• George Kruse

What the Hell is "Market Rent" and Why Are You Paying for It?

Updated: Jun 10, 2019

$1,000 or $1, better know the real rental rate!

Last week we discussed how Buyer Representation is being cut out and you, the investor, are being forced to verify Offering Memorandum numbers to support inflated valuations and ask prices. Starting this week, Pursuit CRE will be going top-down on a financial statement to review the numbers and explain where the inflations can be hidden and how you can cover your ass by finding these questionable numbers and adjusting accordingly.

This week, we’re starting at the top with the Current Rents vs the “Market Rents”.

You make an offer on a property and get push back because the current owner wants every last dollar they can squeeze out of a sale. Yet, you read the Offering Memorandum for that same property with that same owner and you see that “rents can easily be increased by $200/unit/month” by a new owner. For a 50 unit property, this seemingly implies a $120,000 increase in revenue and over a $90,000 increase in cash flow to the owner PER YEAR.

Why did this owner, that wants that absolute last dollar in sale price, willingly leave nearly $100,000 on the table while operating the property? Why did they hate money so much as an owner but care about it so much as a seller?

{Because it’s not real money…}

A favorite adjustment to justify higher valuations is the “market rent” proforma. “Yes, the property is getting $1,000 per unit in rent but a NEW owner can achieve $1,200 per unit”. You’ll see a list of “comps” that show this $1,200 average and you may be convinced that you too can get that rent. And why not? They are the same age, within a reasonable radius of distance from the property and relatively similar in size and unit mix. Now they’ve got you!

At $1,000/mo in rent, the NOI comes out to $313,000. At a market cap rate of 7.0%, we’re getting to a current valuation of approximately $4,500,000. Under normal circumstances, with rents and fixed expenses increasing around 2.5%, Year One will nominally increase that value to around $4,600,000, which is standard and expected appreciation. However, with the seller agent’s “Market Rent”, that NOI is popping to an impressive $406,000 using the same fixed and variable expenses. With the same 7.0% cap rate, our valuation (and, hence, the ASK price) has ballooned to $5,800,000; an almost 30% increase in value with one simple adjustment!

So now, with one adjustment, you’re being asked to pay over $1,300,000 MORE for the same property with the same current cash flow. With all the comparables listed and market reports pulled from Costar, REIS, etc, you’ll be pushed to concede this obvious and attainable “value add”. I implore you, don’t fall for this.

What really is “market rent”? Market rent is the average rent for “similar” properties in the market today. There are two fundamental problems with this number. First, the average is just that. Some will be higher and…some will be lower. Rarely (ie never) is an entire market equally achieving the average. You may just be looking at a property at the lower end of that range due to a specific location, lack of amenities, functional obsolescence of some aspect of layout or floor plan or whatever it could be to drive some potential tenants to pay more elsewhere. The current owner was well aware of this. If not, they would have raised the rents and proved out the market rents implied.

{While we’re on this subject, always look at what that owner did, in fact, get for rents recently. If they are implying $1,200 market rents but the last 3-5 leases were all around $1,050, that’s a red flag. Additionally, and a bit more questionable, if the last 3-4 were at $1,050 and that 5th lease conveniently came in at $1,200 be very careful. Never trust the one “proof” lease right as the property was coming to market.}

Now, while a new owner can’t do anything about functional obsolescence or location, the number one reason for rents being below market will be quality. The property may be lacking an amenity that can be created, could have poor curb appeal due to cracked parking, poor landscaping or dated paint. Or the units could need the renovations necessary to actually be “comparable” to the “comparables” that make up the market rent average. Fortunately, these are shortfalls that CAN be remediated by a new owner. However, and I promise you 8 out of 10 times, the cost to get the property to that level will NOT be in the Offering Memorandum.

You may look at the comparables and truly believe them to be accurate. A closer inspection, however, will show stainless steel appliances, new flooring, new cabinetry and other improvements that justify the deviation in rental rates. You may see a repaved parking lot, a new playground or an upgraded entryway.

You can get those rents; but you will need to be a REAL comparable property. And that costs REAL money.

Let’s go back to our previous financials. The current NOI was $313,000. The “proforma” NOI was $406,000, or $1,853 per unit higher. If we assume an investor needs a 10% Return on Investment for capital expenditure dollars, as these renovations may be coming out of pocket, that would imply an $18,500/unit improvement budget to achieve that increase in cash flow. At 10%, a new owner would happily fund that but the overall investment basis needs to make sense. For a 50 unit property, that cap ex budget would be $926,000. Adding that to the $5,800,000 aforementioned ask price, your new basis in the property is now over $6,700,000, lowering your yield to 6.0% on your investment because you bought the future appreciation without factoring in the cost to achieve that appreciation.

The reality is, maybe the property really is (eventually) worth the $5,800,000 they’re asking, but it’s worth that AFTER getting to the market rents that will require real dollars to achieve. Netting out the cap ex from that value puts your revised valuation at $4,875,000, not $5,800,000. This new value is much closer to the current value of approximately $4,500,000. In fact, you can assume that the delta between these two values (8.1%) is the justified risk premium being incurred by taking on the renovations and re-leasing of the property.

So, after all the analysis, your offer price should still be at $4,500,000 because you’re buying the property today, not tomorrow. There is inherent and real risk in doing a major renovation and a significant rental rate increase. You could lose tenants, have a period of low occupancy, have overages in your budget or simply misinterpret the market rents and never achieve that average proposed at closing.

Could the current owner command the $5,800,000 price? Sure. Go out, re-lease the entire property at $1,200/mo, pay for the renovations necessary to get those rents and then list the property as a stabilized asset and I’ll fully support your value. However, until they are willing to risk that and put their money on the line, you need to pay for actual value.

Never pay for FUTURE value. You are buying it TODAY.

The seller is not your partner and does not have a claim to the future appreciation of the property; and certainly not up-front…before it’s even been proven out. Always assume the rents on the rent roll are what the property can bear. If the seller is fighting you over $50,000 of sale price in negotiation, you can bet your ass they weren’t willingly leaving $100,000 on the table while owning it. Take all “market rent” presentations with a grain of salt and assume there will be a real cost to achieve them.

Always protect yourself and cover your ass.

Related video: LINK

Next week: Why do all properties have exactly 5% of their units vacant?

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