Valuation Example

Sections:

• Introduction
• Assumptions
• Income Approach Valuation
• Market Data Approach Valuation
• Cost Approach Valuation
• Reconciliation of Approaches
• Price to Offer
• Debt Coverage Ratio
• Cash Flow Analysis
• More Complex Properties

Introduction
      We will now do a complete detailed valuation of the same 4-plex property that we used for examples in Lesson 5 and Lesson 6.
      How complicated one needs to make a valuation analysis depends upon a number of factors.

• Size and complexity of property - Obviously, a large mixed-use commercial property requires much more analysis than a single-family house.
• Loan-to-value ratio of planned financing - The higher the loan-to-value ratio, the closer the lender will look at the property.
• Condition of property - The more deferred maintenance, the more carefully you need to analyze.
• What information is available to you - The less information provided, the more difficult it will be to perform the analyses and the more effort will be required to obtain accurate results.

      Regarding actually doing the analysis, there is a wide range of ways to do the math.  For a single-family home, a pencil and sheet of paper may be all you need.  For a shopping mall, you will probably want to use a sophisticated computer program.  For the average property, a computer spreadsheet program such as Corel QuattroPro or Microsoft Excel will be helpful because, once you set up a template, it is easy to do analyses for numerous properties using a variety of different parameters.  We hope to develop some Excel spreadsheet templates in the future for valuation analysis.  You will be able download them from our Forms Web, use them on your computer, and even modify them if you are proficient in Excel spreadsheet construction.  When they are available, we will edit this paragraph to indicate that fact, so check back here in the future.  A link to the first of these templates is found at the end of the Income Approach section of this lesson.
      We will be doing a more complex analysis of our subject property than is usually required for a 4-plex in order that you can see how it is done.  You will be able to apply the same procedures to much more complex properties once you understand them.
      Throughout the entire lesson, keep in mind that valuation is both an art and a science.  While the analyses involve mathematical calculations, the answers are only as good as the data available and as accurate as the various estimates and assumptions that must be made.  Accordingly, one must not surprised when the results of the three methods do not closely agree,  You should also not be very surprised when you cannot make a deal at the value you came up with.  This may occur because the sell overvalues his property or because the market is rising rapidly and data based on previous sales is more out of date than any adjustments you have made.

Assumptions
      For our example, we will assume that  you have available cash of about $35,000 and have found a particular 4-plex for which you are seriously considering writing a purchase contract.  We also assume that the following information has been received from the seller and/or his agent.  We have been told that the expenses are for the most recent full calendar year (not past 12 months).

      The time remaining on current leases is of importance because it tells us when we can get rents up to market, increasing the value of the property.  This information is not always offered prior to making an offer, but should be obtained if at all possible - there is no logical reason for it to be withheld.      

We also assume the following:

• A vacancy rate of 5 percent - the lender will almost certainly not assume less and may assume more if the particular market requires it.
• Any rent tax applying to the location is collected from the tenants, so need not be considered.  To the degree that leases do not provide for payment of the taxes by the tenants (as leases should), the expense must be considered.
• This is the same 4-plex used as an example in Lesson 5, where we determined reserve account set aside of approximately $219 per month in order to pay for the major future expenditures as they come due.
• This is the same 4-plex used as an example in Lesson 6, where we determined the current appropriate capitalization rate for this property is 9.3.

      Furthermore, we assume that there are no market conditions, economic trends, or neighborhood factors that significantly affect the value either positively or negatively.
      Finally, our survey of area rents shows that the rents are under market and that the current market rent is around $650 for a 2-bedroom/1-bath unit and $560 for a 1-bedroom/1-bath unit.

