Understanding the how-to of evaluating apartment buildings will save you a lot of time and potentially expensive effort! By evaluating the numbers correctly, you can determine which buildings have good cash flow and which buildings have poor cash flows QUICKLY! Understanding this process will allow you to confidently recognize poor-performing buildings and build confidence when making competitive offers on buildings that meet your criteria.
If you want to purchase an apartment building in this competitive market where multiple offers have become the norm, you must understand four values:
1. What the building is worth to you
2. What the market value is
3. What the financing value is
4. The expected Loan to Value Ratio
All these values are accumulated from one proforma and it is the input of correct data that allows you to determine a purchase value for any given building in all market conditions. Some of the key indicators a proforma will establish are the capitalization rate, loan-to-value ratio, gross rent multiplier, expense-income ratio, cash on cash return, income after debt service, debt service coverage ratio, price per unit, rent income to suite square footage, and other square foot comparisons.
Canadian Mortgage Insurance allows for very flexible and attractive financing solutions for these properties with as little as 15% down payment required; however, this doesn’t mean you will achieve this ratio so having a good understanding of what is achievable building by building will help tremendously.
It is particularly important to understand the Net Operating Income and apply a cap rate to a net operating income that is correct. The underlying fundamental of applying a cap rate to a net operating income is that it is presumed to be correct and will cause a variation in value every time if not.
Expense numbers must be verified during due diligence to satisfy financing so why not start with the correct numbers? You must keep in mind that for every $1,000.00 in net operating income, the value of a building is affected by $14,000.00 at a 7% cap rate and, if the cap rate is even lower the value is higher. A 3.5% cap rate changes the value by $28,000.
The formula is simple $1,000.00 / .07 = $14,285.71. So, if your net operating income is incorrect by $2,500.00 the representation of value based on a 7% cap rate is incorrect by $33,333.33. This represents a high percentage of value for a smaller building.
If a building’s net operating income has been incorrectly determined and the incorrect net operating income number is higher by $2,500.00 you have just overpaid based on this error by $33,333.33. Vice versa applies, if the net operating income is underestimated by $2,500.00 you have just found $33,333,33 in potential value. Yin Yang. As above so below.
Another mistake I see regularly is not including all the expense numbers or not understanding what industry standard numbers must be included in the expenses to determine a net operating income and satisfy financing!
CMHC and the lending institutions are going to plug in their standard numbers for vacancy, management, superintendent, maintenance, and potentially other numbers unless you can make a solid argument. Even if you have represented an actual number for the above expenses the lending institutions may use their numbers known as industry standard numbers. All this finagling of the numbers will change the outcome of the loan to value in the lending institution’s opinion and potentially yours. Naturally, this will change the final amount required for a down payment by you, the investor. Knowing this in advance is beneficial and helps with the decision process. Crunching the numbers based on the financial institution’s method is one of many ways to analyze the numbers.
Any capital item improvements completed in the past year should not be used as operating expenses when determining the net operating income. Capital item expenditures should not be confused with ongoing maintenance. All capital item improvements are a benefit the buyer will be inheriting and if you use these numbers in the cash flow of a proforma they will decrease the value of the building when capital improvements increase the value of the building.
You may be planning to do all your own property management and superintendent duties. This is ok but remember and understand the lending procedure depending on the building and the institution will vary and may require an actual number representing these expenses or an industry-standard number if someone feels the actual number doesn’t represent the industry average. This will change many numbers and working with a different net operating income will change the outcome received from the lenders. When you receive your letter of commitment the Loan to Value and the down payment you were expecting may be different and this makes a difference to all Buyers, especially the small investor.
If you are expecting to make a down payment of $250,000.00 and you are informed by the lenders (usually 30 days into the conditional period) that you now need $300,000.00 or $350,000.00 for a down payment there is a very high probability that your deal is going to fall apart and you have just wasted 30 days of critical time and you may have spent thousands of dollars out of pocket on environmental reports, other inspection reports and financing fees, some of which are non-refundable.
