Opinions needed...

Recently, I have been doing some research on my local economy and rental market and have a few questions regarding my findings but will first give a little information on my local market.

-Metro population of about 300,000.
-Jobless rate 8.8%
-rental market with vacancy rates of 11% - 12%

Now, the economy in my market has been hit with a major blow from its primary industry (automotive) causing the real estate market to soften greatly. There is still a high amount of panic from the general public in the area, but I feel there is an upside to these economic problems.

As I’ve been doing research I have also found that the job market here is going to be recovering slightly with the support from emerging industries in the area (healthcare, services, and travel), also, there is a large number of young adults which will be entering the job market very soon which I believe will also help lower vacancy rates. However, the economy and real estate market are still in turmoil and it appears that it will remain this way for at least the first half of 2007.

I have also found that the asking rents are far too high than they should be. It appears that landlords haven’t adjusted rents according to the current state of the local economy and market which I believe will inhibit the ability to fill vacancies. Another problem I see is that landlords are dumping their properties as if they are in a good, stable market and are 100% occupied.

So, with all that being said, how much would you pay for a 4-plex that is 75% occupied with an asking price of $240,000, and a proforma cap rate of approx. 8%?

Also, what would be the proper way to value a 4-plex? Would you use the same tools as you would to valuate a 10+ unit building? Are you able to valuate these smaller complexes on their current NOI?

DC,

You didn’t provide the information that we need to know (at least without a LOT of assumptions) to answer your question. What we really need to know are gross rents and what similar properties are selling for at retail (comps if you must use them).

The price I would pay has nothing to do with the cap rate or the asking price.

Yes, I use exactly the same approach in buying single family houses and apartment buildings. What else is there but cash flow and equity? I do know that I wouldn’t buy a property with a cap rate of 8. It definitely won’t cash flow with a mortgage!

Mike

I know I haven’t given a lot of info, but the reason is because I don’t have a specific property that I’m looking at right now. That post was a general assumption of the market and the average asking price of the 4-plexes in it.

Ok, I’ll try to simplify the above question. If there is a 4-plex with only 3 units occupied, would you base it’s value on it’s current NOI and the same formula that you use to value all other income property?

Ex. NOI / cap rate = value

I’m asking this because I do not know if you’re able to valuate an income property of this size this way because of its relatively small amount of units. Reason being, if or when one unit becomes vacant, the building technically has a 25% vacancy rate.

Forget market cap rates, especially pro forma cap rates. Make an offer based on your required return with the best mortgage you can get.

The income approach is ALWAYS the best way to evaluate an income producing property. If a property meets your investment criteria, buy it. If that means that you’d be willing to pay more than an open and fair market, so be it. You out bid the competition and still make money. If your investment criteria can only be met if you offer substantially below market value, your probably not going to get it unless the owner is desperate.

So figure out what a 4-plex with a 25% vacancy is worth to you.

I never use cap rate to determine a purchase price. What is cap rate really telling you - NOT MUCH. At best, it is telling you what your property is worth based on what others have reported as their NOI and purchase price. Where are those numbers coming from? In my experience, sellers grossly underestimate their expenses and overestimate their income. Also, we know that the vast majority of new businesses fail. We also know that the vast majority of rental units in the United States are owned by individuals. So, in my opinion, using a cap rate formula with a local market capitalization rate simply gives you the value you should pay if you want to join the failures in the area.

What you really need to know is gross rents (for all units) and then do a cash flow analysis for each property.

Mike

I would not use cap rates for a small property such as a four plex. I would use the sales comparison approach and from there look to see if the property cash flows out. If not lower your offer price until it does. Using cap rates on such properties just does not make sense.

I could not disagree with this statement more. I believe that you do not understand how cap rates work. Like I have stated before there are to types of value, investment value and market value. It is understood widely that a market cap rate may not serve your interests as an investor. Banks look more at market caps than investors do. Looking at the range of cap rates from sales can give you a good insight as to what is happening in the market. That is where investment value comes in and investment cap rates. You do not need to use any formula to derive a investment cap rate. Just set up the annual property operating data and divide the NOI/value. Cap rates tell you many things about the financial stability of the property.

