January 18, 2022
Joe Fairless

How to Underwrite a Highly Distressed Apartment Deal

If you’re underwriting a normal value-add apartment syndication deal (covered in some of our other blogs and podcasts), you can use our free simplified cash flow calculator, and we provide additional documents that guide you through the process. To underwrite a highly distressed apartment deal, however, the process will be a little different. While you can still use our cash flow calculator, you’ll need to make some adjustments because the assumptions are going to be a little different.

Underwriting a Highly Distressed Apartment Deal vs. a Normal Value-Add Deal

One of the issues to discuss is a low occupancy rate for your multifamily property, not a stabilized value. The occupancy rate will be under 85%, but it can be even lower such as 50% or even completely unoccupied. There can also be deferred maintenance expenses; this deal won’t already have the deferred maintenance cured, so you’ll need to plan accordingly.

In a standard apartment deal, you’ll be deciding whether you want to continue operating as-is or include value-add propositions such as renovations or increased amenities to increase your rent. For a distressed deal, you’ll need to work on deferred maintenance issues such as mandatory repairs. The property could also have issues such as tax liens.

A distressed apartment deal also requires a significant amount of upfront capital. With a standard deal, you’d look at all CapEx investments as value-add, but when you underwrite a distressed multifamily property, your calculations will be different.

Here, your formula will be the stabilized value subtracting the deferred maintenance expense, the stabilized expense loss, contingency expenses, an equity fee, and finally all other expenses. This calculation gives you the maximum purchase price you can spend.

Let’s define those terms:

1. Stabilized Value

The property’s value when it’s fully operational, with 85%+ occupancy. To get this value, talk to your broker or property management company.

2. Deferred Maintenance Expense

Costs to get the property functional. Rather than value-add costs, these are necessities such as roof repairs, replacing broken windows, or fixing plumbing problems. To get these numbers, talk to the property management company to identify these projects and get repair estimates from contractors.

3. Stabilized Expense Loss

Expenses you’re incurring while you’re stabilizing the property. For example, you’ll have expenses such as insurance and utilities during renovations.

4. Contingency Expenses

These cover any additional maintenance you hadn’t anticipated. It’s very common to start repairs and find additional issues. For example, a simple plumbing repair could lead to replacing flooring and walls if there was water damage. A contingency budget accounts for these unknowns. You’ll need to budget at least 10% extra, but some people budget 25-50%.

5. Equity Fee

This is how you’ll get paid for your work renovating the property. Since you won’t be making money from rents, you can recapture your investment through an equity fee. Determine how much money you want to make, and subtract that amount from your purchase price. If you want to realize $100,000 in equity on a $1 million property, you’ll want the purchase price to be $900,000.

6. Other Expenses

These include anything else. This could be tax liens, financing fees, or closing costs. You don’t want to buy the property at full value and then learn you have to lay out thousands of dollars in back taxes.

Once you’ve subtracted all expenses from the Stabilized Value, you’ll know the maximum purchase price. While it’s a significant amount of work to obtain these numbers, if you don’t put in the effort, you can quickly find yourself underwater because you paid too much for the multifamily property or didn’t budget for expenses.

This is just your max purchase price, of course. If you can get the property for less, that decreases your investment risk and increases your potential profits for apartment syndication.

Distressed Property Example

Here’s a real-life scenario to illustrate. It’s just an example, and every property will be different. We’re providing some generic round numbers just to make the calculations easy.

The property is a 100-unit complex with a 50% occupancy rate. Those 50 units have previously been remodeled at a cost of $5,000 each, and they are renting for $1,000 a month. You have 50 vacant units, half of which are flooded and need $1,000 per unit of deferred maintenance, plus the additional $5,000 of needed renovations. So, 25 units need $6,000 in expenses, and the other 25 units just need the $5,000 in renovations.

Your contractor says you need $50K in roof repairs, $5K times 50 units for renovations, and $1K times 25 units for deferred maintenance. He estimates it’ll take six months to complete.

Your research indicates there is $50K in back taxes. From talking to the property management company and broker, you learned that the market capitalization rate is 10%. You calculate that your stabilized annual expense will be $6,840 per unit. Times 100 units, that gives you an annual expense of $684,000.

To calculate stabilized value, assuming a 90% occupancy rate: 90 units multiplied by $1,000/month, multiplied by 12 months, equals $1,080,000. This is your total annual income once you have 90% of the units occupied. Next, subtract your operating expenses of $684,000 to get your net operating income of $396,000. Your stabilized value using a 10% cap rate is $3.96 million, which is $396,000 divided by 10%.

  • Stabilized Value: $3.96 million.
  • Deferred Maintenance: $325,000(25 units x $1K for repairs, plus 50 units x $5k for renovations, plus $50k for exterior repairs)
  • Stabilized Expense Loss: $300,000 (50 vacant units multiplied by the 6 months they’ll be vacant times $1k rent)
  • Contingency: $32,500 (10% of the $325K deferred maintenance)
  • Equity Fee: $396,000 (10% of 3.96 million)
  • Other: $150,000 ($50K in back taxes, $50K in closing costs, $50K cost of raising money)

Running this calculation gives you a maximum purchase price of $2.7565 million.

  • $3,960,000 (stabilized value)
    • 325,000 (deferred maintenance)
    • 300,000 (stabilized expense loss)
    • 32,500 (contingency)
    • 396,000 (equity)
    • 150,000 (other)
    • equals $2,756,500 (max purchase price)

Hopefully, this example of a highly distressed apartment deal will help you underwrite these unique properties in your apartment syndication journey. For more information on apartment syndication, check out the Best Ever Apartment Syndication Book by Joe Fairless.

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.

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