When you are evaluating a building for value it is vitally important to understand the condition of the building and any capital items that may require repair or replacement. Even if the condition is not going to affect value due to extenuating circumstances it is vitally important to identify these items in the beginning. When you determine your offering price this price should reflect these items and eliminate any possibility of abatement on price during the due diligence period. Secondly, if you are using CMHC the building will be inspected by CMHC and any required repairs in the eyes of CMHC will potentially create a holdback in funds not being advanced until proof of the completion of said repairs. This requires additional funds to complete repairs and the cash required to meet any financing terms and conditions.
This is where the rubber meets the road and a solid understanding of how the financial institutions look at the income & expenses of any income-producing investment is not only paramount but easy once you understand the boundaries the lending institutions must operate under.
Income property valuation is simple and one of the first understandings is never to trust the numbers being supplied. So many times, the numbers are estimated, outdated or simply wrong. You must dig much deeper than the proforma statement that is being supplied and one of the easiest ways to start looking at these numbers is on a per-suite basis.
You can’t determine how efficiently a building is running by looking at the bulk numbers. You must look at the numbers on a per door, per yearly cost. This allows you to compare one building to another and easily recognize buildings that have abnormally high expenses or abnormally low expenses.
There is an industry average for energy a unit consumes per door based on certain criteria such as the number of bedrooms per suite and the number of occupants per unit etc.
When you start analyzing enough buildings you will be able to recognize the buildings running efficiently or inefficiently. But don’t shy away from inefficient buildings too quickly as they may represent your best opportunity for creating net worth quickly.
If you know the numbers you are working with to evaluate a building are accurate, then the subsequent valuation calculation is straightforward.
The value of an income property is Effective Net Operating Income (NOI) divided by the Capitalization Rate; however, first, let’s explore what a capitalization rate is as there is a lot of confusion over this number.
A capitalization rate is determined by the marketplace, not the Seller, Buyer, or Real Estate Representative individually.
It is a collective number based on what Sellers & Buyers determine to be reasonable value in any given transaction that changes hands on any given day. A cap rate is fluid and may remain still or fluctuate. As we have seen over many years there is a continuous lowering effect year over year. Cap rates in many areas have compressed beyond even savvy investors’ expectations 10, 15 and 20 years ago.
A cap rate is a number used to determine value when applied mathematically to the Net Operating Income. The only time it is an actual return on investment is when you truly pay cash for a building.
The price per door is a simple calculation and is a quick determinant of how well a building will cash flow. For example, if in your market and everything being equal with rents you find that buildings on average are cash flowing nicely with a price per door of $180,000 or less then the likeliness of a building cash flowing with a price per door of $225,000 is highly unlikely.
Another area to explore is the suite mix and the percentage of units that are bachelor, one-bedroom, two-bedroom, and three-bedroom. A property that has more than two bedrooms than one bedroom will have higher rent or higher revenue per door. Plus, in any given market one or two of the above units may be easier to rent as there is more demand for them due to a variance in the demographics.
Speaking with enough Sellers/Owners of buildings in any market and asking them which units are the quickest to rent is an easy and sure way of getting a handle on the suite mix that is most desirable for any given Micro Market.
Next, we need to look at what numbers will be included in the number-crunching process and not necessarily rely on what is being reported by the seller or representative.
The obvious ones are gross revenue minus a vacancy & bad debt giving you the effective revenue, current taxes, gas, electricity, water & sewer, insurance, superintendent, management, and maintenance.
For the taxes and utilities, you must have the current and accurate numbers representing the past twelve months (not last year) when you apply for financing. The lending institutions and CMHC want to see a snapshot of these expenses for the past twelve months current up to the month of the agreement of purchase and sale date and beyond if there is a long closing period.