Income Approach Valuation
      Although you have been provided the above expense information, in real life one should not take numbers provided by the seller as being correct.  They may be either high or low - more likely the latter.  The current tax bill could be significantly higher than what was used in the old listing, which itself might have listed an older tax bill.  Call the county and get the correct current number.  Insurance expense could be high or low because of failure to shop rates or failure to have adequate coverage, respectively.  Get a couple of quotes yourself.  Landscape maintenance could be high because the seller has used his son and paid more than market cost for personal reasons.   It could instead be low because he used his son.  If your experience doesn't allow you to estimate relatively accurately, get a quote or two for the specific services you will want.   Also, there may be missing expenses, either because they were simply forgotten due to incomplete bookkeeping by the seller or because the seller had deferred certain items in the period prior to listing the property for sale.  Finally, expenses may have been purposely understated because it was thought (probably rightfully) that better cash flow would produce more interest and that corrected data could be provided after a potential buyer was hooked without losing the deal.  So, you need to think about what expenses should be expected for the subject property and include them even if the seller didn't.
      The bottom line is that the potential buyer should carefully analyze all data used for the Income approach.  In other words, utilize data provided by the seller, but improve on it by using experience, common sense, and as much as independently verified data as possible.  The data available prior to making an offer will usually be less accurate and less complete than will be available after acceptance.

Net Operating Income
      Starting with the information provided by the seller, we have determined the appropriate expenses as follows:

• We called the County and found that current annual property tax is $1,875 rather than the $1,560 provided by the seller.

• We got quotes for our desired coverage from two insurance agents and will use the lower one of $475 rather than the $365 provided by the seller.

• Although the agent says that he has viewed the utility bills for the previous calendar year and confirms the water/sewer to have been $1,588  and electricity to have been $489 as provided by the seller, we know that rates have increase during the current calendar year and will likely increase further.  Accordingly, we will use $1,750 for water/sewer and $485 for electricity.

• Although the seller reported trash expense as $641 for the past calendar year, we have called two other service providers and found that we can obtain adequate service for $594 per year.

• Although the seller reports spending $600 ($50 per month) for landscape maintenance, we feel that the landscaping has not been maintained as well as it should and have gotten a quote of $900 from the service that maintains the yard of our personal residence.

• Although the seller reports spending $896 on routine repair & maintenance during the last calendar year, following a discussion with a friend who owns a similar 4-plex, we will use a more conservative $1,200.

• Although the seller did not show such an expense, we have checked with the City and determined that there is a $50 annual fee for a required business license.

• We will throw in an additional miscellaneous expense of $500 because we know there are always unexpected small expenditures.

• Finally, we will include the reserve account expense as determined in Lesson 5.

      Utilizing the information provided and results of our efforts to determine the correct expense amounts, we can generate the following annual income-expense statement:

      Note the following:

• We have included a Laundry income item even though the property under consideration has not common laundry facility to remind you that other income items are often involved.

• We have determined realistic expenses to be $10,346, significantly higher than the $6,158 provided by the seller, about half of the difference due to the lack of a reserve account expense in the sellers data.

Income Approach Value
      We see that with the current rents, the value of the property is:

Current Income Approach Value = NOI/Cap Rate = $15,418/0.093  = $165,785.

      Now, since you are only now preparing an offer, it will likely be at least a couple of months before escrow closes.  Accordingly, we will also calculate value using the the market rents for the three units for which leases expire in less than 6 months.  Using those market rents adds $1,620 to our scheduled income, giving us an additional $1,539 of income after deducting for vacancy, and resulting in a NOI of $16,957. This gives a value with future rents of:

Future Income Approach Value = NOI/Cap Rate = $16,957 /0.093  = $182,333.

      From this significant increase in value from a relatively small increase in rents you can see how future rent increases will increase your net worth.
      For our final estimation of value we will give some weight to the future value because the existing leases expire in the not-too-distant future and renewal dates will be even closer by the time escrow actually closes.  Thus, for later use in our reconciliation of values determined by the three methods we will tentatively adjust the result of the Income Approach to approximately half-way between the two values.  We will likely give even more weight to the future value result after we have reviewed the leases and completed physical inspections if there have been no unpleasant surprises.

