Basing CAP rate off projected income

22 Replies

Hey all, So I was looking at a 10-unit multi-family property the other day online and it was advertising an 8 CAP. But when I ran the numbers, the CAP rate I got was closer to 6. When I asked the broker where the 8 CAP came from, she said it was based off projected NOI. I’ve always evaluated any property or business off actuals, not projected. Is calculating CAP rate off projected NOI an accepted practice in commercial RE? If not, would this be a good point to negotiate a lower purchase price or would I just be spinning my wheels?

You'll get that a lot.  One of the biggest potential pitfalls in the business- the evil proforma.  lol.  So yes, just tell the broker that you buy based on how the property is performing today, not in 3-5 years from now.  It would not be spinning your wheels, but an opportunity for you to demonstrate to the broker that this isn't your first rodeo and ultimately you get the broker to trust you and you can build that relationship with her.

Hi Russell,

I also see that happening quite frequently.  Projected values are simply projections so take them with a grain of salt.  If you are basing your offer on actuals...please ensure the actuals are actually accurate.  In addition to this, I think you may want to check out the market comps(sales comps and lease comps) to come up with an offer that is reasonable and negotiate for a win-win.  

Thanks,

-AJ

My Excel model calculates 40 different cap rates for every property. Cap rate is one of the most misunderstood and misused yardsticks in real estate. Given that it’s one of the primary measures used to value an income stream, that’s no surprise. 

It isn't improper nor uncommon for the broker to advertise a proforma cap rate. But that doesn't mean that if the market is trading at a 6 cap that you should be buying at a 6 cap on proforma numbers. Instead, it should trade closer to a 6 cap on tax-adjusted NOI using annualized T-3 income and T-12 expenses. But the broker is trying to sell something and 8% always sounds better than 6%, unless you're talking about tax rates or management fees.

Not that cap rate should even be the primary calculation used in determining a strike price, but that’s a whole separate issue. 

@Russell Gronsky

Hi Russell

This is becoming so common. I don't know any bank that would lend on projected NOI. This is the biggest mistake with newer investors, buying on pro forma.

Please be patient and buy only on actuals.  You go back with your underwriting and give them the price based on your actual numbers. Have your banker go over your numbers to make sure.

This is where the market is right now. People are overpaying. Don't fall into that trap

Gino

This is one of the biggest problems encountered. Sellers that have kept their rents under market and expecting to sell on potential rather than actual income.

Big mistake on the part of investors on both sides of the deal but a golden opportunity for buyers to take advantage of inexperienced investors that set rental rates below market.

@Chris Tracy @Bharath(AJ) A. @Brian Burke @Gino Barbaro @Thomas S.

Thank you all for the advice. I'm glad I was on the right track with disagreeing to evaluate the deal based off projected. The street smarts side of me raised a flag when I saw the word "projected" but I thought to ask the question here before replying to the broker.

Russell,

Don't fall for the proforma.  Buy off Actual and account for all expenses.  

Small properties are horrible at tracking expenses especially when the owner manages.  

You might listen to the BP podcast episode with Chris Voss that is awesome for negotiating.  I think he was also a guest  on Wheelbarrow Profits.  

Good luck.

Darrin

Originally posted by @Russell Gronsky :

@Chris Tracy @Bharath(AJ) A. @Brian Burke @Gino Barbaro @Thomas S.

Thank you all for the advice. I'm glad I was on the right track with disagreeing to evaluate the deal based off projected. The street smarts side of me raised a flag when I saw the word "projected" but I thought to ask the question here before replying to the broker.

One nuance on wording...you can present your offer without "disagreeing" with them.  A well supported offer is more effective than pointing out a fallacy.  One way shows serious intent and competence and the other way hurts rapport.  You also want them to feel like they are in control while guiding them to your objectives.

@Brian Burke

Will you please explain what you mean by the terms 'annualized T-3 income and T-12 expenses'.  I doubt most people know....I do not.

@Russell Gronsky ,

Two more thoughts. Not only should you not fall for this hijinx on behalf of the broker, you should also examine the leases, what their present rents are, and how many of the units were very recently rented, and to whom. I've found shady deals where the CAP was pro forma, and the seller had a fire sale on rents, putting everyone except Charles Manson in their apartment, to make it appear more profitable than it is.

