San Diego Rent Control and Vacation Rental Update Lunch & Learn

San Diego Rent Control and Vacation Rental Update Lunch & Learn

San Diego Rent Control and Vacation Rental Update Lunch & Learn

San Diego Rent control and restrictions on short-term vacation rentals could have devastating impacts on the San Diego real estate market and economy. Are you an investor, real estate professional, landlord or even a resident that is interested in discovering how this could impact you? It’s time to educate yourself and let your voice be heard. 

In this interactive and informative 60-minute class, Curtis Gabhart will present an in-depth overview of both San Diego rent control and restrictions on short-term vacation rentals.

Topics include

  • San Diego Rent Control
  • National City Rent Control
  • Financial modeling displaying how rent control could impact property value & NOI
  • Short-term vacation rentals impact on the real estate market

Check out Curtis’s San Diego rent control blog post to catch yourself up to speed before you attend.

Click Here to Check it Out

Date

Tuesday, September 18, 2018

12:00-1:00PM

Location

Keller Williams Carmel Valley

12780 High Bluff Rd Ste 130

San Diego, CA 92130

We would be thrilled if you could join us for this special event. Lunch will be provided to those who RSVP in advance. Space is limited so please register as early as possible. Additional details are listed below.  To RSVP, follow the ticket prompt below confirming you will be in attendance or recommend someone else from your office if you are unable to attend. Thanks very much!  We hope to see you there!

 

The presentation will be hosted by Curtis Gabhart, CCIM 

Curtis Gabhart has been a successful Real Estate professional for more than a decade. He has a Certified Commercial Investment Member (CCIM) designation from the CCIM Institute. He is a Director at Keller Williams Commercial Brokerage and President of Gabhart Investments, Inc, a privately held real estate investment firm that manages a syndication of private investors, specializing in acquiring and renovating single and multi-family properties. He also serves on the Commercial Advisory Board at the University of San Diego Burnham-Moores Center for Real Estate and he teaches commercial real estate courses for the California Association of REALTORS® and San Diego Association of REALTORS®. He has been recognized by members of Congress, California State Senators, the City of San Diego, and had a day named after him in the County of San Diego for his community service and dedication to the community. He was awarded as the Dealmaker of the Year for 2015 in Retail and Multi-Family category.

San Diego Rent Control

San Diego Rent Control

Quick Summary

  • Californian’s will get to decide in the November ballots the fate of the Affordable Housing Act (AHA), which would allow for cities to adopt rent control.  The AHA seeks to revoke the Costa-Hawkins Rental Housing Act, which prohibits rent control on buildings built after February 1995.
  • Many San Diegan’s believe this would provide an answer to our housing crisis, however, many professionals and economists disagree.
  • Experts believe rent control would be detrimental to the San Diego economy and would discourage new housing development, further exacerbating the housing crisis.
  • Experts also argue that rent control would eliminate many incentives to own rental properties. This could cause harm to both owners and tenants.
  • Rent control has already been adopted in several cities around the United States, and the results have proved to be harmful to the overall economy by shrinking supply of affordable housing and driving up rental market prices.

Continue reading below to learn more about rent control and the effect it would have on the San Diego economy.

 —————————————————————————————————————————————————

San Diego Rent Control

San Diego is facing a profound housing crisis. Rents keep climbing and supply keeps falling desperately behind demand. According to the San Diego Union Tribune, in March of 2018, the average rent in San Diego County hit an astonishing record of $1,887.

San Diego now ranks as the ninth most expensive market in the United States. Many San Diegan’s are finding it increasingly hard to afford rent and are turning to the government for answers. Their solution? Adopt the Affordable Housing Act and repeal the Costa-Hawkins Rental Housing Act which would allow cities like San Diego to decide on their own rent control measures. The initiative received more than 650,000 signatures and will be placed on the November ballots, giving Californian’s the option to decide on this issue.

Many economists and experts agree that rent control offers no benefits for all parties involved and would be disastrous for our local economy. How would rent control affect San Diego? Let’s take a closer look at the various players in this debate.

*This is part 1 of our series on Rent Control. Be sure to stay tuned for detailed scenarios and further information to come soon.*

What is Costa-Hawkins?

Costa-Hawkins is a California state law that was adopted to counter vacancy control ordinances and spur new construction of single-family homes.

