This valuation method is called the Income Approach and it is based on the principle that the value of the property is determined by its ability to generate cash flow. The first step is to determine the cash flow that the property can generate. This is particularly tricky because sellers and brokers are motivated to get the highest price for the property. In reaching this goal, they may be prone to represent the net operating income at a higher amount than it is. (Not blaming brokers – they are just doing their job). The job of a prudent investor is to take a step back and understand how to properly set up the income and expense.
Here are some of the common things to look out for when reviewing the broker or owner’s income and expense statements.
- The first step is to calculate the potential gross income. This is the total rental income that the property can generate assuming that every apartment is occupied. Be careful to look out for vacant apartments on the rent roll. On many occasions, the broker’s projected rents for vacant units can be quite aggressive. They may assume that a full renovation was completed while in reality, the apartment has not been renovated since the late ’60s. Always be careful to review comparable rentals to determine proforma rents. You may be surprised how much of an impact this can have on your gross rents!
- The second commonly overlooked item is a deduction for market vacancy. Many brokers will show you the income and expenses without accounting for any vacancy allowance. It doesn’t matter if the property has been fully occupied for the last 100 years, you still need to include an allowance for vacancy. By speaking to a local appraiser, owner, or broker you can get an idea of the vacancy rate for a given market. Once you deduct the vacancy allowance from the potential gross income, you will arrive at the Effective Gross Income.
- The next step is to properly account for operating expenses. The most common mistake investors make is not properly accounting for Adjusted Real Estate Taxes. Many municipalities reassess properties based on the sales price or based on improvements made to the property. This can be a massive deal killer; I have seen property taxes double on multifamily deals as a result of a sale alone (think parts of Texas). Part of the due diligence process is to get a handle on what the property reassessment ramifications will be.
- When it comes to other operating expenses it is important to go through each line item including utilities (heating, electric, water sewer, trash), insurance, payroll, admin, repairs and maintenance and compare them to other properties in the market to understand if they are being properly reported.
- This brings to one of the most overlooked items which are accounting for Replacement Reserves. This is not a real expense; it is money set aside for capital improvements (usually $200 to $400 per unit depending on the age and condition of the building). Almost every lender will apply this expense in their underwriting. In many cases, the lender will collect monthly payments for replacements reserves.
- Another item which commonly overlooked is a Management Fee which calculated as a percentage of the effective gross income. Many sellers argue that since they are managing the property themselves, no management fee is necessary. In reality; It does not matter who is managing the property. When underwriting a property, you always need to include a management fee.
- Once the expenses have been fully accounting for, you can deduct the total operating expenses from the effective gross income to arrive at the Net Operating Income.
- Now we can evaluate the property using the Direct Cap Method. By dividing the net operating income (NOI) by the Market Capitalization Rate (cap rate) you will arrive at the value of the property. Cap rates are very subjective; every deal, every investor, and every market will command a different cap rate (subsequent discussion).
- Deducting Renovation Costs and Rent Loss – Being that the potential gross income may include market rents for vacant apartments, you may incur renovation costs and rent loss. In order to arrive at the “as is” value of the property, you will need to deduct the costs of renovations and rent loss.
We have all seen deals marketed as “7 Cap Rent-Stabilized Multifamily Prime Brooklyn Upside in Rents”. In most cases; aside from properties that have a tax abatement, by going through the proper underwriting, that 7 cap is likely not actually a 7 cap. The moral of the story is that you need to do your homework!