How to calculate asking price if expenses are higher than 50%

Multi-Family and Apartment Investing
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How to calculate asking price if expenses are higher than 50%

Taylor Green
Vancouver · Member since 2013 · 159 posts · 6 votes

Hi, I'm trying to figure out how much of a discount I should ask for if the expenses run higher than 50% of gross rent. For example 60% of gross rent... Does that mean I should walk away from the property or just change the asking price? I can't figure out how much I would offer! Thanks for the help...

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Joel OwensBusiness Member
Moderator
Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
13y

I deal in larger apartment buildings where the impact on numbers is stronger than a 4 unit.

The 60% does not include electric. I will get owners and listing brokers saying that I am conservative even more so than the bankers. I really do not care about their statements as the listing brokers many have never owned a building and are just trying to sell and the seller is trying to dupe a buyer showing minimal costs.

It's all about buying right. If you buy right going in almost everything else will work itself out for the better. If you buy wrong you are trying to push a big boulder up a hill and many times the boulder gets to heavy and will run you over.

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  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    13y

    How many units is this?? What is the age of the building??

    If the landlord pays water I go 60% but if the building is really old it can be normal to hit 65% costs in some cases.

    You simply reduce your price.

    So assuming the building has zero capex going in.

    For Example

    Landlord does not pay utilities.

    50 units by 500 rent = 25,000 monthly by 12 =300,000 yearly expected gross income.

    300,000 x .50 = 150,000 NOI at a 10 cap 1,500,000 sales price
    -------------------------------------------------------------------------------
    300,000 x .40 (60% costs) landlord pays water, etc. = 120,000 NOI

    10 cap is 1,200,000 sales price
    --------------------------------------------------------------------------------
    Really old building go .65 costs with landlord utilities

    300,000 x .35 (65% costs) = 105,000 = 1,050,000 at a 10 cap

    Now you have to look at the books and be able to see if costs look high unusual thing snot customary as an expense. Many owners make themselves look like a pauper on paper with paying crazy incomes, fees to another business they own that services their units, retirement funds, etc. They junk it up to pay little taxes. You take those things out and the bank knows for getting a loan what the seller has done and is usually fine with it.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    The building is built in 1983 and its a 4plex. Fully occupied gross rents are $25,200. Asking price is $179,000. The owner over the past 2 years averaged $3800 for water/sewer.

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  • Adrian Mata
    Lacey, WA · Member since 2011 · 48 posts · 8 votes
    13y

    25200(0.4) = 10080 NOI

    10080(10)= $100,800 sales price at a 10% cap rate

    I think you should be careful assuming 100% occupancy.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    @joelowens

    When you factor in the landlord paying utilities you said you use 60%. Does that include water/sewer/trash and electric... or just water/sewer/trash. Thanks.

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  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    13y

    I deal in larger apartment buildings where the impact on numbers is stronger than a 4 unit.

    The 60% does not include electric. I will get owners and listing brokers saying that I am conservative even more so than the bankers. I really do not care about their statements as the listing brokers many have never owned a building and are just trying to sell and the seller is trying to dupe a buyer showing minimal costs.

    It's all about buying right. If you buy right going in almost everything else will work itself out for the better. If you buy wrong you are trying to push a big boulder up a hill and many times the boulder gets to heavy and will run you over.

    Podcast Guest on Show #47
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    1Reply
  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    Thanks again Joel... Big help once again.

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    13y

    Joel has shown how the calculation is done, but no you need to look at your requirements. What are your goals for this property. Are you looking for a specific cash on cash return or are you just looking to pay off the loan for a cash cow down the road.

    The owners numbers may or may not be an indication of what your expenses will be. As Joel stated he could be padding for tax reasons or he can be using cousin Ralph to fix the ac and paying him with Friday night dinners.

