12 unit building - Rent evaluation?

Question

I will start by saying this is my first deal on a multi-family unit.  So please excuse some of the ignorance in regards to how to evaluate this.  I did search and know how to evaluate it based on financials, but still had a few questions..... My current properties are all SFH - so this is truly a new beast for me.

I am currently interested in a 12 unit building.  6 - 1 bedroom units and 6 - 2 bedroom units.  I have a copy of all the financials from 2017.

I am currently calculating ROI, etc to see if this deal is feasible/worthwhile.  I am beginning to speculate that the reason for him selling might be mismanagement (I have several reasons to believe this, my realtor also is starting to lean that way as the seller has just said he wants to be done with it).  I am just not sure how to evaluate with the uncertainties that I have found.

Here is my problem... The rent on the apartments from the financials is all over the place.  Some of the 2 bedroom units rent for less than the 1 bedroom.   1 bedrooms ($560, $495, $555, $475, $410, $515).  2 bedrooms ( $605, $595, $535, $550, $550, $610).  I have actually confirmed this to be correct.... So do I evaluate ROI and other financial numbers on what I think the rent should be and just prepare to raise some of the rents upon taking possession?  Using the rents he has listed, the deal is still feasible but definitely not as good.  How does this play into trying to acquire financing?  Like will they look at the 2017 financials and assumed that those are what is expected?   I have not yet tried to secure financing on a property of this size, so I am not sure how this works.

If I do proceed, I would want to balance out the rent on the apartments.  However, I am not sure a good place to look to see what current market value is (I based my guesses off another local apartment complex).  I want to be fair and find a way to evaluate the trends in the area.  Anyone know of a good side for this?  I am in a rural area, so I usually just check similar places close by.   Really wasn't sure if that was standard practice or not.

If you made it this far, thanks for the read... Look forward to your input!

Lynsey Staes · Answer

@Michael Gansberg  Thank you so much for the reply!!!

Yes that does make sense and clarify things a bit.  I know I will have to raise the rent and it will be a slow and steady change - however I do think within 2 years it can be highly profitable and at market value (profitable from the get go - but a whole lot more wiggle room in 2 years).  Right now there is at least 2 units vacant and I can not find where he has this advertised anywhere at all.  There was a sign out front, but to my knowledge very little advertised online and such.  I also know that a majority of his tenants (8 of the 10) are on a month to month lease - some of them for a couple years.  So literally they have lived there several years with no change to the rent, while taxes, etc have all increased over time.  The two that have an active leases are the two highest rented units with leases expiring in Sept 2018.

I will have to factor this into my analysis and see the effects!!

Thank you for the response!

Michael Gansberg · Answer

Hi @Lynsey Staes - congratulations on stepping up to a larger multifamily property. They can be quite a different beast from the typical one or two family. The primary distinction, in my experience, is the one-bad-apple problem- if you get a bad resident, you must take steps immediately to prevent that resident from chasing the others away or souring them to the building and reducing future referrals.

To your question, I suggest looking at each unit and determining the fair market rent for each one. The current owner may have fallen into the trap of having residents stay for many years without any changes to their rent. That can work well until major repairs are needed- then the owner may not have sufficient resources, and the property can begin to enter a death spiral. It sounds like that might be the case here.

I've picked up my best deals in these situations. The owner is strapped and pressured because of his own failures, so he sells the building at a price that's generous to the buyer. The building won't appraise comparably to similar, well-maintained properties- so you, the buyer, must bid carefully to make sure your financing doesn't fall through. If it's close- say, your bid is $500k and the appraised value is $480k- you might be able to convince the bank that due to under-rented apartments, its true value should be higher.

Once you close, raising rents to market won't be fast or easy. For those who are holdovers(which I assume are the ones paying very low prices whose leases have switched over to month-month,) you can say- "Hey, I know you're paying $530, but the market rent is $650. Let's split the difference- I'll give you a one year lease at $590." Some may take that deal- some may leave- and some may force you to evict them.

For the ones who leave, you'll want estimates of the repairs/rehab costs necessary to bring the unit up to snuff. You can control the rate of leaving somewhat- for example, don't approach all the below-market rate tenants the day after closing with this proposition. Perhaps do one or two per month so you can see the impact and adjust your efforts on the fly. You wouldn't want to be half-vacant within a month of closing!

All that said- turning an under-rented, under-maintained building into a well-maintained properly rented one is generally extremely lucrative. Cash flow soars, and so does the property value.

Hope this helps, Michael