In this episode, Travis highlights three common industry practices for how general partners often predict future sale prices. He notes that some firms use a mixture of all three approaches, or they might combine two of them.
- The Exit Cap Rate Approach
The formula for this approach involves taking the estimated forward 12 months of net operating income on the property and dividing it by the anticipated exit cap rate, which gives you the approximate sale value at exit.
This is the gold standard in the industry, Travis says. When using this approach, you assume where cap rates are going to be in the future when you plan to sell the property. You also expect that the buyer that purchases the property will use the exit cap rate approach as well.
- Replacement Cost
Replacement cost is the amount of money it would take to build a brand new comparable property. With this approach, you consider the replacement cost of the property today as you’re buying it, and then try to predict what the future replacement cost is going to be. You only want to purchase a pre-existing apartment building if it is below the current replacement cost, Travis says.
For example: You purchase a property for $250K per door, and you anticipate that the land value and construction cost, labor, etc., are going to increase by about 5% each year. You plan to hold this property for five years. Using the 5% metric, you could predict that the replacement cost in five years will be approximately $320K per door.
- Next Buyer Analysis
This approach isn’t frequently used. “It’s a lot like the exit cap rate approach, but on steroids, so to speak,” Travis says. First, you determine the cash flow that is currently being achieved. Then model out what you anticipate rent bumps to be over the number of years you anticipate holding the property. Next, you model out what an approximate purchase price would be. Consider who will be buying your property down the road and what they are going to want to achieve for a potential return.
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Travis Watts: Welcome back, Best Ever listeners, to another episode of The Actively Passive Investing Show. I'm your host, Travis Watts, got a very exciting episode for you here today. What we're talking about is how to predict the future sale prices of multifamily real estate. Now, obviously, it's a pretty tall order to predict accurately three, five, ten years down the road on what you think the sales price of a piece of property would be.
For those of you who listen to the show and know me personally, you know I'm not much of a speculator, I'm not much of a gambler. I honestly don't put much emphasis at all on equity upside in the investing that I do. Rather, the angle that I've taken on this episode is to explain what the common industry practices are for how general partners usually predict future sale prices. Whether you're an active investor or a passive investor, I'm excited to share this with you here today. Let's dive in.
Alright, the number one, I would say pretty much the gold standard in the industry of how you predict the future price of a multifamily property is by using what's called the exit cap rate approach. How you calculate a cap rate, if you're not sure what it is, is the net operating income that the property at hand is producing, divided by the purchase price. That's the simple formula.
When using the exit cap rate approach, there are really two assumptions that someone is making. That is, number one, where Cap rates are going to be in the future when you plan to sell the property, and number two, you're suspecting that the buyer who's going to purchase this property is going to follow the same methodology that you are, by also using the exit cap rate approach.
If you're underwriting a property, whether you're a general partner or a limited partner looking to invest in a deal, the formula might go like this. You can take the estimated forward 12 months of net operating income on the property, divid it by the anticipated exit cap rate; that gives you the approximate sale value at exit.
Another industry-standard along these lines, I see a lot of operators just using the simple five to 10 basis point spread per year that they plan to hold the property. For example, if you're buying a property today at a four cap rate, capitalization rate, and you plan to hold the property for about five years, then you might anticipate that the exit cap rate is 4.5%, maybe upwards of 5% upon sale. You might be thinking at that point, "Wait a second... If cap rates go up, doesn't that negatively impact the purchase price of real estate?" Generally speaking, the answer to that is yes. But the reason that so many firms do this is because we are at all-time historic lows when it comes to cap rates and interest rates, so the probability that they go down further or into negative territory versus bottoming out around this timeframe and then going back up again - well, quite frankly, you have a higher probability that they're going to reverse trend and head back up. So it's just simply a way to be conservative when it comes to the underwriting on the property.
That's something to look out for if you're a limited partner investor, you do want to see conservative underwriting, and it's something to consider if you're a general partner, that you want to be making conservative assumptions for your investors, to make sure that you can deliver the results that you're telling him you can deliver.
All of that is the first method, the exit cap rate approach on how to predict the future pricing of multifamily real estate. There are two more I want to share with you, so let's dive into those.