The second thought is that comps do you no good at all in an apartment building. What the building generates in cash is what the bank, and what the assessor will value the building at. One thing that does help set the market, though, is the CAP rate that similar style buildings are selling at. No matter what your lowball offer, if the other 10 plexes are going 5 cap, likely this one will too.

@Russell Gronsky So there are really a few issues here:

1.) The majority (but not all) cap-rate calculations I've seen from brokers are based on their pro-forma of projected gross rents.  What's more challenging is that they sometimes 'forget' to mention that their projected rents are based on $300K worth of improvements.  And those improvements, of course, aren't accounted for in the purchase price.  So the net result is that it can be far, far, FAR from accurate.  And there's really not much you can do about it except to expect it and get more adept and building your own pro-formas.  

2.) I love, love, LOVE using T-12s but they are far from the be-all and end-all.  Property taxes may increase when you purchase the property, who knows what your insurance costs will be, what your PM charges you vs. them, etc.  And if you have someone that has rehabbed the property and invested in it over the past 12 months you could have a good property and a horrible T-12.  Units could have been vacant for 2 months because of major rehab, not a lack of rentability.  

3.) To take this to the extreme, if I have a newly refurbished vacant 8-plex it does have value.  It may have a lot of value.  But a T-12 is going to be zero or show it has a "cash-flow negative" property.  That doesn't mean it's worthless, just that the T-12 doesn't tell the whole story.  

4.) By the way, you can manipulate a T-12 pretty easily but pushing everything through cap-ex improvements to drive down maintenance costs.  Don't repair, replace and you get to manipulate that T-12 in an "acceptable" way.  Decide to skip the quarterly pest control this year?  Sure.  Decide to mow the lawn once a month instead of twice a month this year?  Sure.  Don't repair the dishwasher for $70, replace it for $200?  Sure.

The bottom line, I suppose, is that many times there are some elements of truth in a projected pro-forma, some elements of truth in a T-12, and your job is to figure out what your "relative" truth is for the property. 

  

Originally posted by @David Moore :

@Brian Burke

Will you please explain what you mean by the terms 'annualized T-3 income and T-12 expenses'.  I doubt most people know....I do not.

Great question, David.  My apologies for jargonizing.  Let me lay some foundation before I answer your question directly.

Cap rate equals NOI divided by price. In my earlier post I incorrectly noted that my model calculates 40 different cap rates for each property. I was going off of memory and I was wrong, I went in and checked and it actually calculates 64 cap rates for each property. This just goes to underscore how misused and misunderstood cap rate really is. And how bad my memory is...I wrote the darn program, you'd think the process was arduous enough that it would be ingrained in my brain. Not to be...

It's important is that everyone is on the same page when discussing cap rate.  Trouble is, they usually aren't.  One person's 8% cap rate is someone else's 7.5%.  There are only two prices that can be used, the asking price and the purchase price so it isn't that variable that is causing the confusion. 

But what about NOI (Net Operating Income)? There are so many variations on how NOI is calculated and it makes a big difference in the resulting calculation of cap rate and/or price/value. So it is from NOI that the confusion really sets in.

For NOI you have the broker's proforma, trailing 12 month (T-12), trailing three month income (annualized) with trailing 12 month expenses (T-3/T-12), your year 1 forecast, and your stabilized proforma.

Within all of those categories of NOI, there are different ways to calculate it: Off of the purchase price only with recurring capX above the line (in other words, subtracted from NOI), off of the purchase price only with recurring capX below the line (in other words, subtracted from cash flow but not from NOI), All-In which means purchase price plus costs of upfront capital improvements with recurring capX either above or below the line. Oh and don't forget, you can calculate all of those methods using tax adjusted numbers or non-tax adjusted numbers, which means removing the historical property tax expense and replacing it with the forecasted future property tax expense, which in most states will be considerably higher once the property changes hands and is re-assessed.

