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?
How to Quickly Analyze an Apartment Building Deal using the 50% Rule
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
We are not going to explain the “cap rate 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 criterion.
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 a 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.
Using the 50% rule makes it easy to quickly answer the question “what is the most I could pay for this apartment building investment deal and why? It will save you tons of timing in phase 1 of the analysis and makes you more responsive when a deal first comes in.
When speed and experience are important and crucial to your commercial real estate investing success, a principal at Winston Rowe & Associates is always available to speak with prospective clients.
They can be contacted at 248-246-2243 or visit them out online at http://www.winstonrowe.com