I love analyzing risk and figuring out the best way to protect downside.
I've got a current deal that has significant upside, I am just trying to fully understand and mitigate risks. The current building has low rents and is managed poorly. My partners an I have a big opportunity to renovate, raise rents, and reduce expenses to increase the NOI. I specifically want to know how we can protect our 25% equity investment.
The things I have questions about:
Cap rate seems to be a subjective number. If we have a premium product in a premium location, we assume we will be getting the lowest cap rate in the range of our market. How can we narrow in this range?
There is also a range of what the units will rent for. A $0.10 difference per square foot is significant, based on how it is amplified over multiple units. Do we just calculate minimum and maximum and be sure we are happy with both results?
As far as reducing expenses, it appears that 50% net income is a conservative estimate, and 25% is an aggressive estimate. This is a huge range. How can I narrow this down? As part of renovations, the HVAC will be new and the roof will not need to be replaced. We don't foresee any CapEx.
I want to ensure we are putting ourselves in the safest possible position with our capital. What else can you think of that would be a factor in analyzing the risk? We have two exit strategies, refinancing and holding forever, or selling after the rents have been stabilized. We can afford to hold the building, so long as we can draw out our equity investment after 18 months.
In regards to your expense load, do you have historical T12's you can dig through? Those, in combination with your proposed capex improvements will help you understand what your proforma can look like.
Cap rates: work with your broker to get the cap rates for comparable properties in the market (that is, properties comparable to the finished product).
Rents: perform a rent comp analysis to calculate a $/sqft for comparable properties in the market (again, properties comparable to the finished product)
Expenses: based on how the current owner is operating and how you will operate once you take over the property. The former can be found in the T-12 and the latter can be determined by speaking with your property management company)
Other: ideally, your debt term is the same length or longer than your hold period, create an upfront operating account fund to cover the unexpected, add 15% contingency to your renovation budget.