When analyzing numbers, you need to think with two hats on. First, you must make sure your numbers are accurate and at the same time find areas where an industry standard number acceptable to the lending institutions may allow you to achieve a higher loan-to-value ratio.
You may see a proforma from time to time without any numbers for superintendent, management, and maintenance. These are standard numbers the lending institutions use when analyzing a building for a loan to value and must be represented in your proforma when applying for financing.
Insurance is a good example of a number being reported by sellers that most of the time you will not use when analyzing your numbers. Over time insurance brokers increase the amount they charge on each renewal period and over a few years this number can potentially be much higher than what you will be able to achieve when shopping for new insurance. Buildings are paying as much as two and three thousand dollars more for insurance than what a new buyer will potentially achieve while getting quotes. Insurance is not assumable, and a new policy is required at the time of closing so why not go shopping early?
This amount of money affects the loan-to-value ratio. A $2,600 overcharge in this area can change your loan-to-value ratio by as much as $34,666.
Your goal is twofold, one is making sure the numbers for utilities and other expenses are accurate and you understand the effect of increased cost over time. Second, is finding areas where an industry number may represent the building better for achieving your highest loan-to-value amount.
Once you have and feel comfortable with all the numbers the formula is as simple as dividing the net operating income by the purchase price for determining a cap rate; however, when looking at the analyses you must take into consideration the price per door, cash on cash return, return on investment, GRM and debt service ratio.
While learning the ins and outs of analyzing a building it is important to have an experienced person to reflect your calculations off, as this will save you valuable time, shorten your learning curve and potentially prevent any pitfalls.
By using this exercise, you will be able to quickly ascertain if it is worthwhile asking for a proper set of income and expenses.
| Asking Price | $1,150,000 |
| # of Units | 13 |
| Cost Per Door | 88,461.53 |
| Financing 80% | 5,490.28 |
| Gross | 132,600 |
| GRM | 8.67 |
| Expenses 50% | 66,300 |
| CAP Rate | 5.7 |
| NOI | 66,300 |
| Financing | 65,883 |
| Profit after Debt | 417 |
- This simple exercise can be done on the back of a Tim Horton’s Napkin by knowing two numbers, the purchase price, and the gross revenue. And nine out of ten times if you follow this little exercise, you will have more of an accurate value for the building than the person representing it with incorrect numbers.
- With the rising cost of utilities and the reporting of expenses to satisfy financing these buildings, most of the time will have an income/expense ratio of 50% with a plus or minus. The expense ratio may even be as low as 35% on a larger building with recent retrofits. Either way, it is an extremely easy first quick assessment to see if further detailed analysis is warranted. By knowing the asking price and the correct gross revenue you can determine most of the key indicators. Knowing these ratios can raise a red flag early in the process.
- In this example, the four key indicators are the cost per door, gross rent multiplier, cap rate and profit after debt.
- The price per door is obvious; however, it has many implications and should be the first number reviewed. The marketplace of the subject property will have an average price per door and buildings with a higher-than-average price per door may not have cash flow as well. Buildings with a low price per door may offer an opportunity to increase that number to or above the average.
- The Gross Rent Multiplier is easy to calculate and complements the Cap Rate when compared along it. The lower the GRM and the higher the cap rate the better. When they are analyzed together you have a much better picture.
- Like the GRM the Cap Rate is more useful when compared with the GRM. A high Cap Rate and high GRM may indicate the picture isn’t what it appears. The relation to these two numbers is the exact opposite so beware when they are not in harmony.
- This is a business, and you need to determine and set expectations for the return your business is going to offer.
Calculations:
Cost Per Door Asking/Number of Units
Annual Gross Revenue Supplied
GRM Asking Price/Annual Income
Expenses Rule of thumb 50% of rent
CAP NOI/Asking Price
NOI Annual Revenue/Asking Price
Financing Here is a tip if you don’t know what the multiplier is for financing use .007 (James Bond). 007 is the multiply for 7%.
Profit after Debt NOI – Financing