It limits how cities set rent control in two ways

  1. It prohibits cities from putting a rent cap on single-family homes or apartment buildings built after February 1995.
  2. It gives landlords the right to raise rent prices to market value when a tenant moves out, otherwise known as a vacancy control.

Costa-Hawkins does NOT outlaw rent control. Cities like Los Angeles and San Francisco have been able to adopt some forms of rent control but within the state law.

Source: Union Tribune 

What Is the Affordable Housing Act?

The affordable housing act has three main objectives

  1. It aims to restore California’s cities and counties to develop and implement local policies that ensure renters can find and afford decent housing in their areas.
  2. Improve the quality of life for millions of California renters and reduce the number of people who face critical housing challenges and homelessness.
  3. Repeal the Costa-Hawkins Rental Housing Act

Supporters of this bill hope that if passed, rents will go down and that many San Diegan’s will be able to find affordable housing. They believe that increased rents are a result of landlords fueled by monetary greed.  This act would allow cities to prevent landlords from increasing rents once a tenant leaves.

Source: Affordable Housing Act Website 

While it is no question that rents are sky-rocketing and that a solution needs to be reached – rent control is not the answer. In fact, I would argue rent control would just exacerbate the problem.

 

Why Rent Control Won’t Work

Those against the Affordable Housing Act include apartment developers and landlords (among others). Repealing Costa-Hawkins would lead to shortages in both the quantity and quality of housing. Profits are what incentivize landlords to maintain a building in good shape. If rents are capped at a certain limit, what is the incentive for landlords to maintain the building?  Buildings would become neglected and long-term improvements wouldn’t be invested in. This can create unsafe living conditions for tenants.

Rent control would limit property owner’s potential cash flow to dangerous levels. When you think about things like increased expenses and rising interest rates, this could put owners at risk. If the owner can’t make their mortgage payment because rents have been caped, they risk losing their property. This could create a domino effect amongst many property owners. Tenants might also have to look for a new place to live.

There are already many risks associated with owning a multi-family building, so if you factor in rent control, what is the incentive to buy a place? Owners might opt to convert their building into condos if they do not see enough cash flow to turn a profit. This would take away even more rentals from the San Diego market.

In 2016, the Union Tribune asked 14 experts whether they believed rent control would benefit the San Diego economy, all 14 experts answered, “No”. They cited everything from shrinking the supply, decreasing affordability long-term, to driving tenants out to repurpose buildings.

History has shown us that rent control doesn’t work. Look at New York City in the 1970s and 80s. Landlords simply stopped maintaining the buildings, amenities were no longer looked after, living conditions became dangerous, and eventually, entire streets blocks were left vacant. New York’s neighborhoods fell into an economic recession and investment was at an all-time low. 

The Impact on Development

What about developers and investors? Would the same incentives remain for them to continue to build new construction if they knew property values would be artificially capped?

A recent CoStar report discussed the impact that rent control could have on development.

“Many developers are concerned about the economic impact there will be on new development if it is subject to rent control… it would change the “whole economics” of how developers view potential development opportunities… It’s hard enough and costly enough for a developer to make a decision to build housing, and now they are put on notice that the housing may be subject to rent regulation… they may very well be unwilling to make those tough decisions of being invested in building a development”.

If developers are unwilling to build new units, which San Diego desperately needs, that is a losing scenario for all parties involved. This would place us further behind meeting the demand for housing. Alan Gin at the University of San Diego argues,

“the problem is the lack of construction of both single-family and multi-family residential units. Controlling rents would reduce the incentive to build more multi-family units”.

If developers see fewer incentives to build housing, they may turn to other development avenues like commercial, retail, office, etc…

The Building Industry Association recently commissioned a study that found that up to 40 percent of the cost of a new home is attributable to the 45 agencies that govern home building in California. This means that on a $5,000,000 project, $2,000,000 is spent paying these 45 agencies that govern homebuilding. Legislation like the California Enviornmental Quality Act (CEQA), while once good intentioned, has proven to be a major roadblock to countless developers. 

Rent control not only discourages development, but it would contribute to less affordable housing developments being built. Austin Neudecker of Rev points out that rent control would increase the prices for those who cannot find a controlled unit. New York City and San Francisco are prime examples where soaring rental prices and rampant abuse of rent-controlled housing exists.