Reconciled Income Approach Value = $174,000

      We see that the listing price of $177,900  is a little higher than the value determined by the above Income approach analysis.  This is not unexpected because we know that most listings are at a higher price than market and more than the seller really expects to get.
      However, the listing price is significantly under the $182,333 that the property will be worth per the Income Approach when we get the rents up to market.  Accordingly, based only on the Income Approach analysis, we might consider offering $170,000.  This would be close enough to the asking price for a good chance of acceptance.  We might even offer several thousand less if the market is not very active and we are willing to risk another buyer beating us to a deal.  Finally, we would probably be willing to go as high as the full listing price because of the near-term potential.

Income Approach Comments
      We want to return again to the reserve account.  While $219 per month sounds like a  lot, keep in mind that increasing the rents to market as leases expire, will give you an additional $128 per month even at current market rents and we market rents might be even a little higher by the time leases are renewed.  Furthermore, we could likely easily stretch a few replacements out a little if really necessary.  Finally, we can reduce expenses by that amount by simple doing the landscape maintenance ourselves.
      One additional note regarding the above assumptions and discussion.  Because the heating/cooling systems are old low-efficiency units, you might want to consider replacing them as soon as possible with new higher efficiency units.  This is particularly important if the owner is paying the electric bill, because the payback period is only a few years and gets shorter every year due to rapidly increasing electric rates.  Even if the tenants are paying the electric bills, lowering their utility costs significantly will allow larger future rent increases.  For additional discussions regarding reduction of utility costs, including both electricity and water, visit our Reducing Utility Costs page.
      Finally, we have provided an Excel spreadsheet that can be used to calculate the NOI and value of properties similar to the subject of this example.  A discussion of the spreadsheet and links to various versions of it are reached by clicking here.

Market Data Approach Valuation

The Data
      With the subject property being a 4-plex, it is possible that we will be able, even on our own, to dig out information for comparable properties.  This is usually not as easy for larger properties, where there are greater differences between similar type properties and fewer sales.  If we are working with an agent, he should certainly be able to come up with some comparables.  For purposes of our example we will assume that the following information is available for similar properties.  You will note that some some data for each of the properties has an asterisk in front of the number .  This indicates data that we had to determine ourselves because (1) it was not available or (2) though available, was questionable.  This is often the case in the real world.
      Sometimes the only reliable data is the sales price and income at the time of the listing.  Even this information may require correction if the listing is old.  Even when expense data is provided in the listing, it must be viewed with suspicion.  First, there may be innocently missing expenses, either because they were simply forgotten due to incomplete bookkeeping by the seller or because the seller had deferred certain items in the period prior to listing the property for sale.  Second, expenses may have been purposely minimized because it was thought (probably rightfully) that better cash flow would produce more interest and that corrected data could be provided without losing the deal after a potential buyer was hooked.
      The bottom line is that the potential buyer must usually provide some of his own data for doing the Market approach, just as usually required for the subject property when doing the Income approach.  Again, property tax information is available from the County and, if you obtained a quote from your insurance agent for the subject property, this same amount should be applicable to the comparables.  Other expenses determined for the subject property should also be usable for the comparables, with corrections for known property differences.  While we could utilize income, vacancy, and expense numbers to calculate NOI for each comparable just as we did for the subject property when performing the Income Approach analysis, but there is no educational value in doing and we will simply list the NOI for each.

      We include the 3-plex because it has about the same size units as the subject property, is a very recent sale, and is more comparably located than any of the other properties.  Although we do not here actually determine the NOIs of the comparable, they would be analyzed in the same manner that the subject property was in the above Income Approach analysis.

      The following information is also known about the properties:

Comp 1:  Has laundry room, but no data.  Has dishwashers.

Comp 2:  Each unit has own laundry hookups, no common facilities.   Has dishwashers & microwaves.  One covered parking space per unit.

Comp 3:  Has laundry room.

Comp 4:  Each unit has own laundry hookups, no common facilities.  Has dishwashers & microwaves.  One covered parking space per unit.

Adjustments
      We now need to adjust for differences among the comps.  The adjustment table of that lesson is repeated below.  We take into account all information mentioned about, making judgment, estimating the plus or minus value of each factor compared to the subject property.