The income approach is not always the best approach to value. Typically all three approaches are weighted by there relevance. The income approach may be telling you that the property is worth $1,000,000. After examining the comps you find that for the same cash flow people in the market are paying $900,000. In the former situation what would you rather base value on income or sales?

I don’t mean the income approach for market value is always best. Market value is totally irrelevant in this case. Market value doesn’t consider MY situation and MY cash flow/ equity requirements. Therefore, I’d base my offer based on the value to ME. Not what the market says. If the open market was willing to pay $900,000 for property XYZ, and I was willing to pay $1,000,000 to meet my criteria, looks like I win the bidding. I’d probably only have to go up to $925,000 to win it, but I’d be willing to go higher if it met my goals.

Sean,

I agree with Danny. The only thing that matters to me is 1) how much positive cash flow the property has (using real numbers) and 2) how much equity I’m getting at closing. What anyone else is paying is totally irrelevant.

You are approaching this from an academic standpoint - that of an appraiser. That is fine, but as an investor I’m only interested in making money. I can eat with cash. I can’t eat theory!

Mike

Everything you just stated was investment value.

You don’t find an investment value for a long term holding by the sales comparison approach or market cap rates.

Investment value is the value attributable to your investment goals. The sales comparison approach tells you what other buyers are doing in the market and caps rates they used (with good data). If I’m Joe seller and I know what the market is doing on the sales side and you come in with and you submit an offer with your value and its far from what other sellers are getting he is not going to agree unless hes really motivated to sell, just ignorant or a distressed property. Typically if your goals are that much different from what the market is doing your not going to get the property.

All investment value does is tell you where to start from and what the value of that property is to you. You may find investment value in the market if your goals are such that others in the market feel the same. Saying that you can’t find investment value in the sales comparison approach and market caps gos against economic theory. It just depends where you fall within the the distribution of sale prices and market cap rates.

Quote of the week…

Sean,

This thread is about purchasing investment properties. I know you understand what I’m saying and I certainly understand what your saying.

All investment value does is tell you where to start from and what the value of that property is to you.
Since your not the dumbest person in the world, I’m sure you’d agree that purchasing investment real estate should be based on the value of the property to the investor (investment value). If one’s investment value matches up with market value, GREAT! That makes life easier. The sales comparison approach and market cap rates, as you know, are derived from the market. Therefore, as an investor, I am only purchasing properties based on my investment value, sales comps and market caps have no meaning. It might mean I lose out on some properties, but I wouldn’t want them anyway if they don’t meet my criteria.

From your previous post, your assuming that an investor is going after every property, this isn’t the case.

If I'm Joe seller and I know what the market is doing on the sales side and you come in with and you submit an offer with your value and its far from what other sellers are getting he is not going to agree unless hes really motivated to sell, just ignorant or a distressed property.
If I'm looking through listings to find properties, I glance at thousands before I find 1 that suits me and my investment goals. Yes, I am saying that investment value can't be found from sales comps and market values. Those are 2 external measurements of value, they have nothing to do with my requirements. It would be working backwards to find the sales comp value or market cap value, then see if it matches my goals. An investor should figure out what the property is worth to them, if they can't get it for that or less, move on. What comps are selling for might possibly be the most meaningless number in MY world when buying.

Listings have nothing to do with sale comps and of course you will scan all the listings before finding one you like, everyone does that. I think I explained investment value completely . What I don’t understand is how you can state that you can not find investment value from comps. That is what appraisers do everyday. If the data is not there on the high end the appraisal gets cut or the bank denies it on the low end there is no issues. I am willing to guarantee that your investment goals are not that much different than the market at large. I also guarantee that there are comps and market caps in your area that match you investment goals. All building a cap rate does is to assure the investor that he is getting the required return out of his NOI if he has an accurate picture on expenses.

