How Overpaying For an Apartment Building Can Get You a Deal in Real Estate

by | BiggerPockets.com

We’re taught that we should never underwrite a commercial real estate deal based on future performance—but always on current performance.

This is great advice, but sometimes it doesn’t match reality.

Here’s an extreme example to make my point: What if you’re looking at an empty 10-unit apartment building?

Technically, the net operating income (NOI) is actually negative, and if we apply a cap rate to that, the seller would need to pay YOU to buy it.

But we all know that’s just silly.

Sometimes we have to break the rules because sometimes they just don’t work in ALL situations.

While many of us may not be looking for empty shell apartment buildings, most of us are looking for value-add opportunities.

Let’s suppose that you’re looking at a value-add deal. The rents are 20% below market and vacancies are 25%, but you determine that the market vacancies are 6%.

You believe that within 1-2 years, you could add significant value by stabilizing the asset.

Applying a cap rate to actual financials may not accurately value the building and/or may not make you competitive enough, but it may still allow you to make a good return.

So you may have to overpay.

That’s right. Overpay.

Now, hear me out before you shout and scream that this is not what’s taught in apartment building investing school.

It is true that you should value a building based on its actual net operating income. But sometimes, especially if it’s a value-add deal, you may have to pay a little bit more to be more competitive and get the deal.

Related: How I Bought a Multi-Million Dollar Apartment Complex at the Age of 26

But how much more? That is the question!

Here are some rules of thumb.

Rule #1: Don’t be too greedy or proud.

If you insist on paying no more than the prevailing cap rate on actual financials, even for value-add deals, then this “pride” or idealism might prevent you from ever getting into a deal.

In looking back on many of my negotiations and deals, one could argue that I could have done better, negotiated more, and given up less.

This may be true, but another thing could have happened: I may have lost the deal because I was pushing too hard because I was too greedy and wanted too much at the expense of others.

In my experience, creating win-win deals will get you more deals than beating down the other side and trying to squeeze out everything you can.

Don’t be too proud; get deals done instead!

Rule #2: Let your investment criteria tell you how much you can (over) pay.

If you’re looking for an investment with at least a 10% cash on cash return or an average annual return of 14%, then don’t do a deal with less return.

It’s potentially OK to over pay and maybe give up more upside than you should, but never compromise your minimum investment criteria.

Rule #3: Adjust what you are willing to (over) pay based on the risk.

The riskier the deal is, the higher your returns should be.

For example, let’s say you are, in fact, buying a shell of a building. Your “normal” target return of 14% may not be appropriate for this level of risk, but perhaps a 20% return is more reasonable.

The bottom line is, you can over pay to get into the deal, but only to the extent it still meets your minimum investment criteria, adjusted to the level of risk.



Related: 3 Metrics Crucial for Finding Amazing Apartment Building Deals

Rule #4: Overpay if you get terms.

If a seller is set on a certain (unreasonably) high price, I can sometimes give them what they want and be more competitive if he is willing to give me some terms.

If he agrees to hold a note for 3-5 years or lets me assume existing financing (if it’s favorable), then that may reduce my cost of capital (compared to equity investors, for example). This may boost my returns and allow me to increase my purchase price.

Conclusion

While it’s always more conservative to underwrite a deal base on actual performance, certain value-add deals allow us to overpay and STILL satisfy our investment criteria.

As long as you can meet your investment criteria, don’t be too proud or greedy to pay a little extra—otherwise, you may never get into a deal!

I’m sure a lot of you will disagree with the notion that we should over pay on ANYTHING, so let me hear you shout!

Share your thoughts below!

About Author

Michael Blank

Michael Blank’s passion is being an entrepreneur and helping others become (better) entrepreneurs. His focus is buying apartment buildings by raising money from private individuals. He’s been investing in residential and multifamily real estate since 2005. He is the creator of the Syndicated Deal Analyzer and the eBook "The Secret to Raising Money to Buy Your First Apartment Building".

19 Comments

  1. Calculating potential, is not really overpaying, but I understand your point.

    However, the costs to re-position are still acquisition costs, and must be calculated into the purchase and rate of return. Sometimes, it may makes sense to go outside your bounds if the properties potential is probably going to be greater.

  2. Great article. I generally use the rent multiplier for the area to understand the current value and what can potenially be realized (forced appreciation by some definitions). Finding mismanaged properties can take some time and effort to turn around (risk), but I’ve realized great cash flow and reasonable appreciation in return. Thanks again for the insight. Your note on purchase negotiation with current financing is a facinating angle.

    • Michael Blank

      > Your note on purchase negotiation with current financing is a facinating angle.

      I have an offer in right now on a 46 unit in Richmond, VA, and I asked the question “would the seller be interested in holding a note in return for a higher price” and the broker said that might be interesting, to submit both proposals. Let’s see what happens.

  3. Seth Wilson on

    Yup, I agree.

    I bought my 12-plex by ‘overpaying’ per the CAP rate. Now, I am working on another 12-plex that I will ‘overpay’ for. But the upside on both of them is very favorable.

    I look at what the property’s value is today versus what it will be in 6 months, 1 year, etc. and will make an offer based on that and take the accordingly amount of risk.

  4. Denny Robert on

    This is exactly what I’m looking at right now. I live in my triplex, and the owner of the fourplex next door is willing to owner finance. I’m planning/hoping to overpay a bit, but on a no money down deal. Rents are below market, so it will still cashflow once I get ahold of it.

  5. Stephen Steric

    Great article! I think people get stuck into the mindset of a cheap sales price, as if they’ve “won” when they beat up the price. In reality, paying a little more on the actual sales price, and getting creative with other parts of the deal ultimately end up working in your favor!

  6. jon levine

    I think overpaying works when you are in the beginning of a bull cycle. Since I believe we are at the latter stages of this bull run in RE you have to be quite carefull. Seeing a lot of people buying on potential rent increases. What happens if you buy based on potential and the economy dips a bit. What happens if you cant raise rents or for that matter what happens if you have to decrease rents???

    curious to hear your thoughts?

  7. James Schoeman

    Hi Michael, Thanks for another great angle as a possible way to acquire an apartment building.
    I have an off topic question: If you are going to use private investor money (syndication) for a down payment, do you disclose this anywhere in your offer? What about when you approach a local bank for the balance?
    Thanks for all the great articles.
    James Schoeman

    • Michael Blank

      YOUR QUESTION: If you are going to use private investor money (syndication) for a down payment, do you disclose this anywhere in your offer?

      ANSWER: Nope, not necessary. Unless you’re asked.

      YOUR QUESTION: What about when you approach a local bank for the balance?

      ANSWER: They may want to ask how you’re coming up with the equity, and you just tell them. You have nothing to hide (do you? 😉

  8. I like your article, iam submitting an LOI on a 30 unit in Baltimore where the seller is carrying back some financing, and giving him his asking price. Almost ready for contract stage

  9. Tim Czarkowski

    This wasn’t a commercial property but a four unit we bought back in 2010 or so. It came up in a very hot neighborhood at 135k and I knew it was going to get multiple cash offers and we wanted to finance it. I calculated what was the highest I could offer and still get my cash on cash return and went straight in at 165k and got it . If I had cheaped out I most likely would not have and I even ended up having to argue with the appraiser to get the loan through. This building was recently rehabbed and fully rented and not three months after the closing the building next door in worse shape sold for 180k. They’re now selling for about 400k. Sometimes you have to be aggressive.

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