seeing it (which is why I brought him to it), but the project would be sectioned off.  For instance, we'd start by finishing the apartments above the storefront and the owner's suite first.  Get them performing, then take draws on another section.  Repeat until done.  Going this way, I think my lender will continue to loan on it, as the value increases.

Knowing that, would you structure an offer based on (very) conservative pro-forma, or point to the current income and say "Hey, that's what it's worth right now as it stands"?

Michael Seeker · Answer

When doing a value-add project I always look at the potential income and potential costs (very conservatively) and then determine if the numbers make sense.  You mention 700-800 average rent, I would assume $650.  You suggest $175K in rehab costs which seems like it would be quite low for 10,000+ square feet worth of work...I'd maybe double that and hope it's conservative.  Using that information and some back of the envelope math you're looking at:

$550K total investment$5850 total rents (on 9 units)

Those numbers may or may not be good depending on the area and expected expenses.

Regarding the bank, are you looking for a rehab loan or just an acquisition loan?  Depending on your answer, the bank may want to value the property very differently.  For construction loans, banks will generally consider a pro-forma income statement as the basis for their NOI (and for approving the loan).  They will likely have an appraiser do an ARV appraisal which would be their way to validate your pro-forma numbers (you can't just say rents would be $900 if they might only be $600).  For a basic purchase with no construction component, the bank has nothing to go on other than what exists today which doesn't sound good from what you've described.

Since the lender has already walked the property with you, you should call them and talk through the options.  They've likely been through similar transactions and might be able to add value to your analysis and decision making process.