Evaluating Deals Part 5: Profit and Loss Bottom Line

You’ve seen the numbers. You’ve compiled a list of discrepancies. You’ve come up with a bottom line, that precious NOI which helps you to determine what the value of the property is. There is still much to do.

Assumptions

The P & L is making a bunch of assumptions. The seller is telling you how much rent they brought in, but not whether they are getting market rents or not. They are telling you how much they paid in various expenses, but not whether you will pay the same amounts. Your next step is to compare what they report with what you expect.

The Comparisons

Market Rents

We talked about this in Part 2 of the Evaluating Deals Series. Go back and read it now if you have forgotten. Perhaps the market rent is higher than what the Seller is getting. This is great! You will plan to increase rents and suddenly get increased income, which translates to increased NOI and property value. A deal like this is very desirable. Good job. Just don’t pay too much. The Seller may already know he is getting sub-market rents. He might even argue that the value is more because of this. You will retort that if it was so easy to get the rents up the Seller would have done that already. The real property value is probably somewhere in the middle.

Late Fees and Laundry

These will typically be on a per unit basis. A certain amount of people will be late each month. For me, this is around 5%. The amount varies but is pretty typical over a year per unit. Each unit will use only so much laundry services and this can be estimated. Go to the property and see what they are charging per load. Better yet, have a look a the prices at a few neighboring properties. If prices are too high, people will go elsewhere. Too low and you aren’t capturing the money you should be; in fact, you might even be losing money on water and electrical expenses.

Expenses

Go back to Part 4 of the Evaluating Deals Series for more on this. You need to generate a list of expenses per unit for your typical properties. This will be unique to your location and your property type. For instance, if I’m buying a property with boiler heat, I know that it costs me about $300 per year per unit to keep the place heated. If I purchase a property in a warmer latitude, this will be less.

Insurance costs are about the same and can be calculated on a per-unit basis. Insurance costs are different based on location as well. Repairs can be estimated on a per-unit basis as well, but they are different depending on the age and condition of the property.

Some expenses don’t work this way. Accounting costs don’t go up as much for each unit and you probably will have a flat rate per property you can get by talking with your accountant. Filing expenses and bank fees won’t go up as much per unit either.

Management fees are typically a percentage of the gross receipts. You will look at the total annual income and multiply by 8% (or whatever your management company charges) to arrive at a fee.

A quick and dirty way of evaluating the expenses is to use the Expense Ratio. At this stage in your evaluation, you will likely have more information on the property and so the Expense Ratio is less helpful. Use this ratio when you are first evaluating the property.

Capitalization Rate

You will probably disagree with the Seller about what Cap Rate is the right one to use for the property. Be sure you are confident you are using the correct Cap Rate for the property and area. You might consider arguing to the Seller that you only buy at x Cap Rate for this class of property and that’s why you use x% to make your figures. If he doesn’t agree to it, you won’t even negotiate.

The Bottom Line

Compare the Seller’s NOI with yours. You will hopefully have been using conservative numbers. They will have been using optimistic numbers. They will always have a higher NOI than you do. Well, maybe not always but if not, then you better recheck your calculations: this deal may be too good to be true. The key is that if the NOIs are close than you might be able to find a deal here.

The next step is to apply the Cap Rates. You will know the Seller’s proposed Cap Rate by now. He will have given you the NOI and the proposed sale price. Read the Cap Rate post to find out how to find the Rate he is using.

 NOI 
 Seller’s Estimation  Your Estimation 
 Cap Rate  $                 100,000.00 $              90,000.00
7.0% $             1,428,571.43 $        1,285,714.29
6.0% $             1,666,666.67 $        1,500,000.00
Here’s an example

In the example above, the Seller is probably asking for $1,666,666 for the property. If you think the true Cap Rate should be 7% and your estimates give an NOI of 90k, then the price you should pay is no more than 1.285M. You are pretty far off. On the other hand, if you agree that a 6 cap is right, your prices are about 10% off and you might be able to reach a deal. That 10% is not a hard and fast rule, but I see Sellers overprice by about 10% in their initial asking price because they assume that Buyers will always offer about 10% less.

In the end, if you are close, you are ready to make your offer. That part is negotiation-heavy and isn’t part of the Evaluating Deals Series. We will get back to negotiation at some point in the future. See you next time.

Dr. Equity

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