Retrospective Appraisal Of Small Apartment Building – Below Market Rents

[Gobears81]

The sophistication of the market participants and the liquidity of the market dictates how this should be handled. If it is a 15-unit property in a market that has a low degree of liquidity and a prospective purchaser is an entry level investor that does not have large portfolio of properties, they might not catch that market rent should be, say $700 per month, rather than the $500 per month that it is now. Maybe they will price in some potential of the upside in raising rents, but if the market is particularly dead, they might just be able to purchase it based on current income. In strong, liquid markets with sophisticated investors, the discount for below market rents on apartments would be smaller, and perhaps none in some cases. You mentioned a couple sales with below-market rents-those would be the ones to drill down on-how did the purchaser factor it in and what kind of discount was there?

 

[PS111222333444]

An investor may require some additional inventive (EI, entrepreneurial incentive) for taking on the stabilization process itself, so that would be factored as an add-on to the expense.
If it is going to take more than a year, most would apply discounting to a multiyear stabilization analysis.

Would EI be based upon the cost to stabilize the project or other factors?

 

[hastalavista]

Would EI be based upon the cost to stabilize the project or other factors?

So your best bet would be to take my suggestion of EI and Gobears81 advice in post #11 and consider them jointly.

The concept of EI is based on what it would take someone to risk whatever they are going to risk to achieve whatever they are trying to achieve.
EI is the minimum it takes to incent the entity to take an action. EI is therefore, by definition, always a positive number.
EP (Entrepreneurial Profit) is what is actually achieved. So, an entity may require a 10% incentive to take an action, but may achieve a 20% profit. If we are using EI in our consideration, we would use the 10% figure. Concurrently, although I might target 10%, I may achieve zero or I could lose money. Therefore, while EI is always a positive (and applied before the action is taken, as part of the projection) EP can be positive, negative, or zero, and can only be calculated at the end of the project/action is completed.

If I am purchasing a multifamily apartment building that is 30% under market, but I think I can bring it to market in 12-months if I
(a) say, make $30k in upgrades/repairs.
(b) Spend about $10k in leasing costs
(c) Experience about $20k in lost rent and/or below market rent during that period
Then I have about $60k in costs. I might require a 20% incentive on those costs to incent me to take on this project. So, my total deduction would be $72k ($60k costs + 20% of the costs for EI).

The above is how a rationale investor would evaluate the situation in most of my markets. However, depending on the market conditions or the sophistication of the buyer-type, that evaluation could change. In hot markets, the discount may be minimal (or zero). In depressed markets, the discounting may be significant.

I hope that helps.

 

[gregb]

So in a hot market, when subject is rented below market, one is going to use the projected market rent for the subject units in the GRM and Income analysis. And those comparables that are rented below market rent, one is going to project or use the proforma rent for purposes of analysis in the Income approach, right?

 

[hastalavista]

So in a hot market, when subject is rented below market, one is going to use the projected market rent for the subject units in the GRM and Income analysis. And those comparables that are rented below market rent, one is going to project or use the proforma rent for purposes of analysis in the Income approach, right?

That's the way I've seen it done (unless there is some significant rent control).

 

[NachoPerito]

I do both.

Many appraisers project economic rent for the subject but analyze comparable sales on actual rents when they are usually +/-10% below market. This is wrong.

I analyze income/expenses for the comps with actuals and at market to get two cap rates and I measure how far below market rent they are. I do that for all comps then graph the relationship between the cap rate and the % below market the actual rents are. Then I develop two values for the subject, based on actual and projected rents.

I know this is more work, but I fee it is important for getting at the right number.

I don't spend much time at all on the sales comparison approach though and I don't develop a value by the multiplier anymore.