Opinions needed...

[The DC Group]

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?

 

[propertymanager]

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

[The DC Group]

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.

[DannyTheGreat]

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.

[propertymanager]

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

[Sean_L]

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.

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.

[Sean_L]

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 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.

[Sean_L]

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.

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?

[DannyTheGreat]

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.

[propertymanager]

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  

[Sean_L]

Everything you just stated was investment value.

[DannyTheGreat]

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

[Sean_L]

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.

[Rich_in_CT]

I can eat with cash.  I can't eat theory!

Quote of the week.....

[DannyTheGreat]

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.