Cap Rate 28 ??

Question

There's a property I've had my eye on in a working class neighborhood (residents upkeep yards, partake in home improvements, plenty of small children playing outside). Advertised as triplex but county property search reveals it's a duplex (agent allegedly unaware of this).  The current owner is living in the 1/1 unit, breaks even, cannot afford repairs and now in short sale. Per agent original loan in 2008 for $196K, current job status of owner unknown.  Property needs upkeep and has some signs of distress.

Here are the numbers:

Asking price $40k

3 units (2/1, 2/1, & 1/1)

2/1 #1 = $600

2/1 #2 = $700

1/1 = 0  (inhabited by owner)

Taxes = 645/y

Utilities? (no separate H2O meters)  I've guesstimated $1200/y

Insurance = Not sure, but guesstimated 2400/y

Vacancy rate= 100% occupied for the last 3 years

Rent Roll = 15,600/y

AOE = 4245/y

GRM (Based on 2 units)= 2.56

Cap = 28 (??)

My questions are as follows:

1.  Did I calculate this correctly??  Cap of 28? (cash sale)  Should I be basing everything on 2 or 3 units?

2. I know fixing the illegitimate unit will be costly and time consuming, but at this price point and cap rate should I even worry that?

3.  What am I missing here?

Any thoughts?

Jeff Rabinowitz · Answer

The operating expenses seem low.  Taxes are only $645 annually on a property that was worth ~$196K in 2008?  Check with the City.  Why guess at the figures for insurance, utilities, etc.?  Contact the utility companies, insurance agent, etc. and ask the seller for their figures.  Comparing the two sets of figures may give you a good feel for whether you should trust any of the seller's other claims.  Have you verified the rent?
	
	If there is deferred maintenance that will need to be cured.  That expense is part of the purchase price.  Even though there has not been a vacancy there will be.  That has to be accounted for.  Same for maintenance.  Even if you fix all deferred maintenance issues there will still be maintenance expenses.  That needs to be accounted for.  After adjusting for these factors your calculation for Cap rate should look considerably different.

Vana G. · Answer

Jeff S Na Will be sure implement the advice I've received from both of you in case the 1st deal doesn't come through.

Thanks again!

Jeff S. · Answer

This is residential property, @Vana G. , not commercial.  There's no such thing as a prevailing cap rate for residential property. If you're trying to find a metric to value it according to what the market would pay, you should use comps.  Either way, once you find a candidate property, you'll want to do a proper cash flow analysis.  What anyone paid for the property in 2008 is irrelevant.

Assuming the third unit is illegal, which you might have to tear down, the most conservative analysis would assume two units.  Whether you live there of not, I suggest you include rent for both units since you'll either have to pay it somewhere yourself, or you might rent the unit sometime in the future. If these are both the 2/1's, your income would be $1300/mo.  Just another rule of thumb, but this is 3.25% of cost and on it’s face, a deal worth considering.

Alternately, you could assume 50% of the income goes toward operating expenses, resulting in a gross income of $650/month.  You didn't say how you would finance this but if you borrowed $32000 (20% down) at 5% amortized over 30 years, your payment would be $213.45 leaving you $436.55/month; still positive even with one unit.  You could use this to calculate an ROI except the big question is how much will it take to bring this property up to code.

“I know fixing the illegitimate unit will be costly and time consuming, but at this price point and cap rate should I even worry that?”

This is all you should worry about.  As I noted, you don't buy on cap rate.  While price is important, if you don't have the cash to fix and maintain this property, nothing matters.

@Jeff Rabinowitz   gave you some good advice.  You should be able to accurately confirm many of the expenses you're currently estimating as well as the repair costs from a thorough walk-thru, before you move forward. This could be a great deal, but it's cash flow that counts.  Don't fixate on rules of thumb.

Jeff

Vana G. · Answer

@Jeff Rabinowitz Jeff S Na Thanks!  A contract was obtained a few days ago (after sitting on the market since 2012).  Unless the deal falls through and she calls me as potential backup I won't be given access to leases or rent rolls.  Also here in Florida trash pick up is included in the taxes.  In this particular case total taxes are 445 + 200 for solid waste management.  But I will definitely review leases and tenant screenings, and make a request for any potential deposits. Hopefully at this price point, there are good records of all this information.

Thanks to all for your incredible advice!

David Jacques · Answer

While cap rates should never be more than a quick gut check, they are less applicable to residential property because the credit worthiness of tenants can vary wildly. Build in at least a month of vacancy per year to hedge against future problems and expenses.

A cap rate is a quick assessment of risk.  A very high cap rate insinuates a high risk/ high return type of deal.

Mehran K. · Answer

Do the tenants pay the water bill? I know you mentioned the units are not separately metered, but what does the lease say?

If you're paying water/trash/lawncare, you're looking at higher expenses than 50%. Most probably in the 60% range.

Jeff Rabinowitz · Answer

@Vana G. , @Jeff S is correct that cap rate does not really apply to residential properties but I think it is a good idea to do the calculation anyway, especially if you are planning on holding the property for awhile.  The decision to buy an income property should be weighed against the available returns on other types of investments or other properties.  Calculating a cap rate can be a good way of quantifying what the return could be and comparing it to other investments.  Remember that a prospective calculation is only as good as the data you use and even if the data is great it is still only a guess.  Build in a fudge factor to protect yourself if the data proves to be incorrect or the market changes. I would not make any mention of cap rate to the seller of a residential property or their Realtard as you may just confuse them but I like that you are using this as one of your evaluation tools.  Best of luck.

Vana G. · Answer

@David Jacques Great advice, thanks David!

Vana G. · Answer

Jeff,

Thanks, I appreciate your insight! There is deferred maintenance which I had not thought to add.  From what I visualize it needs total landscaping, paint, and bahama shutter repair to start; no pics of the inside.  I took the taxes off the county appraiser's office for 2013, which have steadily been decreasing to arrive at that number in 2013.

I've guesstimated the insurance and utilities because I did not think to get a quote (duh!) as the agent informed me they had just obtained contract and no longer available.  She filled me in on the seller's info because I pressed her to discuss in case the sale fell through.

However, I will be making calls tomorrow to the power company and insurance co. to obtain quotes, as you suggested, in case the original deal falls through.

Do you think the illegal addition is anything to be concerned about?

Thanks again,

Vana

Cap Rate 28 ??

Most Popular Reply