Another big concern with rent control is tenants deciding to stay for extended periods of time in their current unit or subleasing it out. This makes it harder for people who need affordable housing to get into units.

A 2017 Standford Study and this LAO report also concluded that rent control does more harm than good. I recommend giving these a read, they provide some valuable insight into what happened in San Francisco and their attempts at rent control.

Final Thoughts

Think about this for a moment. If produce is too expensive, should we limit how much the farmer makes? What about if Apple Computers are too expensive? Do we start paying people who make them less?

The same concept applies to landlords when being asked to accept rent control. Just because rents are going up, it doesn’t mean the responsibility falls on owners and developers.

More permanent solutions lie within increasing zoning, reducing the time it takes to build, and expanding our public transit system and building communities around those transit centers.

Lowering parking space requirements could prove to help as we enter a future where vehicle ownership could decline. Developers fees should be prorated by size. As it currently stands, big and small units face the same fees, which gives developers no incentive to build smaller, less expensive units. 

These are just jumping off points but could be great starts to solving what is arguably one of San Diego’s biggest dilemmas. I will be updating this post as more developments arise, so please stay posted.

More Information

San Diego Union Tribune “What’s the Deal With Rent Control” 

EconoMeter Critics Panel Report

Rent Control is No Answer to California Housing Crisis 

Written by Blake Imperl in collaboration with Curtis Gabhart

Curtis Gabhart and Gabhart Investments, Inc – 2018 All Rights Reserved
The material contained in articles that appear on gabhartinvestments.com is not intended to provide legal, tax or other professional advice or to substitute for the proper professional advice and/or commercial real estate due diligence. We urge you to consult a licensed real estate broker, attorney, tax professional or other appropriate professionals before taking any action in regard to matters discussed in any article or posting. The posting of an article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

Hold vs Sell Decision – Real Estate Investing Class

Hold vs Sell Decision – Real Estate Investing Class

Hold vs Sell Decision

Commercial Real Estate Investing Class

One of the most important decisions for real estate investors is to hold an investment or sell it. This class will demonstrate a methodology to evaluate the hold vs. sell decision. Investment pro-forma’s will be used to measure the impact of keeping an investment or selling it.

Topics will include:

  • Estimating Investment Base
  • Forecasting cash flows
  • Comparing alternative investment strategies
  • Estimate investment performance with Net Present Value and IRR.

Registration is at $50.Seats are limited to 50! RSVP in advance to reserve your spot!

________________________________________

The presentation will be put on by Curtis Gabhart, CCIM and Mark Goldman, CCIM of SDSU. 

Curtis Gabhart has been a successful Real Estate professional for more than a decade. He has a Certified Commercial Investment Member (CCIM) designation from the CCIM Institute. He is a Director at Keller Williams Commercial Brokerage and President of Gabhart Investments, Inc, a privately held real estate investment firm that manages a syndication of private investors, specializing in acquiring and renovating single and multi-family properties. He also serves on the Commercial Advisory Board at the University of San Diego Burnham-Moores Center for Real Estate and he teaches commercial real estate courses for the California Association of REALTORS® and San Diego Association of REALTORS®. He has been recognized by members of Congress, California State Senators, the City of San Diego, and had a day named after him in the County of San Diego for his community service and dedication to the community. He was awarded as the Dealmaker of the Year for 2015 in Retail and Multi-Family category.

Mark Goldman has been a loan officer in San Diego since 1991. He has a degree in real estate finance from the University of Connecticut. Mark has a Certified Commercial Investment Member [CCIM] designation from the CCIM Institute. He has authored several books on real estate financial analysis and given seminars on real estate financial analysis and financial planning topics. Mark also teaches real estate finance at SDSU. His areas of expertise include analyzing financing alternatives and searching for specialized loan programs. Mark has been a “Certified Community Home Buyers’ Program” instructor. He can help to maximize your home purchasing power or achieve your refinancing goals.

