I am new to apartment complexes and commercial property. What do I need to evaluate to determine if a 32 unit complex is a good investment.
What do I need to evaluate to determine if a 32 unit complex is a good investment.
Gross rents, purchase price, and loan terms.
And operating expenses, market comparables (both from a sales and rent standpoint) and best possible use estimates.
Must get these for us to evaluate:
-Term of the loan (seller financing, commercial financing, interest rate, length of loan)
-Utilities, who pays what (heat, electric, water, sewer, garbage)
-Management (property manager or you)
I would add that it helps to know your exit strategy.
If you plan to buy and hold it highlights the importance of a good loan and comfortability with the local rental/vacancy rates.
If it’s shorter term, rehab or improvement costs are more important. Anything you can do to improve value (and therefore rental rates) will mean a higher selling price.
When looking at comparable sales of other apartment buildings you can utilize three approaches - price per square foot, price per unit, and GIM (gross income multiplier, if the property had a gross income of $100,000 and sold for $500,000 it had a GIM of 5). The latter two are the most commonly used. Using all three of these techniques will give you a good idea of the market value. Ideally, you want to be below market :biggrin
Don’t waste your time with the aformentioned valuation approaches. The best way to place value on a property is what’s called a capitalization rate. Basically you’re converting the properties income to a value for the property. Take your NOI and divide by the purchase price and that will give you something like .08, .09 etc…You’ll have to talk to a local Realtor, development authority, or whoever and ask them what people are getting for cap rates and if they know they’ll tell you. If they act like they don’t understand, move on! Utilizing the cap rate method will give you a more realistic view of what the property is worth. Price per foot and per unit are ok but not desirable. Stay away from the GIM though. This valuation method doesn’t take into account the expenses for the property, which you’re gonna want to know of course. It’s a good formula to have in your head just to get a GENERAL idea, but the cap rate gives you a more realistic picture of your property. You should also learn about DSCR (debt service coverage ratio). Your bank’s decision will weigh heavily on this. Good luck.
Cap rate is NOT the best way to evaluate property IMO. Anyone that uses cap as their primary screening tool is destined for problems.
I must agree with Rich. Many investors swear by Cap Rate but it is such a horribly unreliable number. I’ve seen properties that were steals at 6% and others that were a disaster waiting to happen at 18%.
I would really enjoy someone explaining to me how a valuation method such as gross rent multiplier, which doesn’t take into account expenses, is better suited to evaluate a property than the cap rate.
Cap rates rely on the seller or selling broker to estimate expenses, these are almost always way underestimated. If I look around on Loopnet I can find maybe 10% of the buildings actually derive the cap from reasonable expenses. Most of these buildings have expenses that are 25-30% of the gross rents, this is completely unrealistic. I’d rather know what the gross rents are and derive my own estimates from there, if I plug 50% of gross rents I know I’m closer to the national average and have a better guesstimate. Obviously if I want to compare dissimilar buildings I can use my own expense numbers then derive realistic caps to compare apples to apples but I am certainly not going to use some crooked broker’s numbers.
For most residental rentals to cash flow properly, they need to have gross rents that are at least 2% of the acquisition cost (purchase price + rehab). That 2% rule is the same as having a gross rent multiplier of 50. This does take into account the REAL WORLD expenses of 45% to 50% of gross rents.
Cap rate is simply NOI divided by purchase price (or value). The problem with using cap rate is that you don’t know what the owner used as expenses. Most sellers overestimate the rents and underestimate the expenses. In addition, there is no accurate source of expenses and therefore NOI for a given market. Therefore, the market cap rate is just someone’s guess of the expenses and NOI. Furthermore, since the majority of residential rentasl are owned by individuals (look up the census numbers) and the vast majority of new landlords fail in a short period of time, all the cap rate tells you is what the failures are paying for their property.