Number two is considering the replacement cost of the property today as you're buying it, and then trying to predict what the future replacement cost is going to be. Replacement cost simply means how much it costs to build, brand new, a very similar, comparable apartment community. Just as a general rule of thumb, take a look at the comps in the area and it's just good to realize what single-family homes are selling for, what brand new construction is selling for... Because generally, you only want to purchase a pre-existing apartment building if it is below the current replacement cost. Otherwise, it'd be like buying a used car at the same price that it would be to go to the dealership and buy a brand new one; it doesn't make a lot of sense.
Break: [00:07:29] - [00:09:16]
Travis Watts: Let's take a look at a mathematical example of this. If you've got a property today that you're looking at purchasing for $250,000 per door, and you anticipate that the land value and construction costs, labor, etc. are going up about 5% per year, and you plan to hold this property for approximately five years... Then you would forecast out using that 5% metric and you'd say, "Hey, approximately in five years, the replacement cost here is going to be about $320,000 per door, rather than $250,000 which it is today."
The third and final that I want to share with you is not necessarily the most common, but I have seen it used... It's called a next buyer and analysis. It's a lot like the exit cap rate approach, but on steroids, so to speak. Essentially, what this entails is you're buying the property today, you're looking at the cash flows that are in place, you're looking at your business model and saying, "We think we can bump rents up to about this, which will take the net operating income to about that, and we plan to sell in about five years." So now you're looking at who's my buyer in the future. They're going to come in, buy this asset at approximately this new number of net operating income, and you're going to have to kind of assume what their business model is going to look like, and what kind of IRR return they're going to want to achieve, and so you're modeling forward. I know that sounds a little bit complex, but let's break that down into a few easier steps.
Step number one is that you're looking at today's cash flow that's actually being achieved, and then you're modeling out what you anticipate the rent bumps to be over the course of five years, for example, if that's how long you anticipate holding the property. From there, assuming that would be the cash flow and the net operating income, you could then model out what an approximate purchase price would be, keeping in mind that multifamily apartments are treated a lot like businesses, in that a primary driver of their price is the net operating income. It's simply that investors are out there looking for passive income, they're looking for an income stream. So if your property produces $1 million per year, that's obviously pretty valuable. How much? It depends on the market. But just like when you look at stocks and P/E ratios, price to earnings ratios, multifamily investors are out there looking at the NOI, and saying maybe, for example, purposes, "I'll pay you a 20x multiple for that income stream. Meaning if your property produces a million a year, I'm willing to pay you $20 million to purchase that income stream from you."
Back to the underwriting example real quick... So you're five years out now on anticipated cash flows and purchase price; now you're going to push it another five years, and you're going to look at who's buying my property down the road, and what are they going to look to achieve for a potential return? So you're going to keep modeling out for a 10-year period. To be honest, I don't see this method being used a whole lot. Some firms do a mixture of all three, some will just do one, and some will just do two, so it just kind of depends. But I wanted to make you aware again, whether you're an active investor or a passive investor, to look out for this underwriting.
To recap this episode in a nutshell, the exit cap rate analysis is kind of the gold standard and the industry standard, but there are additional ways you can do it. Speaking personally, as a limited partner investor, I'm always a lot more interested and focused on the cash flow, what it's been in the past, what it is today, and what is reasonably achievable as far as rent bumps are concerned.
The equity has a lot of factors to it beyond what we're able to cover in this quick episode, such as obviously interest rates, what the overall general economy is doing, what alternative investments are offering as far as a passive income yield, and who the anticipated buyer is of your property. Is it an institutional capital, is it mom-and-pop investors, all of these are factors. That's why it is, quite frankly, too difficult, in my opinion, to be that accurate with a future sale price.
But with that said, I hope you found some value in the episode. Again, this is Travis watts with The Actively Passive Investing Show, thank you for tuning in. Let's connect on social media. I'm on LinkedIn, BiggerPockets, Instagram, Facebook, joefairless.com, ashcroftcapital.com. I'd be happy to help answer any questions you have if you're looking to passively invest. Have a Best Ever week everyone and we will see you on the next episode.
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