Commercial Real Estate Due Diligence Class Recap

Commercial Real Estate Due Diligence Class Recap

Commercial Real Estate Due Diligence

After having a great discussion during my last class on Commercial Real Estate Due Diligence, I wanted to take this opportunity to share with you some of the key takeaways. This article is intended mainly for apartments/multi-family, however many of the same principles will apply across different areas of commercial real estate. I’ll start with a brief overview, then dive into each topic a bit more, and finally leave you with my powerpoint presentation that gives an overview of the topics I covered in my class. It is my hope you will add many of these ideas to your property analysis toolkit.

What is Due Diligence?

Due Diligence is a necessary part of any real estate transaction.

  • It is the process of examining a property, related documents, and procedures conducted by or for the potential lender or purchaser to reduce risk.
  • Applying a consistent standard of inspection and investigation to determine whether actual conditions reflect the information represented.
  • The process by which you confirm that all of the facts of a deal are as they have been represented to you by the seller.

 

Conducting proper due diligence can be the difference between turning a profit or suffering a financial loss in a real estate transaction.

If you’re new to commercial real estate transactions, I recommend that you consider bringing in someone with more knowledge. It’s OK to admit you need help. Getting help from an experienced commercial real estate broker can add a lot more money to your pocket and make the process much easier for all parties involved.

 

Start With Initial Due Diligence

Once you’ve found your target property, begin by requesting all of the information in the seller’s possession (expense reports, property records, profit and loss statements, etc…). Often you will find on smaller to mid-sized apartment buildings that owners do not keep detailed records. This means you will need to do a little more investigating to get the accurate expense numbers.

Talk to the current tenants about things that are wrong with the building. Ask how long have they been there, if they are happy with things, what’s the neighborhood like, etc.… Current tenants can be a tremendous resource for learning about a property. If there is a current property management company in place, ask the tenants how responsive they are to their needs. A lot of times it’s easier to keep the same management company in place for the first few months of acquisition if they are doing a good job. Talk with the maintenance people about matters not tended to or problems that will have to be fixed in the future. They are often going to be more honest than a seller would about the actual condition of the property.

 

Financial Due Diligence

commercial real estate sales comparable

  • Review the profit and loss statements (P&L). Make sure you pay extra attention to any areas where significant gains or losses occurred and try to spot any discrepancies.
  • Underwrite the property. Never take a seller and brokers provided pro forma at face value. Their numbers are usually a smaller look at the property and might not reflect how the financial performance of the property in a few years time.
  • Look at rent and sales comparable in the area.
  • Since your evaluation of the property will depend upon income today and tomorrow, the accuracy of the historical data, as well as the validity of projections, will significantly alter your potential financial return.
  • Look into the rent roll and leases including the terms, deposits, and payment history.
    • Be aware of handwritten changes to the leases
    • Get written confirmation or an Estoppel Certificate from the tenants if you can’t read the document or if the statements are unclear.
      tenant estoppel certificate

      Tenant Estoppel Certificate

      • An Estoppel Certificate is a statement signed by the landlord and tenant that states that particular facts are correct, that there are no defaults, and that rent is paid on a specific
    • Look for rent concessions
    • Are the security deposits mentioned in the lease the same as those outlined in the rent roll? (This is usually a problem area)
    • Cross check the rent roll against the income statement.
  • Get a lease abstract. This is a summary of the essential financial, business and legal information that exists in a commercial real estate lease. It should bring to the reader’s attention any important lease provisions, financial obligations or other issues of importance.
  • Always add your property management fees back into your expenses. Quite often, the current owner could be managing it and won’t factor that cost into their expenses, which could make the NOI appear higher than it would be if you bought it.
  • Reconstruct the financials on your own… add things back like long-term capital improvements (HVAC, electrical, roof, cabinets)… then show how that would affect your financials as you spread those costs out over time.
  • Recommend taking CCIM classes for understanding the financials and underwriting a property.

If you’re an expert in the location you’re interested in; you may still feel comfortable buying a property without the expense reports because you’re familiar with what expenses should look like. This is another reason why having an experienced broker could help because sometimes you will find properties that could be good deals but may lack proper financial reports.