Analysis

Summarizing the above tables, we have

Market Data Approach Value
      Based on the above information and discussion, we estimate that the value of the subject property is $175,000

Market Data Approach Comments
      We note that the value determined by the Market Data Approach is very close to that found from the Income Approach, which we determined as the average of the Current and Future values from that analysis.  The results from two different valuation approaches are not usually so close.  In this case it occurs partly because we chose a reconciled Income Approach value half-way between the Current and Future value results.  Often the Income and Market Data approaches provide values differing by 5 or 10 percent.  For example, a sellers' market, resulting from a shortage of inventory, usually pushes sales prices (Market Data Approach) significantly above values justified by incomes of the properties.

Cost Approach Valuation
      You will not usually perform a cost approach valuation of a 4-plex for two reasons.  First, it's a lot of work.  Second, the result is not usually particularly useful for smaller properties.  Duplexes, triplexes, and even 4-plexes are typically developed in groups, often one or two dozen at a time, just as for single-family homes, to make them economically viable.  Accordingly, determining the cost of reproducing a single small property leads to high values that cannot be easily or reliably reconciled to the other two methods of valuation.
      Although you may seldom, if ever, need to do a Cost Approach analysis, we will take the effort to do one for this example because we want you to understand how one is done so that you can utilize the method when necessary to do so.

Procedure
      The basic steps of the Cost approach are as follows:

1. Estimate land value as if vacant

2. Estimate reproduction or replacement cost new of all improvements.

3. Estimate the amounts of accrued depreciation from physical deterioration, functional obsolescence, and adverse economic influences.

4. Deduct the accrued depreciation of step 3 from improvement costs of step 2.

5. Add the land value of step 1 to the depreciated cost estimate of step 4. 

Site Valuation
      There are at least four different procedures for use in the valuation of land.  The one most applicable for our purposes and generally preferred is the Market Data Approach.  This approach requires the gathering and analysis of sales data for comparable sites, with the most weight placed on actual sales of similar land made relatively concurrent with the date of valuation and under comparable conditions.

      For our example, we have come up with the following comparable land sales, all of which were properly zoned and had utilities to the lot lines:

Adjustments

      Note that, while one could base the lot size adjustment directly upon the exact square footage of the lots, we have not done this, but have simply given an estimated value of the difference.  The reason for not using an exact proportional calculation is that the value of a lot greater in size than needed for the desired project is not directly proportional, but is often significantly less or nothing at all.
      Based on the above information and discussion, we determine that the current value of the site of the subject property is $35,000.

Construction Cost Estimate
      A distinction must be made between reproduction cost and replacement cost.  Reproduction cost is the cost of constructing a new replica of the improvement.  Replacement cost is the cost of constructing a substitute improvement which has the equivalent utility.  The difference between the two becomes more important for older properties because (1) new construction materials and methods are now available and (2) the market requires different functional considerations.  Because our subject property is only 15-years old, has basic residential use, and is not of unusual or complex construction, we will not need to consider the distinction.
      Both materials (e.g., lumber, concrete, and shingles) and equipment (e.g., air conditioners) are factors in the cost of construction.
      Construction costs must include not only the cost of constructing the building itself, but all other items including utilities, parking lots, sidewalks, landscaping, etc.
      Building costs must include both direct construction costs and indirect costs.  Direct costs are those for material and labor, including contractor's overhead and profit.  Indirect costs include professional services (e.g., design, engineering), permits, and carrying costs during construction and until occupancy (e.g., construction loan costs, property tax, insurance).
      There are a number of ways to determine construction costs for a given property.  One extreme would be to treat the analysis as a construction project and determine costs of the materials, equipment, labor, and other costs needed to reproduce or replace the improvements of the subject property even to the point of obtaining bids from contractors.  This approach would be quite accurate because it would be based on current costs for the specific improvements.  However, it would also be very time-consuming and costly and, unless willing to compensate contractors for preparation of bids, might be considered unethical.  It would certainly give you a bad name among builders in the community.
      The much easier approach and that most often utilized by professional appraisers is to utilize available data regarding construction costs.  This information is collected, analyzed, and published by various construction-related industry associations.  The available information is categorized by location and type of construction in considerable detail.
      Probably the simplest method of determining cost is to use the published per-square-foot construction cost for the particular type of property in the subject area and simply multiply that number by the gross square feet of the improvements to calculate the cost.  However, one must be certain that the number used includes all construction costs (e.g., parking lot & landscaping) and not just the cost of the building itself or, worse yet, only the building shell.  Adjustments must be made for items not included n the available cost per square foot.  Direct costs must also still be considered if not included in the number used.
      Even though one may often use the per-square-foot method because it can be done quickly once one has the proper numbers, we will use a modified version of a full construction project analysis.  This version will use known costs for principal components and tasks to arrive at the construction cost.  While this method requires one to obtain fairly detailed information and this might be considered daunting, it is possible for the layman to accomplish.
      There are a number of ways to come up with the data.  You or your agent might know

