# Analyze This Apartment Deal

I’m looking into buying a 10 unit, 1 story apartment building in Indiana. The building is brick and in good condition.

Operating Expenses are \$1350 / Month
Potential Gross Income of \$5450 / Month

If I use a cap rate of 12 percent, I see the property being worth \$545,000.

What do the experts think of this deal? How is that cap rate? Your thoughts and suggestions are greatly appreciated.

Thanks!
Fred

What is the effective gross income?

How about an itemized list of those operating expenses…

Does the cap rate fit your return requirements and debt service eligiblity?

You need to get all the real numbers before anyone can answer properly.

Based off the numbers you provided NOI = \$4,100/mth \$49,200/yr (potential)

Debt service on say a 500k loan at 7.5% 30 yr am = \$3496/mth \$41,952/yr

Cashflow = \$604/mth \$7248/yr

That is less then \$100/unit !!

Also, you need to consider that insurance and RE taxes will most likely go up and cut into your cashflow. Was this building well maintained? Does it need any capital improvements, this will also cut into your cashflow or bottom line. How are you going to manage this? This could also be an additional expense.

It’s typical that those numbers aren’t the real numbers - which will cut into your cashflow even more. It’s possible you could break even

Jordan

Also, based off the numbers provided ofcourse, and buying this at \$545,000, it’s more like a 9% cap, not 12%

\$545,000 x 9% = \$49,050

and after you purchased it ,it will be even less due to the additional expenses I mentioned above. Maybe a 7-8% cap.

The expense figures are broken down as follows:

Insurance \$3291
Property Taxes \$3498
Personal Property Taxes \$165
Trash Service \$744
Water Softener \$1293
Electric \$2750
Sewer \$3726
Water \$640

Total \$1342.25

I don’t know. This building is beginning to look overpriced and not a good buy unless there is an unseen advantage to owning it.

What should I be looking for as far as a return goes?

Is this course, Apartment House Riches by David Lindahl, educational at all? Is there a better course to get? A better book to buy?

Thanks for everyone’s input.

Fred

Fred,

Take a look at the list of possible operating expenses from my post.

There are a number of expenses that the current owners haven’t included in their numbers given to you that you WILL have. This deal is garbage unless you can knock that price down considerably. Focus your time on deals where there is room to create value. - Bad management, need of repair, motivated owner, low rents for the market, etc.

Danny;

Thanks for the input ! It is appreciated. I have saved your list for future reference.

What would you place the value of this property at? How much do you feel that you need to profit from each unit to be a workable deal?

Are there any good courses or books that you suggest? Any other web sites to scour for information or educational materials?

Thanks again!
Fred

What this property is worth will be determined by your investment value. What is your required rate of return? How much money or equity will you have in the property when you buy? What’s the mortgage constant on the best loan you are eligible for? Do a search for something like “band of investments method” to explain this more.

Cash flow per unit is up to your criteria, I’d recommend you determine one based on what you feel your time is worth. The general consensus among the members of this forum start @ \$100/ month and go up from there.

Any book on commercial RE, multi- family properties, property management, etc. should be able to help. I’d give you a list but I’m short on time. Maybe someone else will chime in.

Fred,

This is a TERRIBLE DEAL!

Throughout the entire United States, operating expenses run 45% to 50% of the gross rents. In this case, operating expenses would be about \$2,725 per month, leaving \$2,725 to pay the mortgage (P & I) and to provide profit.

A 20 year mortgage for \$575,000 at 8.25% would be about \$4,900 per month. This would give you a LOSS of about \$2,175 per month! OUCH!

One thing is very common with apartment buildings. The owner almost always overestimates the gross rents and almost always underestimates the expenses. It is imperative that you understand the real world numbers before you buy anything!

Run far and fast! This deal STINKS!

Good Luck,

Mike

I agree. It’s a very nice building but overpriced. I am going to move on in search of another deal.

Thanks for everyone’s input.

Fred

I wouldn’t walk away from it. Try to negotiate the deal you want. All they can do is say no. I am willing to bet that if he doesn’t sell he may come back to you.

Good Luck

Sean,

This property would have to be bought for about \$273,000 to make it a good deal. It is easier to find a real deal than to try to turn a retail sale into a deal. However, I agree that it can’t hurt to make an offer.

Mike

Gross income has nothing to do with CAP, only NOI. I recently looked at a 3 building medical park for a client with 70% expenses, partly due to 360k/year RE taxes and gross leases rather than net. If CAP was based on GOI, it would have been a 32 CAP at asking price. But obviously it wasn’t, it was actually a 9.7 CAP after filling vacancies, an attractive CAP for a stabilized office property.