Make sure you’re comfortable with the deal above all else.

financial due diligence checklist

Here is my quick financial due diligence checklist

Physical Due Diligence

commercial real estate physical due diligence

  • Walk every unit. It sounds like common sense but make sure you take a look at everything.
  • Don’t trust the seller/broker to tell you the unit is in perfect condition.
  • As you walk the units, I recommend using a “walkthrough sheet.” I have included a sample in my PowerPoint, which you can find at the end of this blog post. If you would like the full checklist, please let me know if the comments below.
    • As you walk the units, assess the overall condition of them. Take inventory of things that need to be addressed, breaking it into what must be fixed and then a “wish list” of items you’d like to get to eventually.
    • Look for any warning signs or safety concerns.
    • Are there any tenant concerns? Things like hoarding, multiple pets, an excessive number of occupants, unapproved alterations, illegal activity, …
  • Building inspectors are never a bad thing to have. Often you’ll get your money back in the deal.

physical due diligence commercial real estate

Legal Due Diligence

Here are some necessary things you’ll need.

  • Title inspection and survey
  • Environmental inspection (typically paid for by the buyer)
  • Inspection for building code violations. This is critical for understanding any potential hazards or areas that need immediate addressing.
  • Checking to make sure that the property is in zoning code compliance

Disclosures

When using AIR Commercial Real Estate Forms

  • Seller Mandatory Disclosure Statement (SMDS)
  • Property Information Sheet (PIS)
  • Tenant Estoppels (TEC)
  • Commercial Property Owner’s Guide to Earthquake Safety (pre-1960 buildings)

AIR is a leading, member-owned real estate network. From contracts to networking and education, they’ve been helping commercial real estate professionals for years. Developed by top commercial real estate experts, AIR CRE Contracts are recognized as the industry standard, and the most efficient way to close a deal. I highly recommend you look into becoming a member as they offer over 50+ contracts that you can use and edit to your own needs. Learn more by clicking here. 

When using CAR (California Association of Realtors) Residential Income Purchase Agreements

  • Know Material Facts
    • Seller property questionnaire (CAR Form SPQ) or Exempt Seller Disclosure (C.A.R. Form ESD) if TDS-Exempt
  • Commercial Property Owner’s Guide to Earthquake Safety (Pre-1960 Buildings)
  • Tenant Lease Agreements
  • Tenant Estoppels (TEC) if agreed in the contract
  • Survey, plans and engineering documents, if any, prepared on seller’s behalf or in seller’s possession.
  • Permits and structural medication documents – if in seller’s possession

Statutory Disclosures

When using CAR Residential Income Purchase Agreement (cont’d)

  • Lead-based paint pamphlet and form
    • Applies only to residential property built before 1978
  • Natural and Environmental Hazards
    • Seller is required to disclose if the property is located in a special flood hazard area; potential flooding (inundation) area; very high fire hazard zone; state fire responsibility area; earthquake fault zone; seismic hazard zone; and (iii) disclose any other zone as required by law and provide any additional information needed for those zones. These are satisfied with an NHD Report.
  • Withholding Taxes
    • Seller shall deliver to the buyer or qualified substitute, an affidavit sufficient to comply with federal (FIRPTA) and California withholding law (C.A.R. Form AS or QS)
  • Condominium/Planned Development Disclosures
    • Seller has seven days (standard) after acceptance to disclose to the buyer whether the property is a condo minimum or if its located in a planned development or other common interest subdivision.

Click here to download the CAR Sales-Disclosure-Chart

The California Association of Realtors (CAR), is real estate trade association to develop and promote programs/services that enhance a member’s ability to conduct business with integrity and competency. They have many tools designed to help you thrive in your real estate career. From their zipForm transaction tools to their education courses and more, they are a great resource. Learn more by clicking here

legal due diligence checklist real estate

Final Thoughts

Thank you for taking the time to read this article. I hope you found it helpful. As always, please leave any thoughts or comments below. We hope you will join us for our next class on “Don’t Take Cap Rates At Face Value” on Thursday, May 31st.

Stay up to date with all of our upcoming real estate classes by clicking here. We offer one class a month that covers relevant and important commercial real estate topics.  

