INTRODUCTION
We will cover fundamental concepts such as cap rates, rate of return, investor motivations, current market conditions, financing, and more subjective aspects such as maintaining client engagement during negotiations and due diligence periods.
The apartment building industry is a specific niche within Commercial Real Estate and is considered the most conservative type of real estate investment in Canada. Prospective buyers can easily obtain financing with flexible and attractive financing solutions through the Canadian Mortgage Housing Corporation. These mortgages are considered commercial mortgages in many ways, but they also have residential mortgage features, as they can be insured and have loan-to-value ratios as high as 85%.
The supply and demand of multi-residential buildings has become unbalanced in the past ten to twenty years, with a surplus of buyers for good apartments and a shortage of available units. This is partly due to increased interest from small, large, and institutional investors who see these investments as secure with good returns. Additionally, the influx of immigrants to Canada and the familiarity that many investors have with owning physical properties have further fueled the demand for suitable real estate. Brick-and-mortar investments offer a sense of security and are easy to manage, making them highly sought after.
The challenge for investors nowadays is finding suitable properties for sale. As a seller it is important to know these properties meet the objectives of many potential buyers and CMHC financing. Sellers should understand these objectives to successfully close a deal. Understanding these parameters will help distinguish qualified buyers and assist in setting the right asking price for the market. This will result in a smoother sales cycle, due diligence, and financing period. The objective is to filter out buyers who do not meet financing criteria and persist in finding the right qualified and motivated buyer.
INCOME PROPERTY VALUATION
It’s essential to understand the income evaluation criteria of CMHC when selling this type of investment property. This understanding helps you grasp the process potential buyers will go through and whether they qualify for financing. It reduces the risk of a deal falling apart. Recognizing signs that indicate if a building is a good fit for a buyer, along with seeking advice from experienced individuals, will help in determining a competitive asking price.
This is where the rubber meets the road and a solid understanding of how the financial institutions look at the income & expenses will assist you in evaluating the property you are interested in selling. The value of real estate in most markets is determined by the ability of the Buyers to achieve reasonable financing and return on investment. Other than the highest and best-use value, a reasonable return on investment is required, by most Buyers. Even large institutional buyers will pass if their return-on-investment criteria are not met. This is another reason your proforma must be correct. It doesn’t always take a large amount of additional income to turn a red light into a green light in the eyes of a Buyer.
Property values based on capitalization rates are calculated on a formula based on rental income generated from current tenancy agreements minus a set of expenses. The capitalization rate of any building is in constant fluctuation based on market conditions. The capitalization rate is the return on investment if the purchaser pays cash without financing. In addition, a person providing a value may determine an Estimated Value based on potential upside due to many factors resulting from existing and past management. Potential upside has real value to the bottom line, but it is important to know this potential upside doesn’t have one hundred percent value to you, the seller. Someone must do the work and take the time and risk to achieve this upside. However, as a seller, it is important to recognize this upside value to you. You don’t want to leave this upside on the table for the buyer, it should be shared between you.
Pricing your building accurately and as close to the final selling price as possible will bring you the greatest number of offers, demonstrating true value. Many listings on the market are priced incorrectly due to a lack of knowledge and investigative exploration of the asset. Putting a one-dollar value on the listing has become extremely popular in some markets, which leaves you open to buyers and their agents incorrectly valuing your building. The experienced investor will base their value on a Cap Rate, Price Per Door, condition, unit mix, gross rent multiplier, DCR, and upside. Understanding buyers’ needs and goals will attract qualified buyers with the ability to secure loans.
Adjusting expense numbers to justify the asking price within an honest parameter may be necessary and can be justified by obvious overspending. For example, if you are overspending in areas such as property management or insurance, you can adjust these numbers, knowing that any purchaser can and will achieve better results upon transfer of the building. Any prudent buyer and new owner will understand this and have quotes establishing the changes. Insurance overspending is usually a result of long-standing insurance policies and annual increases. Since insurance can’t be transferred to the new owner, when they get quotes for new insurance, they will likely achieve a better price than you are paying. It is recommended to receive new quotes for some of these services and include them in the due diligence package. Adjusting these numbers in the sales proforma is an honest adjustment that can and will change the numbers in your favor. Inexperienced sales representatives seldom utilize this representation of the numbers.
You should now have the information required to offer an informed price for your property by knowing the Net Operating Income (NOI) and the appropriate capitalization (cap) rate based on the location, type of building, and its condition. Using this information, you will be able to quickly determine if any offers are accurate for the marketplace and make decisions with an informed mindset. Be prepared to supply two years’ expenses and a current rent roll during due diligence to verify the numbers represented in the proforma.