Do you pay for upside potential when purchasing multifamily? Or should you only be paying for the NOI * Cap Rate?
I am in the same situation. I am looking at a value add where the rents are below market but the seller is trying to sell based on close to market rents. Great upside but not cash flowing right now.
Nothing wrong with making a purchase based on your feeling for 'potential'. Better be right though.....
You pay the price that generates the returns your investors deserve and expect. The price the seller is asking is irrelevant.
I personally don’t have the experience to say one way or another. But I just finished reading Brian Murray’s Crushing it in Apartments and Commercial Real Estate and he specifically says you never pay for the potential income a property may generate because that is where your big money is made after you acquire. You treat it like a business and only purchase it based on the current income it is currently generating it. If they want to sell it based off potential, then the seller needs to raise rents to market and wait foe the year or more it takes to stabilize before they sell it.
Everyone says: "buy on actuals!" and "buy below market!". Yet nobody does.
Every buyer stretches their expectations (AKA Proforma) and justifies paying not only the asking price but also outbidding other buyers to "win the deal". That is true for both "value add" and for performing properties.
You lay based on actual performance. If the seller thinks the property can perform better, they need to make that happen and then sell. You even see similar things with SFH sellers. Eg thinking they can sell for ARV - the cost of materials to create that ARV.
We are typically buying based on projections, as we are completing value add with a large amount of upside. With that said, we are still typically buying close to market cap, based on the current NOI, but that is not our main focus when we are purchasing.
@Philip Liu The classic rule is to buy based on actuals, not potential. If the seller thinks it is worth more, he/she should put it into shape to be worth it. However, in this seller's market, many buyers will push the limits and buy based on at least some increase in value over the current value, depending on their confidence in the upgrades. You should always try to be precise in underwriting and let the returns of the deal and your confidence in your underwriting guide you. This may call for guidance from more experienced investors for your initial deal(s). You may also want guidance from brokers, contractors, or lenders for specific questions on your underwriting.
All good feedback. I agree on buying the current NOI and not projections. I still believe there is tremendous upside but the seller will have to be reasonable.
The goal is you buy undervalued and force appreciation by increasing NOI. This is one of those do as I say, not as I do type of rules. I say that because people are buying based on future NOI in most every market. There is a frenzy to get deals and SOMEONE (I am sure none of you) are paying based on future potential. In my market they are putting up new construction apartments as fast as they can move dirt and all of those properties are banking on future NOI.
The consensus seems to be to buying on current performance and not proforma. I understand currently the market is in a frenzy. How do you convince sellers that their property should be selling for NOI x cap rate instead of some other price?
@Philip Liu We've sometimes shown the seller our underwriting and ask them if we've missed anything or done anything wrong to justify their price. Our hope is to buy the existing property as it currently performs. It also depends on the competitive situation. If you are buying true off-market, the competitive pressure is less to increase your offer. With a seller broker and multiple offers, you likely have to match or beat other offers. Just don't fall in love with a property and make an offer that exceeds your pre-determined max.