• A general contractor who builds 4-plexes (even duplexes would be close)

• An appraiser who has the information at his fingertips or at least access to the data

• Direct access to the published data discussed above.

      For purposes of our example, we will assume that we have used the appropriate sources to determine that the costs related to constructing the improvements of the subject property are as follows:

NOTES

1. Water, sewer, electric, phone, cable TV.

2. Considering both chronological age and condition.

3. Takes into account fact that some were changed out over the past few years and are not original.

4. Takes into account fact that some units were re-painted since construction.

5. Includes property tax and insurance prior to rent-up.

      We note that the total cost divided by the total square feet is $57.07 per square foot, a typical cost for a project of this type in a typical region of the country.

Accrued Depreciation
      Accrued depreciation is the loss in value that has taken place up to the date of valuation.  Estimating accrued depreciation is an important step in the Cost approach to valuation.  Depreciation includes loss in value from all causes, including physical deterioration (both curable and incurable), functional obsolescence (both curable and incurable), and economic obsolescence.  Each of these categories can be taken into account when determining the accrued depreciation.  Which categories are considered depends upon the age and type of property as well as the time available to complete the valuation.
      Physical deterioration is not just deferred maintenance such as the need for paint.  It is also the decrease in life of all components, including roofing, heating/cooling systems, and parking lot surface.
      There are a number of methods that can be used to determine the accrued depreciation, of varying degrees of complexity and accuracy.  The simplest method would be straight-line basis of physical life.  For example, we will assume that the building has a life of say 100 years, for ease of computation.  Depreciation would therefore be one percent per year and the accrued depreciation for our example would be  percent (15/100) of the $198,600 cost, or $29,790.
      However, as you might have already guessed, this method usually underestimates the degree of physical deterioration because many components have a useful life considerably under 100 years.  As examples, a range may have a life 25 to 35 years, carpeting a life of 5 to 8 years, and exterior painting a life of less than 5 years in particularly hostile climates.  In spite of this deficiency, the basic straight line method is adequate for some uses and is often used because it is so easy, adding a few percent to the calculated number to take into account the error from short-life components.
      A more complex analysis that takes component lives into account is sometimes called component physical life method.  For this method the useful lives of the major components are separately considered, with the deterioration of some items (e.g., heating/cooling systems and plumbing) based strictly on age and normal useful life while deterioration on other items (e.g., painting, roof, and parking lot surface) based on inspection.
      Discussions of functional and/or economic obsolescence (see Glossary ) are beyond the scope of this lesson.  For our example it is likely that any functional or economic obsolescence would be negligible compared to physical deterioration because the subject improvements are of general use and are only 15 years old.  Also, we will not distinguish between curable and non-curable physical deterioration.  If the property under consideration has obvious functional and economic obsolescence issues, one should take those factors into consideration, even if only by making rough estimates.  Although an appraisal will likely be required by the lender, it will usually not be a full-blown one that would consider obsolescence in any detail as would an appraisal for a more complex property.
      Although we will assume a physical life of 100 years for our example 4-plex, you should be aware that the life of a particular building can be significantly more or less, depending upon versatility of use, type of construction, type and quality of materials used, and the severity of the climate where located.  We now expand the above Cost table to include depreciation information.

