A deal comes in for a 12-unit apartment building from one of your brokers. He faxes you a rent roll and a list of expenses. The asking price is $575,000, and he’s asking for what you want to do.
It’s relatively easy to answer the question “is this a deal?” (the answer is usually “no”), the harder question to answer is “what is the most I would pay for this deal and why?”
When I first got started with analyzing apartment building, it took me about 4 hours to answer this question. This is extremely time consuming, and when you’re looking at a lot of deals, it can be overwhelming.
The trouble is, if it takes you too long to get back to the broker with feedback (or if you don’t get back to him at all), he will stop sending you deals. The same is true if you always respond with “that price is too high, it needs to be X”. Without usable feedback, the broker won’t know what you’re looking for and/or won’t be able to articulate to the seller why his asking price won’t work for you.
In this article I’d like to describe how to answer the question “what is the most I would pay for this deal and why”, and to answer it promptly.
Step # 1: Determine your Investment Criteria
Before you can seriously answer this question, you need to decide what your investment criteria are. If you plan to syndicate the deal, you need to answer the same question for your investors.
What is the minimum cash on cash return and average annual return that you and your investors will be happy with?
For example, you might decide that you won’t touch anything with less than a 10% cash on cash return and an overall average annual return of 20%.
If you’re syndicating the deal, you need to decide what returns you want for your investors. What minimum returns will you need to show to attract capital?
Before you can analyze a deal, you need to determine your investment criteria. Otherwise, how will you know if you have a deal?
Step # 2: Determine fair market value using the cap rate
I’m not going to explain the “cap rate” here (Bob Diamond does that in his REI Club article here), but I do want to give you some tips for determining what cap rate you should use in your analysis.
The BEST way to determine what similar properties have sold at is to ask you brokers. Hopefully you’re working with a handful of good brokers who are feeding you deals. If they’re worth anything, they’ll tell you what the prevailing cap rates are in the area and will send you comps for the area you’re looking in. From that, you can create valuable information about the cap rate and price per unit.
Let’s assume that the prevailing cap rate for your market is 8% for similar buildings. That just means you have a way to assess “fair market value”, but who’s happy with that? You may decide that you don’t want to get into a building with anything less than a 10 cap, and that is a fine investment criterium.
Knowing the market cap rate is important for estimating the re-sale value and your financial projections later on. Also, it may be unrealistic to look for 10 cap deals in an area where everything else is selling at an 6-cap, make sense?
Step # 3: Assess the value of the Building using the 50% Rule
Now you can quickly assess what you want to pay for any deal that comes in.
Assume the seller is reporting gross scheduled income of $100,000. In our income projections, we will use an occupancy rate of 90% unless the seller provides a lower number.
If the reported expenses are less than 50% of income, then ignore what’s reported and use 50% to calculate the Net Operating Income (NOI).
Apply your desired cap rate to get the current valuation of the building:
If the asking price is above $450,000, you can now quickly get back to the broker and say that the fundamentals aren’t right. You can say that the expenses are clearly under-reported, or the vacancy rate, etc. You might say, “The expenses are way low. Assuming 50% of expenses, and using the reported rental income, in order to get at my desired cap rate, I could spend no more than $425,000” and see how flexible the buyer is.
For me, the financial model is a bit more complex, which is why I created my own syndicated deal analyzer. Instead of using a relatively simple return like cash on cash return, I look for the average annual return for the investors. That is what drives all my deals.
The average annual return is made up of cash flows, loan amortization, and any appreciation from re-sale. How the profit is split with the investors also influences the return.
While my financial model is more complicated, it does the heavy lifting (not me), and the process is exactly the same and quick. And I can still use the “50% Rule”!
Using the 50% rule makes it easy to quickly answer the question “what is the most I could pay for this deal and why?” It will save you tons of timing in the early phases of the analysis and makes you more responsive when a deal first comes in.