Listings have nothing to do with sale comps and of course you will scan all the listings before finding one you like, everyone does that.
Chances are, the appraiser and listing agent used the sales comparison approach on a 4-plex to determine it's asking price. It's in the agents best interest to list the property for the highest the market will bear. Appraisers are there to determine the market value, they pay no attention to me having the world's lowest credit score and thus eligible for the world's worst financing. But that would be a very real, practical factor that I'd have to consider when purchasing.

What I don’t understand is how you can state that you can not find investment value from comps.
Maybe I worded my statements wrong. When I’m purchasing a property for nothing more than it’s income, (I want the property to pass on to my great grand children) why should I care what the market would be willing to pay? My credit is a little different, I might have more or less cash to put into the deal, I want a lot of equity (discount on purchase) so I can say I’m a millionaire, etc.

My investment goals are very unique from the next investor. I’d be purchasing this property with cash to rehab, others would be purchasing this property @ 100% financing for cash flow. We’d have totally different investment values and totally different prices we’d be willing to pay to meet our goals.

For long term holdings, building a cap rate tells me immediately if I should investigate further. If my cap rate based on my required return and debt service are 15% and I come across a property with a market cap rate of 4%, I don’t spend another second looking at it. I’d use my own cap rate as a prequalification.

I’d only EVER be willing to pay my investment value for a property. If it is identical to the market value, I’ll be competing with the market. If my investment value is greater than the market value, I’ll certainly out-bid the market. If my investment value is less than the market value, the seller would have to be desperate or stupid to accept my offer, but that’s still all I’d be willing to pay. NOT the market value. This is why I say that comps have no bearing to my investment value, unless my investment criteria includes reselling in the very near future. What comparable properties have sold for don’t chance my credit score and they don’t change the cash in my pocket. If you’d be willing to pay market value for any property, anywhere, at anytime, you’ll be in trouble fast.

Most investors purchasing SFH’s for rentals, can’t compete with the market of homeowners. They have to go after the desperate, motivated, stupid, and distressed. They can only pay their investment value (which is usually less than market value) or they don’t make money. They CANNOT derive their investment value from comps because what homeowners are paying for similar properties doesn’t have anything to do with their strategy (renting).

I am willing to guarantee that your investment goals are not that much different than the market at large. I also guarantee that there are comps and market caps in your area that match you investment goals.

Sean,

This is where you’re completely off. My investment goals are MUCH different than the market at large. The market is buying at retail. I am buying at a MAXIMUM of 70% of the market value. The average new investor will fail and will be out of business in a rapid fashion, because they are paying retail. Retail properties generally will not cash flow using real world numbers. The average rental property owner has absolutely no idea what their expenses are. I use an expense number that includes all the real world numbers expenses. The average seller reports ficticious income and expense numbers. I only believe what I can verify.

As I said earlier, I need real profit - I do this for a living. I don’t need theoretical profit or I’d be working for someone else!

Mike

Even if you do find comps and cap rates of properties that would meet your goals, it would be backwards to say you can figure out what your goals are based on those same comps and cap rates.

I don’t look at comps to figure out the property I’m looking at is worth $2.2m, then decide my investment value is going to be $2.2m as a result. I decide what I am willing to pay to satisfy my needs and the awful shopping habits of my girlfriend, that becomes my maximum offer. Market value has no part in my decision making for a rental property.

Danny,

Again listing prices have nothing to do with sale prices. It also can be said that it is not in the best interest for the listing agent to list the property at the highest possible price. A lot of agents make that mistake.

As far as credit issues they are represented within the market caps. If you believe they don’t then you don’t believe in market capitalization and what it represents or you believe that other investors private and institutional of commercial real estate are totally ignorant to financial ability and it’s effect on cap rates. It all gos back to the type of property your buying

Mike,

So you think that you the only one in the market trying to get a deal. That is a ridiculous statement. Every wholesaler in the city is doing the same thing as you are…lol Not to mention there are many issues with properties that sell for extreme discounts. Not to say that there are not diamonds in the rough because occasionally there are. As far as expenses are concerned of course you want to do your due diligence, I would never tell you any different. That is the prudent thing to do.