    We have seen expenses running 45-65 %

    Never offer the asking price unless the market is really tight

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    Yes Jeff. The short while I've been trying to purchase a multi-family property, I have noticed the advertised expenses are way less of what they truly are once I add everything together... Most of properties are running about 60% for expenses and if the purchase price was to stay the same the advertised cap would drop from say 10 to 6... Is this a very common thing?

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  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    13y

    90% of the time the cap is overstated and the expenses are understated.

    Many sellers would rather overprice and have wiggle room in their asking price and then overstate returns hoping you miss something.

    This is very common with 2 to 4 unit owners whereas in the larger buildings it gets less common with more seasoned professional buyers and sellers.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    Joel, for a property in a C+ area, what would be the lowest cap rate you'd take? Also, what percentage of cash flow return are you willing to take on something small like a 4plex? (I know your on to bigger projects, but hypothetically)

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  • Jeff S.
    Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    13y

    There is nothing wrong with the calculations or the approach here, @Taylor Green, but understand that 1-4 units is considered residential, not commercial property. You can value it as you wish, but the market values residential property using comps, not cap rates.

    Homeowners, who don’t have to make a return, are typically willing to pay much more for a property than an investor; up to 4 units. Lightening could strike, but you might not be as successful using a commercial metric to value and make offers on residential property as you would using comps.

    I think your real question is not what cap rate should you expect but what ROI. These are only the same when the deal is unleveraged. That is, roi=cap when you pay all cash for your property. In your case, I have a feeling you will use financing. Yes?

    Either way, while market comps might differ, you’ll want to do a proper cash-flow analysis to establish the value of a property as this to you. Financing, a substantial expense, is not included in the cap rate. You might find you and the seller are too far apart to make a deal.

    Even larger commercial property owners will use a cap rate for ballpark valuations and screening, and a cash flow analysis to establish the value of a property to them.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    @Jeff S
    Thanks for adding to the conversation... It had never even crossed my mind that I would be competing against homeowners for a 4plex. Most of the reason I wanted to go to MFH was because I didn't think I'd have to compete against the inflated offers of homeowners.
    In terms of the cap rate question, I thought I was asking what would be the minimum cap rate I should be looking for at each level class of property and area. For example an B class area 6-7% cap, C class 8-9% cap. Maybe I am getting myself confused...
    Also, when figuring out ROI, does that only count the cash flow the property produces, or does it factor in the equity build up on the property as well...
    Thanks again...

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  • David Turner
    Real Estate Broker · Flower Mound, TX · Member since 2012 · 58 posts · 30 votes
    13y

    Taylor Green you cannot look at cap rates as set in stone. Every market is different. Cap rates also fluctuate with the market. Right now here in Texas the market is on a major upswing. Cap rates are dropping. If you say that you will only buy a C class property at a 9 cap then there might be years that you will be priced out of the market. Thats why cap isn't necessarily the best metric for analyzing.

    You have to look at ROI and Cash on Cash in order to take into account financing. These tell you the real return on the deal. A lower cap rate might still be a good deal if you're able to get a low interest rate. It all depends on your required return.

    ROI does not include equity until you sell. That equity can fluctuate with the market. If it goes south again then you could loose all that equity, so why should you include it in your calculations. Until you cash out, equity is a fictional number.

    You said that you were going after 4plex's because you don't want to compete with homeowners. You also have to understand that there are less 4plex's out there at a discount. That is because that people who buy them are in it for business. This leads to savior business people who are less emotional and less likely to be desperate to sell.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    Great response @David T. Those responses are the exact reason I joined up here as I'm trying to learn... Everything you said makes perfect sense.
    Is there a rule of thumb percentage how much ROI I should get from the cash flow? Thanks again...

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  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    13y

    Taylor you have to understand the metrics of your market you want to invest in.

    You have the area averages and then you have the investors goals. For instance an investor that already has millions and millions in cash might not be looking for the best yield but the best quality asset and where they can take the most depreciation. For them wealth preservation and estate planning is key.