NOTES

1. Water, sewer, electric, phone, cable TV.

2. Considering both chronological age and condition.

3. Takes into account fact that some were changed out over the past few years and are not original.

4. Takes into account fact that some units were re-painted since construction.

5. Includes property tax and insurance prior to rent-up.

      Thus, we have determined the accrued depreciation to be $44,668, half again more than the $29,790 determined with the basic straight line method and a much more accurate amount.  This is another example of why it is important to do as accurate a valuation as possible.

Cost Approach Valuation
      The rest is easy.

Value = Site Value + Construction Cost - Accrued Depreciation

Value = $35,000 + $198,600 - $44,668

Value = $188,932

Cost Approach Valuation Comments
     For our example, the cost approach value is significantly higher than either the Income Approach value and the Market Data Approach value, as expected from our earlier discussion.  If we had been considering a dozen such buildings, costs of most components would have been less due to economy of scale.  Some costs would be significantly less.  For example, design and engineering would have been divided by 12 for each building if all buildings were fairly identical.  Most of the hard construction costs will also be less per building.  For larger projects, for example a 50-unit complex, the cost approach can produce quite accurate results if good cost data and depreciation data are utilized.

Reconciliation
      We have three different answers from three different approaches to determining value,  We repeat the current and near-future values for the Income Approach, as they will be of interest in making our final reconciliation value.

Income Approach Value (current rents) = $165,785
Income Approach Value (near-future rents) = $182,333
Income Approach Value (adjusted) = $173,000

Market Data Approach Value = $175,000

Cost Approach Value = $188,932

       We need to reconcile the above valuations to one "true" value. 
       For this particular example, we will give the Market Data Approach result more weight than the Income Approach result and, for reasons previously discussed, we will give negligible consideration to the Cost Approach result.
      Taking the above factors into consideration, we will estimate that

Reconciled Value = $175,000

Price To Offer
      As discussed at the end of the Income Approach section, if this is a pre-offer analysis, then based on this value we would probably offer $170,000, but, in view of the below-market rents that can be raised soon after closing escrow to give a value of over $182,000, we would probably not hesitate to go to the listing price of $177,900 if necessary.  Just be sure that you include adequate contingencies so that you can cancel the deal if unable to renegotiate the price if, after doing further analysis and inspections, you find things different than expected.
      If, instead, this a post-offer valuation that comes in significantly under the contract price, we can also exercise the contingency (that we were supposed to have written into our offer) and walk away if the seller is unwilling to re-negotiate a lower price.  If willing to spend the extra time and costs of continuing with the inspections and loan application, including paying for the appraisal and inspections, we can continue with the escrow and see how the lender's appraisal comes in.  Since we should have also included a contingency that the lender's formal appraisal would come in at least as high as the contract price, if it doesn't, we can at that time decide whether to continue if the seller refuses to re-negotiate.

Debt Coverage Ratio
      As discussed in an earlier lesson, many lenders utilize the Debt Coverage Ratio (DCR) in making loan decisions and, although the DCR may be more a financing issue than a valuation issue, we will cover it here because it is intertwined with the Income approach to valuation.
      We can check whether our proposed deal will pass muster in a couple of ways.  First, we can calculate the ratio using the expected purchase price, the amount of cash we have available, and the loan terms expected.  Second, we can instead work the problem backwards and, using the same information, determine the maximum price that we can pay for the property for a given ratio.  The first approach is probably more intuitive for most people, but the second approach is often more useful in the real world.  Accordingly, we will use the second approach for our example.  We also want to verify that the property will support the amount of loan we need considering the amount of cash that we have available, $35,000.
      Since the debt coverage ratio is not normally used with a NOI that includes a reserve account expense item, we first need to calculate the NOI without the reserve.  We will use the actual current numbers rather than near future improved income because there is no guarantee that we can get the lender to consider potential.  Adding the reserve expense amount back in, we have