So as you can see, a lot of cap rates.  So how do you value the real estate?  The OP's question is whether it's appropriate to value it using the broker's proforma numbers.  No, it's not.  But that doesn't mean that the broker can't quote a profoma cap rate nor does it mean that a proforma cap rate is irrelevant (well, it is from the context of setting a strike price but there are other uses for proforma cap rates).

This also doesn't mean that if the broker is quoting an 8 cap on proforma that you should be able to buy the property for an 8 cap on actual (no matter which "actual" you are using).  I don't know where the property is located but my guess is similar properties probably trade between a 5 cap and 7 cap on actuals.

But when you think of properties trading in that range on "actual" numbers, which "actual" NOI are you supposed to use? Generally it's normal to take the last three months of income (called "trailing 3" or "T-3"), multiply it by 4 (which annualizes it) and then subtract the expenses from the last twelve months (called "trailing 12" or "T-12"). (This one sentence is the answer to David's question). This method is the most up-to-date of snapshot of the property's current performance, and the most in-focus view of it's immediate future performance so long as the economy cooperates and the property is well-managed.

Of course if you buy it, you'll do a much better job than the current owner and take the income even higher, right?!?

@Mike Dymski @David Moore @Andrew Johnson

You guys bring up great points. Guiding the seller to your outcome while making them feel like they are in control is certainly an art. I'll do my best.

The quality of tenant is something I haven't considered in initial calculation of the numbers and hiding things in a T-12 by pushing to cap-ex. I suppose a viable counter to letting that slip through is to know what a typical cap-ex would be in a given year for a property of this size but how would I go about knowing that, aside from analyzing deals until I dial in on approximate cap-ex I should see in a year? Is there a rule of thumb to get you in the ballpark? For example, when flipping a property, I know from experience that it will cost me roughly $15 per square foot doing majority of the work myself and about $28 a square foot if I contract out the work. If I see renovation expenses 10% or more outside those numbers, it will prompt me to look very closely at why that is. 

@Russell Gronsky For me, cap-ex expectations are always property dependant.  Some of the stuff (like replacing an appliance) is easy to handle with cash-flow.  And in other cases you're dealing with a huge difference if you're dealing with asphalt-ish stuff or concrete.  Concrete lasts a lot longer but it more expensive to replace.  The same disparities can come up if you're looking at siding vs. brick.  Or roof replacement (per unit) on a 3 story vs. 2 story building.  If there's a pool that you'll have to resurface in an apartment complex.  So, the short answer is, I don't know how you'd generalize ppsq flipping costs into a commercial multifamily property.  

Tenant "quality" is also pretty relative and some of it you'll be able to address when it comes time to review leases.  That's going to be after you have it under contract.  You can ask to review leases, if anyone didn't put down a security deposit, some will keep rental applications, etc.  Whatever you find it's always good to assume 12 months of "stabilization" with the tenants.  Basically, plan for more turnover during the first year.  Tenants (at least this is my experience) can get a little spooked, are more likely to move out, etc.  And you figure out pretty quickly who the problem tenants are that you wish weren't there :-)

@Brian Burke

I really don't use this term much, but twice in one week....a scholar level analysis.  Wow, love it.  But another quick question.  How on earth, in your due diligence, can you get the seller to divulge what his trailing 12 months expenses are?  Some you can lookup, sure.  Some you can extrapolate from the broker.  Do you request a schedule E,  and if the seller owns more than one property, how do you untangle the cords of his/her financial web?

Originally posted by @David Moore :

@Brian Burke

 How on earth, in your due diligence, can you get the seller to divulge what his trailing 12 months expenses are? 

In the context of large multifamily it's industry standard for sellers to provide a T12 income statement broken down by month. Certainly some owners are better than others at maintaining their income statement but for the most part they are usually pretty good.

In the context of small multifamily it's a complete grab bag ranging from CPA level income statements all the way down to a shoebox full of receipts.  These are certainly more challenging and also call into question the accuracy and believability of the information.  You just have to do your best to reconstruct what is going on and compare that to typical costs for that size of property.  Trouble is, most people investing in mid-size multifamily properties are in that space because they don't have the experience to go larger and thus lack the comparative operating history.  I suppose that's where the collective knowledge bank of BP comes in really handy...