    In the early years it's yield, yield, yield and then the dynamic crosses over. This doesn't mean everyone is like that but you will find different investors with different cash flows at varying ages will have different takes on things.

    Many of the markets being mentioned Texas, California, Phoenix are what I call speculatory in the booming areas. Caps are dropping and buyers just cannot get any yield. You are playing an appreciation game at that point and a herd mentality. You might win big or be the one left holding the bag when the market cycles again.

    Other markets historically do not have the wild losses and wild gains and on a graph the losses and gains are less dramatic. If you have 1 million for say and throw 200,000 at a speculation play then it will not take you under if it goes bad. If it's all you have I would not do a spec play.

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  • David Beard
    Investor · Cincinnati, OH · Member since 2010 · 1k+ posts · 928 votes
    13y

    IMO, you generally you want your true cap rate to be at least 2.5 points above your borrowing rate (assuming at least 25 yr amortization on the loan), in order to not set yourself up for potential cash flow problems. You can currently borrow conventionally on this property at 4.625% (per amerisave.com with 25% down), and so a cap rate of 7.125%+ is a reasonable minimum assuming it's in a solid area, and in good condition. If you can acquire the property at this price, your ROI should be around 15% (includes the principal paydown). Factor in the tax benefits from depreciation, and your effective return pushes to the 20% range, not too bad in a world of low single-digit bond returns, with some solid inflation protection built in from the ability to raise rents in the future, plus the fixed long-term rate on the loan.

    So, $25,200 * 40% / .07125 = $141K as your max acquisition price. Appraisers will use comps to value the property, so you need to thoroughly understand what similar buildings are selling for as well.

    This is all very simplified, and assumes a decent property in a decent area. Rent of $525/mth/unit sounds like it might be borderline in terms of being a decent area. Water/sewer of $79/mth/unit certainly sounds high, but that must be the reality there. Built in 1983 sounds pretty good.

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    Thanks for the input guys. David that was exactly the rough rule of thumb I was looking for... 2.5 points above the borrowing rate. Now I know that's just a rule of thumb, but still that helps... And, yes that ROI crushes any index fund or whatever else I have put my money into before.
    I am not clear on why the comps matter on multi-family properties, if the cash flow analysis and everything else is good... How do the comps come into play?
    Thanks for the help.

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    13y

    Comps come into play because 1-4s are still considered residential and that is how it will be appraised.

    The competition for these sized units is very tight since many investors start out in this space. Quickly moving to larger cuts down on the number of investors that are able to play. That is why partnering with someone to be able to double your size, might not be a bad plan. Then when you get into the 150 and up you get to start playing with the bigger boys and the competition tightens again.

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  • Jeff S.
    Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    13y

    Like it or not, comps matter for 1-4 residential because that’s what defines your competition, Taylor. I didn’t make this up, Fannie Mae did. If your cash flow analysis results in an offer price substantially below the going comps for similar properties in the area, you’ll likely waste your time making an offer.

    I know you want to think that all multi-family is commercial, and should be evaluated similarly, but it’s not.

    Jeff

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  • Taylor Green
    OP
    Vancouver · Member since 2013 · 159 posts · 6 votes
    13y

    I appreciate the answers once again... That does make sense.
    Jeff Greenberg - Hypothetical, if finances were not really an issue, where do you think the beginner investor should start 10 unit buildings?

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    13y

    Taylor Green anything above 4 gets you into commercial and place the value on the NOI. With that said, it will depend if you are buying locally or across the country. It now comes down to manage and finance the property. The smaller properties cannot support on site management unless one of your tenants can take that on for a discounted rent. So you will end up as the manager.

    If you can't find deals locally you may find it difficult to find good PM's until you get to much larger properties. As you get larger your net worth, liguidity, and experience will be weighed as much as the property(not like the old days). You may need to partner with someone that has what you are missing.

    There are many varibles that need to be considered.

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