So if I understand correctly you guys don’t like cap rate because you feel like you are using non-exact expense and rent numbers provided by the seller. When I buy I know exactly what the rent rolls and the expenses for that property are or will be. My contract states that I get to review/approve all leases so I derive my revenue numbers from that and my own research/experience. As far as expenses go if you are not planning on paying utilities then you have insurance and taxes, two numbers you can calculate down to the penny and then you can give yourself an 8-10% buffer for maintenance. That’s a pretty accurate picture I like to think. I would agree Rich to obtain your own numbers as opposed to broker or seller provided. If you know anyone who does that please introduce me I have some buildings for sale! Also, it does not hurt to be armed with everyone of these techniques and rely a little more heavily on one or the other, which it sounds like we all due. When I plug the numbers from a potential property into my spreadsheet I look at Cash Flow, Cap Rate, DSCR, ROI, Break-Even, Margin, GRM, and Yield. All of which give me an idea of how the property will perform and how it matches up against my other holdings. Good conversation!
If you are using taxes + insurance + 8-10% for expenses, you are not going to last long in this business.
I also include a vacancy allowance, I just forgot to insert that in my last post. What else are you looking at? I’m in my 20’s, have been doing this for 3 years, have over $2 million in student rental properties and don’t have to have a ‘real’ job because my properties generate enough positive cash flow. I think I analyze my deals pretty damn good. I think maybe there’s a reason you are a propertymanager and not a propertyowner/investor.
Throughout the United States, operating expenses run 45% to 50% of the gross rents (you can look it up if you don’t believe it). Operating expenses include taxes, insurance, management, maintenance, vacancy allowance, advertising, entity maintenance, utilities paid by the owner (during vacancies, etc), legal fees, evictions, damage done by the tenants (in excess of the security deposit), lawsuits; capital expenses (although not technically an operating expense), etc, etc, etc.
FYI, I own several dozen rentals. However, I think you should stick to your taxes, insurance, and maintenance. I’m sure you’re right! :rolleyes
You can add the 10% for expenses and then add separately the insurance, taxes, managing, etc, or you can add them all together, but either way, you have to have a total.
Seems like you 2 just get to the total in different ways.
Seems like you 2 just get to the total in different ways.
That it simply wrong. Taxes + insurance + 8-10% does NOT equal 45% to 50% of the gross rents - not even close. The number one reason newbies fail is that they don’t understand the operating expenses and therefore end up with negative cash flow when reality finally kicks in.
I’ll have to agree with Mike. You guys are kidding yourself if your are evaluating expenses with just taxes+ insurance and adding some imaginary % to that. If you have owned properties then you should realize that it’s not that simple. Sure taxes and insurance are a big part of your fixed expenses however there is a long list of operational expenses.
I do believe CAP rates are a valuable tool. Mike and I have had this discussion before and saw each other points. I don’t feel that cap rates are really neccesary when evaluating your initial proforma/projections, because after all it’s just a percentage, it’s not money in your pocket. However, I believe understanding cap rates is a crucial part of your market/submarket and help determine future projections. This will also give you an advantage when trading assets.
I guess I should respond since the last several posts have come from my intial comments about valuation. Obviously the approaches I mentioned should not the be only way you value an apartment complex. From the sales approach, they are the only way you can value an apartment complex. Because if I see a grouping of similar GIM’s from the sales of comparable apartment complexes, I’m going to assume that the buyers and sellers were educated and experienced enough to properly analyze the overall apartment complex and set a purchase price based on their analysis. That analysis is REFLECTED in the GIM. Now, if I were to see a GIM way higher than most other GIM’s I would assume they probably paid too much unless that was a good explantion. If I were to see a lower than average GIM I would assume they got a better deal. You obviously have to dig deeper and each sale should be analyzed separately.
At the end of the day you just want money in the bank. So yeah, run the numbers, check your cap rate against the market and do whatever helps you sleep at night. But I recommend using as many valuation models as you can. That makes sense to me.