45-50% expense across the US is not in fact standard for multi-family, but it is close. Here’s a realistic rule of thumb for armchair owners employing property managers:

50% cold climate landlord heated
45% cold climate tenant heated
40% warm climate(electric baseboards) and no heating system maintenance

Your deal is in Indiana so here’s your scenario IF the property is fully leased with no deferred maintenance:

Landlord heated: \$2,725 mo/32,700 yr
Tenant heated: \$2,997 mo/35,970 yr

Indiana is a secondary market, unless you’re downtown Indianapolis, so your upside and exit strategy is only strong performance, YOY rent growth and good management. A 10 CAP is attractive if you have your financing in order (under 7%), but shoot for an 11 CAP or better. Otherwise, your interest rate +3 is a good target CAP. In a primary market, multi-family in the 7-8 CAP range are even attractive, especially with good debt(prior assumable loans under 6%). CAP is not the end all unless you are buying all cash. It’s the relationship between capitalization and financing.

So here’s what your property is worth at an 11 CAP, in perfect condition, no deferred maintenance, 100% leased and not accounting for vacancy:

Landlord heated: \$297,270
Tenant heated: \$327,000

At the proposed purchase price of \$545,000 TH CAP= 6.6%, LH CAP=6.0%. This is a negative deal even if the building is perfectly maintained and 100% leased.

CHIBroker,

While I generally agree with what you said (in fact, we said almost the same thing), you have certainly managed to take something that is very simple and turn it into something much more complicated.

What I, as a rental property owner, am interested in is Cash Flow and Equity. You can either go through all the gyrations that you listed in your post (and still not have cash flow information), or you can subtract the operating expenses and mortgage payment from the gross rents to determine cash flow. I like to have \$100 per unit per month, but a person could go with whatever they like.

Why is all the rest of that nonsense needed? Why should I do the additional step of calculating the cap rate? Why should I “shoot for an 11 cap” instead of shooting for an actual cash flow of \$100 per unit per month using 100% financing? Almost none of the investors on these forums are paying all cash and many (including me) are not using ANY of our own money. Why should I?

My personal opinion is that all this talk of CAP RATE, GRM, DSCR, etc is all extraneous nonsense. What really matters is CASH FLOW and EQUITY - whether you have a Duplex (why bother in your words) or a \$100 million dollar high rise.

Mike

All the rest of that “nonsense”? Brilliant Mike, you should market your ideas to investors as a new method of valuation that discards useless indicators like capitilization and debt service coverage ratio.

I guarantee the bank doing your 100% financing 2 flats cares about DSCR, but why should you? You’re much smarter than such silly notions and have a brilliant new tool called \$100 per unit cash flow.

It doesn’t matter, apparently, whether you are paying 10k, 50k, or 100k per unit, as long as you get \$100 per unit, right? You’ve managed to completely eliminate the relationship between price and income with one swift stroke. LOL.

In reality, Mike, CAP is the simplest way of looking at a property’s income. It is much easier than looking at “\$100 Cash Flow per unit.” Looking at “cash flow per unit” is like a little kid trying to sound out a word letter by letter rather than just reading the word. That’s the reason behind all the endless “nonsense” about CAP rates. Of courese I didn’t have the cash flow information for the subject property in this post “after all those gyrations”. Neither did you. Why? There’s a variable missing: Input his debt service info and POOF, like magic, there it is.

Why “shoot for an 11 CAP” rather than just figuring out \$100 per unit after expenses and mortgage? Because, if you did, you might stop deceiving yourself as to whether or not your deals are profitable.

The CAP rate is not the “additional step” silly, it’s a primary step. Why should you go through this oh so laborious 30 seconds to figure out a CAP rate? Because \$100 dollar per unit doesn’t illustrate any relationship between your income and the value of your property.

\$100 per unit tells you nothing about a deal.

ChiBroker,

I’m sure that you’re right. It is much more important to have a cap rate of 11 rather than a positive cash flow. I just haven’t figured out how to spend that cap rate! Next time I’m at the bank, I’ll see if I can deposit a cap rate.

Good Luck.

Mike

Unless you know the language of capitalization, you might not recognize the true values of cap rates. The obvious recognition is that it gives a birds eye view of the relation of income and value throughout the market. Often this is taken for advantage by sellers who pull an asking price out of thin air to derive an acceptable cap rate instead of the market cap rate. For this reason, it loses it’s true value unless your intimately familiar with a cap rate inside and out. It probably tells you more information about a property than any other number. I won’t go into every facet of a cap rate in an open forum as it would probably cause more confusion than anything (evident from previous discussions) but it is worth it to spend the time intimately getting acquianted with. I wouldn’t rank either cash flow or a cap rate above one another in order of importance because they are both important numbers. Cap rates can provide both a snap shot along with very detailed information.