Originally posted by @Brian Burke :
Originally posted by @David Moore:

@Brian Burke

 How on earth, in your due diligence, can you get the seller to divulge what his trailing 12 months expenses are? 

In the context of large multifamily it's industry standard for sellers to provide a T12 income statement broken down by month. Certainly some owners are better than others at maintaining their income statement but for the most part they are usually pretty good.

In the context of small multifamily it's a complete grab bag ranging from CPA level income statements all the way down to a shoebox full of receipts.  These are certainly more challenging and also call into question the accuracy and believability of the information.  You just have to do your best to reconstruct what is going on and compare that to typical costs for that size of property.  Trouble is, most people investing in mid-size multifamily properties are in that space because they don't have the experience to go larger and thus lack the comparative operating history.  I suppose that's where the collective knowledge bank of BP comes in really handy...

 I'm meeting with a mentor locally before I go into the bigger stuff.  Too many details I don't know.  

This is a great thread and I really appreciate all of the detailed answers from you more experienced folk here at BP. @David Moore Another thought not mentioned so far is to, at least initially, not even worry about the cap rate. Run the numbers through your deal analyzer and focus on your CoC and IRR goals. When you plug in actual numbers the sale price (and actual cap rate) are usually laughable, especially on the smaller deals that I have looked at. I will then go through a series of iterations to my analysis, plugging in actual numbers (the seller's and my own research on taxes, insurance, PM, etc.) and ultimately (conservatively) coming up with an offer price. This is where I work cap rate back into the equation, using a market cap rate (or the cap rate in their listing/OM) with my adjusted NOI.

The biggest gotcha that I have learned in analyzing my deals as a rookie, is assuming annual rent increases and disposition cap rate. In any market, but especially today's market, Be VERY CAREFUL with these calculations as they can kill a deal and leave you with a loser that you can't sell or can't refinance.

This is a great thread.  How can you get true comps for these commercial deals?  I current use loop net for looking at recent sales and sometimes it's hard to find recent sales.  What is the rule of thumb when dealing with smaller buildings up to 10 units that the owner can't provide the T-12 numbers? @Mike Dymski, How do you suggest approaching the disagreement with proforma vs actual findings of the deal without ruining your negotiations with the potential seller?  You mentioned "guiding them to your objectives". 

@Russell Gronsky it is common practice for sellers to use projected numbers rather than real numbers. In other words, if every unit was rented at market price, this would be the income. Expenses often ignore reality of past performance. It is basically a sales tactic to make the property look better than it is. I would ask for the last two years of income/expense statements, either their tax forms or a statement that is certified by their CPA. Real numbers don't lie. If someone is scared to share the real information with you, it just means they are hiding something. 

I think you're wise to meet with a local investor who has been there and done that. I don't touch the small stuff anymore because it's just not worth the time. For the same time and risk cost, the larger deals make more sense. If you cannot do a larger deal yourself then definitely team up. Be an investor or a capital raiser on another deal. Learn that way and down the road your knowledge and experience will be way ahead of where you are now. Great thread here!

A couple of things to add:

1. As far as rent increase projections, it's often possible to get a ballpark number from the broker (i.e. "they spent $2500 a unit on 10 units and raised rents by $100 per month"). As always, it should be taken with a grain of salt (unless it's an actual result and reflected on the rent roll) but they're usually able to provide a good high-level number. Once I identify a property that looks like a deal at that level, it's a good idea to engage a local PM in order to verify those assumptions, and firm up your expenses as well (especially payroll and management costs).

2. I'm not a huge fan of targeting a certain cap rate as a purchase criteria, and the sheer number of ways to fudge it (by fudging the NOI) is one reason. Here's another: your investors don't really care about cap rate, they care about what return they see. It's possible to meet your target returns with a 6-cap in some situations, and in others it may take an 8-cap. Just depends on what your post-purchase plan for the property is. Now, that being said, cap rate is still important (it helps make sure you don't overpay for the property), but it's not as important as other things like the value-add proposition or the price itself.

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