How do you base your offer (Re: Pro Formats)

Question

Hello beautiful people of BP,

Sorry for the auto correct in my title, I can't fix that, but "Re: Pro Formas"

I hope to be in a position to buy a smaller (10-15 units most likely) apartment building in the next 6 months. My first purchase was a 12 unit (3 fourplexes to be precise), but that was a different situation. Totally off market so I could and did go directly off rents at that given time. Plus, it could have been viewed as non-commercial, so the same refinance rules may not have applied to what I'll be doing next.

At the moment, I'm reviewing pro formas, typically what is on a broker's website. The question I have, how much do you base your offer on what current rents are vs how much they could go for. Obviously, the selling broker loves to point to how much it could go for and base the purchase price on that. I personally will always expect a nice discount if I'm going through the effort of repairing the building and raising the rents.

But what do you more experienced investors do? Only offer on current rents? What the rents could be? Somewhere in the middle?

FWIW, my goal is buy at a price where I can add enough value to a level where I can pull most of my money out w/in a year or so via refinance.

Theo Hicks · Answer

Dustin,

First off, do not trust the broker's pro forma, ever.

Instead, create your own pro forma based on how you will operate the asset once you've taken over the operations. Create an income and expense budget for each year you plan on holding the property and set disposition assumptions to the best of your ability. At that point, you will have a projections for a yearly cash flow and profits from sale. Once you have that data inputted, set an offer price such that the overall returns meet your investment goals.

Theo Hicks · Answer

Hi Dustin,

It will be difficult to buy based solely on the current NOI. The offer price needs to be based on the current NOI and the potential NOI. It's all about your business plan and budget. So, create a 5, 7, 10 year, etc. budget based on how long you plan on owning the building, how long it will take to complete the value add business plan, and the new income, expenses after you take over the property, and disposition assumptions, and set an offer price that will result in the returns you want. It will likely fall between the current value and the potential value. The better you are at executing the business plan, the higher you can pay.

Bjorn Ahlblad · Answer

@Dustin Beam I go off rents and ignore most of the listing-expenses are missing and often wrong, and never have seen an ad that did not include; 'rents below market' or 'just raise the rents' or similar. Other than that it really depends. If the property has been on the market awhile, or relisted repeatedly I may lowball-sometimes by a lot. I use an agent and bounce stuff off her. In Wa it is customary to make an offer on MF to get to see the property, so my offers are cash with an inspection provision which includes financials and property. The real haggling starts after that anyway. I have to add that the way MF market has been lately I have not bought anything this year. Prices have been inflated and too many buyers are willing to buy ignoring the fact that their investment will be underperforming-at least that is my opinion. ;<)

Dustin Beam · Answer

Ha, no (to your first question). It's a weird story, but I once found myself catching a ride from a guy I didn't know late at night who turned out to be a broker and I told him all pro formas were bullsh#t lol. I can be pretty forward at times. :)

I totally agree to do an analysis on any property a person buys. But that's not the angle I'm taking here. For instance, let's say that the pro forma number are reasonable. And you'd make a little money at that price. But, as we all know, there are hurdles to jump to get to market rents typically. Even if repairs/rehab are not needed, you're still going to have to raise the rents...and even if no leases are longer than a month, you'll experience turnover.

So I guess what I'm saying is that if the market  CAP is say 7%. And the listing broker is trying to sell the property at that 7% CAP, but at the pro forma rents. So they are trying to sell the property at full amount, while the new owner has to go through the hassle/expense to get there. I think we would all agree that you don't pay the full asking in that scenario. My question then, is if the market CAP is 7%, are you willing to pay a lower building  CAP knowing that it will eventually meet or even exceed the market CAP? Or are you only willing to pay a price where the current performance CAP rate and market CAP rates are equal?

I hope I'm not making that too confusing. Maybe numbers are better, sorry for being so lengthy. So simple numbers:

Asking Price: $1M

NOI: $60,000

Potential NOI: $80,000

Building CAP: 6%

Market CAP: 7%

Potential Building CAP: 8%

Market value at existing NOI: $857k

Market value at Potential NOI: $1.14M

So as you can see, the asking price is too much for what the market says it should be at its existing performance. But you think you can get it to actually exceed the market CAP, thus raising the value. How hard do you bargain to get it at market value based on existing performance?

Dustin Beam · Answer

I hear ya, and that's how I feel about it too. Agree with pretty much everything you said. I just saw one the other day that had real vacancy at 0% and the pro forma had it at 1% lol. The actual may have been zero, but if you go to market rent, doubt you only have 1%.

Paying close to market cap for pro forma rents seems ludicrous to me.

How do you base your offer (Re: Pro Formats)

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