AMA - How Much Should I Pay, part 2
Danielle asks: "I am considering purchasing a 4 unit apartment building that is approved for higher density to six apartments. How do I know what is a fair price to pay for the property?"
Danielle, this is a great question.
When we buy real estate for a long term hold, or a quick sale we use a very similar approach that is pretty standard in the industry. The method is called “Residual Land Value Analysis “. Click HERE for a copy of the spreadsheet
It’s a fancy term that basically means you need to work backwards from the answer to the question, or work backwards from the value of the finished product to the raw material that you are starting with.
On yesterday’s show we looked at the case of a simple new construction project or a flip. We did a bunch of math to explain how the residual land value analysis works. For those of you that want to follow along with a spreadsheet, there is an example you can link to in the show notes for this episode. Just go to the show notes, click on the link and you’ll get a copy of the example. The same spreadsheet that we used for yesterday’s show has a second sheet embedded in it with the buy and hold analysis.
On today’s show we are going to look at the case of a 4 unit apartment building in a hot area. The first thing you need to assess is the as is value. That’s based on the current rent. For your specific property, the rents are quite low at about $1,050 a month. The taxes are high and the expenses will probably run near 50% based on a building of that age. If we valued the property aggressively at a 5% cap rate which would be high for that quality of asset, you would find that the property is worth no more than $500,000. That is a long way from their asking price.
So now we are going to look at the residual land value analysis assuming you redevelop the property into a six unit apartment.
The property you found is in a great area that is in high demand. Rents for new product in the area are running at about $2.30 per square foot. We are going to build 4 apartments at 900 SF each with an additional overhead of 20% for the common area. We only charge rent on the rentable area of 3,600 square feet. Gross rent will be $100,000.
I’m going to cut a few corners here in the rental analysis like accounting for vacancy. The point is not how to model a rental, but the residual land value analysis.
The expense ratio is going to be much lower than the previous case because the rents are higher and you have a new building. We will assume a 35% expense ratio. We will use the same 5% cap rate as before. Once built, the building should be worth 1.4M
Your business is going run as a healthy business and I recommend that you set the profit margin for your business somewhere between 25-30%. I would start at 30% and as you get more experienced with strong and predictable systems you can lower your margin requirement.
Except in this case the notion of margin is different. We’re not selling the property. Instead we are going to refinance. We want to target a refinance at 70% loan to value so that you can recover 100% of the initial investment in the refinance.
If we take 70% of the value, then our maximum investment is $980k. Our loan closing cost is going to be about 3% of the loan amount or $35,000. We are now down to 935,000.
We are facing a year of holding cost, so we can budget $60,000 for that. We are now at 835k. Just like the case yesterday, we need design engineering and permit for $30k.
We can build a good quality B+ product these days for about $126 per square foot in many markets. We subtract the hard construction, foundation, and site servicing costs and that leaves a residual land value of $331,400.
This exact same calculation that applies to a flip or a new construction project for sale .
Go to the show notes with this episode to download the spreadsheet example.