Danny,

Shed some light on this discussion.

In this case, we’re talking about a 10 unit apartment building. Here are the facts as we know them:

Gross Monthly Rents: \$5,450
Stated Expenses: \$1,350 (bogus)

Here is how I would analyze this deal if I were buying it. To be conservative, I would assume operating expenses to be 50% of gross rents. That means NOI = \$2,725. The only real variable left is the mortgage payment. I could get money from my small local bank at 8.25%. I know CHiBroker claims to be able to do better - good for him. The money will cost me 8.25%. I do not put money down, although I don’t have a problem with people that do.

As a general screening tool, I must have monthly gross rents that are 2% of the purchase price. By this swag, the maximum purchase price would be \$272,500.

I need positive cash flow from my properties each month, because I like to eat and ski. My minimum is \$100 per unit per month.

Therefore, the maximum mortgage I can pay is \$1,725 if I want to make \$100 per unit per month. Plugging this into a mortgage calculator, the max I could pay for this property with a 20 year loan is \$202, 449. With a 30 year loan, the max would be \$229, 612. Obviously, if I put money down or got a better interest rate, I could pay more.

In addition, I never pay more than 70% of the market value for a property. I have looked at hundreds of properties in my local area and know the market values. As personal confirmation, the bank’s appraisal always comes out close to what I had estimated. Of course, this situation is not in my market, so I am not personally familiar with their market values. However, based on experience, I would be willing to bet that a purchase price of \$202,449 is at least 30% below market value.

So, what value does cap rate add to this equation? In reality, haven’t I really already considered cap rate since we are using market value and NOI in the evaluation? After all, cap rate is NOI/value. You’ve got to know 2 of the 3 variables to solve for the 3rd.

Also, we know that for small residential properties, the vast majority of new investors fail. Therefore, if we determine a market cap rate for these properties, aren’t we actually determining the market price that the average failure paid? I realize that as we move up the food chain with larger and more expensive properties, the failure rate goes down and the market value MAY be a little more relevant.

I’d like to get your take on this.

Mike

Mike,

You do inadverently use components of a cap rate, but don’t tie it all together. Every market condition is taken into account for a market cap rate in some form; vacancy rate, cost of capital, debt to equity ratio, acceptable market profits, appreciation, depreciation, etc. I would give little weight to a market cap rate in smaller residential properties (especially SFHs) for the obvious reason that most are not purchased at a price in relation to it’s income or potential income.

Unfortunately, you make it much more complicated by using amortized loans opposed to interest only so it would be required to have an amortized schedule to figure out your true yield. But that’s another thing to gain from a cap rate. Your cap rate would be changing with every debt service payment thus a stabilized cap would be needed or step up to yield capitalization which would entail discount rates or annuity rates. All kinds of complicated.

Your purchase price of 2% of the gross rents and 50% operating expenses is the same as a 12% cap rate. \$50,000 purchase price and \$1,000 a month gross rent equals \$12,000/ year gross. NOI of \$6,000. \$6,000/ \$50,000 is .12. If your market cap rate is 8.4, you will meet your full criteria every time buying with a 12% cap rate provided that it’s expensive enough to give your minimum cash flow.

The moral of the story, it might work better for your circumstances to not use a cap rate because they would be skewed all over the place. You already use a modified GRM which makes your return proportionate to the purchase price. A cap rate isn’t the only answer to the question and might have little bearing to your circumstances, and despite what ChiBroker says, that’s not the end of the world. Your doing just fine without it, but in larger properties as you said, it becomes much more relevant.

Danny is right on here. Propertymanager just doesn’t understand capitalization in real estate and how it functions. A cap rate is all inclusive of every aspect within the cash flow of a property. It even takes into account for amortization within the MC (mortgage constant). If it is an interest only situation you would just take the stated interest rate and multiply it by your debt position within the “band of Investments” equation instead of the MC for that part of the equation. I also think he is in a residential real estate investment frame of mind. Secondly, I don’t know a commercial lender that will do 100% LTV not to say they are not around but, I can tell you your not getting it for 8.25% even with a > 700 score. That is why he has to buy properties at such low sales prices because his leverage ratio is so high. If he did not and a down turn came around he would be in trouble. I do not recommend financing at 100% LTV ever!!! Unless it is for your primary residence and you don’t have the down payment even then I recommend 80% because of mortgage insurance. The former can be gotten around with an 80/20 piggyback product.

F.Y.I. Cap rates do and always have included your all important “Cash Flow and Equity”…And cap rates should not be used in residential properties…ie 1-4 units.