Understanding the how-to of evaluating apartment buildings will save you and any potential buyer a lot of time and expensive effort! The more accurately you determine value increases exponentially the likeliness of any Agreement of Purchase & Sale successfully closing without any unwanted abatements. By evaluating your numbers correctly, you can determine the value of your building(s) with a predictable level of accuracy. You will understand which of your buildings have good cash flow and which of your buildings may have poor cash flow. As a strategy, you may want to address any poor-performing buildings, determine the reason for poor performance and remedy this before you go to market to maximize your return. In any case, knowing the correct value in advance will give you a level of confidence and enhance your expectations when dealing with a buyer and an Agreement of Purchase & Sale, lessening the potential for disappointment.
Purchasing an apartment building is a business and understanding the underlying and current principles of purchasing can benefit you the Seller tremendously. It may have been some time since you purchased a building and understanding the current guidelines buyers find themselves operating in and having to follow will raise your expectations.
Understanding the different industry approaches to value and the reason for them will tremendously help you the Seller recognize good, qualified Buyers with achievable goals, the ability and motivation to close. Understanding these four values will assist you in determining an asking price and a final expectation for a selling price. In the case of multiple offers understanding these values and achievable outcomes will assist you in choosing the right Buyer, the Buyer who will work with you and close:
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
As a Seller it is always important to have a reasonable expectation for any given building and the loan to value a building is likely to achieve when potential purchasers approach the various lending institutions for their financing. Buying an apartment building is slightly different than purchasing residential real estate in terms of being pre-qualified. The building is one half of the equation, and the Buyer is the other half. The building and the buyer will be analyzed based on his or her own performance and ability. The building performance will determine the achievable loan-to-value ratio, and the financial strength of the Buyer will determine their qualification for this loan-to-value ratio. This loan-to-value ratio will determine the amount of money required as a down payment. Knowing this will assist with choosing the correct Buyer.
Canadian mortgage insurers allow for very flexible and attractive financing solutions for these properties with as little as 15% down payment required; however, this doesn’t mean a building/buyer will achieve this ratio so having a good understanding of what is achievable will help you tremendously in determining your final selling price and qualifying purchasers.
Having an accurate snapshot of your income and expenses for the past twelve months (current up to the date of analysis) is paramount as applying a cap rate to a net operating income that is incorrect produces an incorrect value and will always motivate the Buyer to come back to you looking for a haircut, or price reduction abatement. Financing will verify expense numbers during the due diligence period to satisfy themselves, 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.
The formula is simple $1,000.00 / .07 = $14,285.71.
Another mistake I see is not including all the expense numbers or not understanding which industry standard numbers must be included in the expenses to determine a net operating income that will satisfy the lending institutions.
CMHC and the lending institutions are potentially going to plug in their numbersfor vacancy, management, superintend and maintenance and even if you have accurately represented a number for these expenses the lending institutions will use their numbersdepending on the size of the building. As an example, you may have a great deal with the superintendent that is below market value in the eyes of financing. This doesn’t mean their numbers is a more accurately represent of your building it just means you and the Buyer are going to see a potential variance during financing and knowing this in advance is power.
Any capital item improvements should not be used in the expense Column as these expenses improve the value of the building and including them in the NOI will decrease the value of a building. Capital item expenditure should not be confused with ongoing maintenance. Any capital item improvements are a benefit the buyer will be inheriting and if you use these numbers in the cash flow proforma you will be decreasing the value of your building, when these expenses increase the value.
You may be saying to yourself, well who cares I do all my own property management and superintendent duties. This is ok but if the Buyer doesn’t understand the lending procedure and is working with a different net operating income than his lenders when he receives his letter of commitment the loan to value and the down payment, he was expecting is going to be different and this makes a difference to all Buyers. Having and projecting correct expectations in the beginning will reward you with a fruitful outcome.
For example, If a Buyer was expecting to make a down payment of $250,000.00 and he is informed by his lenders (potentialy 30 days into the conditional period) that he now needs $300,000.00 or $350,000.00 for a down payment there is a remarkably high probability that your deal is going to fall apart, and you have just wasted 30 days of critical marketing time.
When a building is under evaluation 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 conditions are not going to affect value due to extenuating circumstances it is vitally important to disclose these items at the beginning of any sales cycle for two reasons. When a Buyer determines their offering price this price will reflect these items and eliminate any possibility of abatement during the due diligence period secondly if the Buyer is using CMHC when the building is inspected by CMHC any holdback of funds for mandatory repairs (condition of advancement of funds) being advance will be expected and budgeted for. This is all part of qualifying the Buyer and their motivation to close. If they don’t have the necessary funds in reserve to complete repairs dictated by CMHC, it will be very difficult for the buyer to close.
The value of an income property is 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.
First, the capitalization rate is determined by the market 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.
It 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 pay cash (zero financing) for a building.
Next, we need to look a little closer at what numbers will be included in the number-crunching process with the intent of satisfying both the Buyer and lending institutions. The obvious ones are gross revenue minus a vacancy & bad debt giving you effective revenue, and a current snapshot for the past 12 months for 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 the Buyer applies for financing the lending institutions. CMHC wants 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. If you experience a long closing period due to unexpected or expected reasons, these numbers will have to be updated.
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 selling price.
Many times, I see a proforma 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 the Buyers’ proforma when applying for financing.
Insurance is a good example of a number being reported by sellers that can potentially increase the value of a building. Over time insurance brokers increase the amount they charge on each renewal period and over a few years this number will be much higher than what you will be able to achieve when shopping for new insurance. Insurance is not assumable so get a new quote from an insurance broker that is acceptable to the lending institutions.
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 amount of loan-to-value financing. Some of these numbers can be moderately adjusted to represent the building in the best scenario and enhance value.
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 and debt service ratio.
Income property valuation is simple and as a Seller, you need to step into the mindset of a Buyer and represent the numbers fairly while maximizing value. Oneof the first lessons a Buyer must learn is never to trust the numbers being supplied. This is an opportunity for a Seller to win the trust of the Buyer and have a great working relationship with him/her. As a Seller, it is your responsibility to have a full and accurate understanding of the numbers being represented. The time to organize yourself for the potential sale is now.