 

Curtis Gabhart and Gabhart Investments, Inc – 2018 All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of Gabhart Investments, Inc. The material contained in articles that appear on gabhartinvestments.com is not intended to provide legal, tax or other professional advice or to substitute for the proper professional advice and/or commercial real estate due diligence. We urge you to consult a licensed real estate broker, attorney, tax professional or other appropriate professionals before taking any action in regard to matters discussed in any article or posting. The posting of an article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

Don’t Take Cap Rates at Face Value When Buying Your Next Multi-Family Building

Don’t Take Cap Rates at Face Value When Buying Your Next Multi-Family Building

The Quick Facts

  • Cap rates on properties can be misleading without proper expense reports
  • Many small to mid-sized multi-family buildings don’t have accurate expenses records
  • By only looking at cap rates can cause you to lose out on potential good deals
  • It is imperative to do your due diligence and analyze the expenses
  • Pairing yourself with proper representation (commercial broker) can make a huge difference
  • Learning standard expense multipliers can save you a lot of time and money

 

So, you’re looking to purchase your next multi-family building. You’ve selected a few perspective properties, gathered the financial reports, and are trying to decide which is the best investment. How do you know which one is the best deal? Many investors would run straight to comparing capitalization rates (AKA cap rates).

While this is a good start, I’d argue that you should be cautious when comparing cap rates. It is crucial never to take a cap rate at face value and always conduct proper due diligence and seek appropriate representation. Not only could you overpay for a property, but you could also miss out on some great deals. The answer to this dilemma lies in the expenses.

First, I will explain why cap rates can be inaccurate due to inaccurate expenses and then offer a more accurate and efficient alternative.

If you’re unfamiliar with cap rates, get caught up to speed by checking out my earlier blog post on cap rates. 

Be sure to make it down to the end of this post for my PowerPoint presentation on “Don’t Take Cap Rates at Face Value”. I’ve included some valuable and practical examples of the topics discussed in this post. 

CAP Rates

To understand cap rates better, it is best to take a look at a crucial component, the net operating income (NOI).

Net Operating Income on commercial properties

To arrive at the net operating income, we must subtract gross operating income from operating expenses; but what if the operating expenses are misreported? That can have a drastic effect on the final calculation of a cap rate.

Most small to mid-sized apartments available on the market don’t have actual expense reports or profit and loss statements from the owners.

This could happen because the owner is:

  • Unorganized
  • Hiding expenses
  • Doing repairs themselves and not factoring in things like labor costs
  • Miscategorizing capital expenses as maintenance expenses
  • Keeping incomplete expense reports or in some cases, no reports at all.

Other times it can also be the broker’s fault because they don’t ask for the expense reports from the owner.

A failure to have actual expenses can lead to you, the potential buyer, to purchase an over-priced deal or worse, walk away from a great deal.

Here are some ways it can be inaccurate

San Diego Painter Mr Magoo

I’d like to introduce Mr. Magoo, a carpenter, and the owner of a small apartment building that has recently been put on the market. He’s seen a couple of Martha Stewart shows and thinks he’s quite the handyman, so he decides to do all maintenance and repairs himself. He’s made some questionable decisions like when he mixed several leftover paint cans to paint the exterior of the building, or when he patched a leaky roof with plywood. He’s also read online about property management and decides he can manage the building himself.

By doing this, Mr. Magoo has been able to save thousands of dollars on labor and maintenance expenses. He’s able to avoid placing these line items on his expense report, which makes his NOI appear higher than it is.

So, one day you’re on LoopNet or Costar looking for commercial property and stumble upon his building and decide to give him a call. When you speak to Mr. Magoo, he tells you it is an excellent building with little expenses. He claims that maintenance and repairs only cost him 5% of total expenses, which is drastically different from another owner who may assign 25% of their total expenses towards maintenance and repairs.

After doing some math on the given expenses, let’s say you calculate the cap rate of his property to be 6%. You think this looks like a great deal and are considering making an offer.

This can pose a severe problem if you, the potential buyer, take his expenses at face value without conducting any due diligence.

If you were to look into the expenses on Mr. Magoo’s property, you would find his cap rate is inaccurate unless you plan to hire yourself to be the painter and the property manager. The reason his cap rate appears to be high is that he was not accounting for the labor or market costs of maintenance. Unless you’re making less money than a property manager or painter at your current job, you should hire professionals. You’re going to save more money by paying them to do these services, and a lender will always add these expenses to their underwriting criteria. Your job should be running the operations, finding more properties, or continuing your career that pays you more than painting or managing your property. So, in this scenario, the cap rate is useless because Mr. Magoo’s expenses do not represent what you, the new owner, would be paying.

Without digging into his expenses, you might end up paying far more for a property that doesn’t produce anywhere near the stated NOI.

