When valuing a property, there are three distinct valuation methods. As investors, two are most relevant to us. If the subject property is a residential property – single family, a duplex, triplex, or 4-plex – an appraiser will utilize the sales comparison approach. They will locate recently sold, comparable properties, adjust for any differences (age, size, amenities, etc.) and determine a property value. For multifamily properties with 5-units or more, an appraiser will utilize the income approach. To determine how to calculate the income approach for real estate and the value of a property, the appraiser considers income generated and market cap rate.
Therefore, if you have a duplex, for example, even if the cash flow is extremely high, typically, the appraiser won’t take that into account when valuing the property.
Nick Baldo, who has been a full-time rental property investor since 2014, was able to convince a lender to accept an income approach appraisal on a package of four duplexes. In our recent conversation, he explained how he was able to do so.
Setting the Stage
Here’s the story: The four properties were all located around the University of Buffalo in New York. Nick found two of the properties first, and then randomly came across the second pair of duplexes. “The way we did it was we identified two [duplexes] that we were going to buy,” Nick explained. “It was an off-market [deal]. We had an agent we were working with [and] he had an investor who owned two houses in the area.”
“As we were there one day doing our due diligence, an older gentleman walked up to us asking if we owned those houses,” Nick continued. “We said, ‘well not yet,’ and he said ‘come with me.’ He walked down the street to two other houses that he owned.”
“He was not interested in owning them anymore and was really interested in lending money. What we were able to do was we bought all 4 through different means for each, but on those second two, we did some owner financing.”
The typical property in the area of campus Nick was investing in, he said, were “run down, fraternity and undergraduate housing.” However, for these duplexes, Nick said, “we made them a little bit nicer, increased the rents a little bit, and started really focusing on either upperclassman, the graduate students, and medical students, which was the trend of the area, so we caught that wave.”
Since the surrounding properties were “run down,” a sales comparison approach appraisal would have valued the properties much lower than the new, increased rents demanded. Nick said, “the struggle of the appraisal was trying to convince the bank to go off of income-based metrics, as opposed to the comps approach, because the comps approach would kill us. We had to really [tell the lender], ‘hey, we get it. If you sold it to a homeowner, you’re not going to get the value, but these, as a package to an investor, are very attractive because of the income and cash flow.’”
Related: One Tactic to Increase Property Value By Up to 30%
Income Approach on a Residential property
How did Nick accomplish getting an income approach appraisal? “Our loan [was a] commercial loan [from a] small, regional bank loaning our business money with the property as collateral,” Nick explained. “The coolest part about commercial loans is there’s no hard rules. They’ll loan your business money, given that there’s collateral to back it.”
When Nick initially purchased the properties and approached the bank asking for an income approach appraisal, it didn’t go well. However, when it came time to refinance the properties, he was successful! “What we were able to do was get the loan officer to really sit down with us, understand the cash flow we were looking at, and he was able to go to his board and we were able to get the appraiser to give us the income-based approach,” Nick continued. “He got the bank to take that as the appraised value.” Persistence paid off.
Going to Smaller Banks
That’s one of the benefits of the smaller, regional banks. Their loans give you a little bit more flexibility to actually talk to real people.
Related: Don’t Be a Slave to the Lender
Nick was able to get the income approach appraisal on properties that were less than 5-units because he was working with a portfolio lender locally. It was a regional bank that keeps loans in their portfolio. Therefore, they’re their own bosses. They’re not selling the loan on the secondary market, which allows them to come up with creative terms that make sense.
The bank Nick used, he said, “has a board that approves all their loans. They have pretty strict standards still, but they have human-beings that can make rational decisions because in the end, they want to make money.”
Nick purchased the entire 4-property portfolio for $230,000. He put in $15,000 per property, for a total all in price of $290,000. Rather than having the property appraised using the sales comparison approach, which would have probably valued the property around $300,000 or less, using the cost approach, it appraised for $375,000. That’s a difference of a least $75,000 in equity, all because Nick was able to negotiate terms with the lender.
What’s the main takeaway from Nick’s story? Portfolio lenders, as well as regional commercial banks and credit unions, are our best friends when we seek them out and build a relationship with them.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.