Now I’d like to demonstrate how over-reporting maintenance expenses can drive you away from potential deals.      

Let’s say you stumble upon a 6-unit apartment building that has everything you are looking for in a multi-family property. The only issue is that it has an alarmingly low cap rate of 3.5% and very high expenses. Many inexperienced investors or brokers may walk away from this deal without even digging into the expenses.

Upon further investigation, you discover the current owner has been overstating expenses because they don’t know how to accurately spread out repair costs over the life of the repair. When looking at the report, you see that there were two consecutive years of significant electrical upgrades that cost about $30,000 per year. This adds up to $60,000 in total expenses for new electrical that was meant to last 50 years. The owner should have spread out that $60,000 expenses over the life of the electrical rather than doing it up front. An experienced broker would be able to spot this and reallocate the expenses to the property area. After correcting the error, you will see that the cap rate will go up and expenses will go down.

As you can see, by the owner not understanding how to report expenses accurately, the property seems to be a bad deal. You may have walked away from a great opportunity had you not conducted a little due diligence.

Property Taxes

Another way cap rates can be misreported is through property taxes. The property taxes for multi-family apartment buildings in San Diego is 1.2% of the purchase price of the building. Where many inexperienced brokers can make mistakes is by basing their cap rate calculation off the old property taxes which is not accurate of what the new owner will be paying. Here’s an example:

Let’s say you have a property that the current owner bought for $1,000,000 over ten years ago.

Old commercial real estate investment

Currently, the owner would be paying $12,000 a year in property taxes. The property is then listed on the market for $2,000,000. Instead of calculating the new property taxes, which would be $24,000 per year, the broker decides to use the same $12,000 that the current owner is paying.

New owner for commercial property

What results is that the expenses will be reported at less than what they actually will be. This has the unfavorable result of artificially increasing the cap rate. When the new owner acquires the property, they will not be receiving that same income as their property taxes will be based on the new purchase price.

Furthermore, this could cause you to pay more for the property than it’s worth. Take a look at the following spreadsheets.

Old vs New commercial real estate investment

The difference between the old and new property taxes comes out to be $12,000. If we value the $12,000 difference at 5% cap rate ($12,000/.05) we get a value of $240,000. Now, let’s say the property requires a 25% down payment. If you were to pay the original asking price of $2,000,000 assuming the old property taxes, your down payment would be $500,000 ($200,000 * .25). If, however, you took into consideration the reduced value given the updated property taxes, you would see the offer price comes down to $1,760,000 ($2,000,000 – 240,000). This makes your 25% down payment $440,000. That’s a $60,000 savings by accurately accounting the property taxes.

This is why it is crucial to pair yourself up with proper representation. An experienced commercial broker would realize this and account for it in the offer.

The pay between experienced commercial brokers and new ones is not far off, so why not pair up with one who is experienced?

So now that I’ve demonstrated some ways that cap rates can be inaccurate let’s look at a better alternative.

Standard Expense Multipliers

With properties that may not have accurate expense reports (especially small to mid-sized apartment buildings), I recommend that you use standard expense multipliers to learn the price per square foot. This puts you in a much better position to understand a properties performance and overall value. I have found the Institute of Real Estate Management (IREM) Apartment Expense Multiplier sheet to be extremely valuable when determining baseline expenses.

Operating expenses for commercial real estate

When used appropriately, this will allow you put a better estimate on what your actual expenses may look like on a price per square foot basis.

This will allow you to compare the owner’s expense report versus your estimate. Any significant discrepancies could be a red flag that requires further investigating. These calculations will save you a lot of time and potential money spent.

If you’re trying to look through 180 listings, you can’t underwrite every deal promptly. Instead, what you can do is quickly look at each deal and say, “okay, this is a $170,000 unit. It’s a 14 times GRM.  If you put about a 40% expense on it, it is going to be in the 4% cap range”. Using this approach is going to make it much quicker for you to go down the line of properties.  Also, sometimes you’re going to find very similar buildings. If you saw something that sold for a particular gross rate multiplier, that may be a better way to sort through properties quickly. It will become easier to make apples to apple comparisons because those rents that they listed are usually accurate as long as they’re not pro forma rents.

So, when do you use Cap Rates?

Well, the larger the property or, the more organized an owner is, the more likely it’s going to be accurate. Also, the more respectable and experienced the broker is, the more likely it’s going to be a precise number. If the pay difference between an experienced and new broker isn’t far off,  why not pair yourself with an experienced broker?

Rarely, when you get down to it, will expenses be precisely what any owner says.  The question becomes; how far off is it?  So, my first piece of advice is to try to deal with people who are reputable and looking at the numbers. If everything you see in the market is at a 5% cap rate, and all of a sudden you find a property with a 7% cap rate – you should think to yourself, “that’s suspicious, why is it still on the market?”. Another example is if you see two comparable buildings with similar rents but drastically different cap rates; this could indicate something is off.

If you’re looking at larger properties or ones run by management companies, the numbers are more likely to be accurate because the owner is going to be able to print out a profit and loss statement. However, another problem arises.

What you could find is that the owner wants to write off as much money as they can on the property. Besides depreciation, they can achieve write-offs through two main ways.

  1. First is by doing maintenance and writing it off the in the year you did the work. This could be things like fixing your toilet or patching the roof.
  2. The second is capital improvements. Capital improvements typically have a long life but can range from one year to several years. A roof, for example, is a capital improvement because even though I paid $10,000 for it today, that write-off might be over the ten-year life of the roof. Because of this, I’m only able to write off $1000 per year against my income.  Although this is the case, a seller may say, “no, that’s still maintenance, so I’m going to write off the entire $10,000 this year”, even though it’s very questionable if not outright fraudulent to do so – but it still happens more than you’d think. A good broker would be able to spot this right away and reallocate it to the proper area of the financial statement. This would change your overall NOI.

So, when working with cap rates where you get income/expense reports, it is imperative to take a look and identify which numbers are actual maintenance and which ones are capital improvements. You also need to see if they’re moving their maintenance into capital improvements. Sellers often do this so they can report more income in the year that they sell, which gives them a higher sale value. Doing your due diligence here can save you a lot of time and money.

Here’s a great example of a multi-family apartment building in San Diego that I bought a while back. The property had a very low cap rate, which typically means that it’s not producing a lot of income. Many investors would walk away right there without digging into the financials. However, after we got into the property, we realized the expenses were misallocated, and the CAP rate turned out to be higher than it was initially stated. We were able to turn a healthy profit on the building by not taking the CAP rate at face value right away.

The moral of the story is be careful when you rely on the CAP rates of small to mid-sized properties.

  1. Learn your expenses
  2. Learn the price per square foot
  3. Learn the market rents in the area so you can apply those metrics to buildings you are analyzing
  4. Take a look at who is listing the property. Is it somebody who has experience? Are they missing a lot of financial numbers?
  5. Do they have expenses listed out, or do they just give you a bottom line number?
  6. Do they have a marketing package? Are they seeming overly aggressive with what they’re proposing?

Sometimes the best deal you buy are the properties that were not marketed correctly. These can often be opportunities for you get a lower price if you conduct the necessary due diligence.

Please leave in the comments below any thoughts you have on cap rates and valuing a property or any stories you may have run into…

Curtis Gabhart, CCIM

Edited by: Blake Imperl

Disclaimer: I’d like to point out that none of the content in this article is absolute. It’s just food for thought and is based on my numerous years of experience dealing with commercial real estate.

These are just some things you may want to think about when analyzing commercial properties. It isn’t always advantageous to rely heavily on CAP rates when looking at properties where you don’t know their actual expenses. This post was designed to offer an alternative for when you’re looking at dozens of properties and trying to find the best deal available.

Additional Education

Please take a look at my PowerPoint Presentation from my recent class on “Don’t Take Cap Rates at Face Value”. I teach monthly commercial real estate classes on a variety of topics from due diligence to getting started in commercial real estate and everything in between. If you’re interested in finding out more about my classes, please visit my Eventbrite Page where you can find the complete list of upcoming classes. 

Looking for some more tips on buying multi-family properties?  Click here to check out my multi-family inspection tips!

Want to get more return on your investment? Here’s a great article on how to increase your buildings’ property value fast by investing in a new paint job. 

How to Value Commercial Real Estate 101 Slideshare – This crash course will take you through the basics of valuing commercial real estate. It has over 106,000 views so far!