NOI w/o Reserve expense = NOI* = $15,418 + $2,517  = $17,935

By definition, Debt Coverage Ratio = DCR =  NOI*/ALP

Where ALP = Annual loan payments

Thus,

ALP = NOI/DCR

Assuming that our lender uses a DCR of 1.2, a typical criterion, we have

ALP = $17,935 /1.2 = $14,946

and

Monthly loan payments = ALP/12 = MLP = $1,245

      For our analysis we will assume that, in the current market, we can get a 25-year fixed rate loan at 8 percent with one discount point.  We also assume that the appraisal will cost $500, a lenders title policy will cost $500, and other costs will total $500.
      With our loan assumptions and using a calculator or amortization tables, we find that the loan supported by this payment is approximately $161,000.  Thus, with our assumed loan and a Debt Coverage Ratio of 1.2, we will have no trouble buying the property with the amount of cash that we have available.  Note, however, that with a higher interest rate and/or higher DCR, the result will be different.
      However, lenders will not finance rental property without the borrower having a relatively significant cash equity.  We will assume the worst case scenario that

• We must pay the full listing price of $177,900

• The lender will loan 80 percent of value

• The lender's appraisal will equal the purchase price

      Accordingly, we can obtain a loan of $142,320, requiring a down payment of $35,580.  Now, since we have cash available of $35,000, we're only short $580, which we know we can borrow from our kids, and we've got it made, right?
      Not quite.  We now know that the one point discount point will equal $1,423 , so 

Closing costs = $1,432 + $500 + $500 + $500 = $2,932

      Thus, we will need $38,512 ($35,580 + $2,932) cash in order to close escrow and we're short $3,512.
      We see that, with our available case, we cannot give quite as much for the property as we were willing to pay even though we know that the property will be worth significantly more soon after closing.  At this point, we can either come up with additional cash of  in order to reduce the loan needed or we can offer a lower price.
      For our example, we could pay the listing price by borrowing the difference of $3,512 on a credit card if the kids won't loan that much to us.
      Intuitively (without any math), we guess correctly that we wouldn't have a cash shortfall if we could buy the property for only $170,00.  We can also calculate the exact price we can pay with the amount of cash we have.  Rather than go through the exact calculations, a simpler approach is to realize that the cash shortage divided by the loan-to-value ratio gives us the approximate amount that the sale price must be reduced from the listing price in order to avoid a cash shortfall.  We say approximately because the loan fee will also be reduced, but since the fee is only one percent, the error will be negligible if ignored.

Reduction = Shortfall / 0.8 = $3,512/0.8 = $4,390

If we want to correct for the reduced loan fee, we can round the reduction to $4,300, giving us the price of $173, 600 ($177,900 - $4,300).

Cash Flow Analysis
      As for the house of Lesson 2, we can now do a cash flow analysis based on having to pay the full listing price.  We have already calculated everything that we need, so we just have to do a little basic arithmetic.

      The monthly payment for the 80 percent loan on the full listing price the monthly payment will be $1098, or $13,176 per annum, 

Current Cash Flow = Net Operating Income - Loan Payments = 

$15,418 - $13,176 = $2,242/annum = $187/month.

      For one final calculation, we'll determine the cash flow after renewing the shortest leases to market rents as discussed in the Income Approach analysis.

Near-future Cash Flow = 

$16,957 - $13,176 = $3,781/annum = $315/month

      We can now determine the return on investment, similar to what we did in Lesson 2.  We can easily see that the cash-on-cash return will simply be $3,781 divided by the $38,512 cash invested, or 9.8 percent.  We could also look at the other returns considered in Lesson 2, including after-tax cash-on-cash and considerations of appreciation, but we'll leave those calculations as an exercise for you.  Just follow the Lesson 2 example.

More Complex Properties
      Analysis of larger residential properties is really little different from a 4-plex.  Most differences are simply those of degree.  That is, more units, more rent prices, and a greater variety of expenses.  The latter may include resident manager, maintenance personnel, and community amenities such as pool and/or fitness room.  Mainly, it's just that all the numbers are larger.
      Commercial properties usually offer more of a challenge to analyze than even very large residential properties.  This is because commercial properties usually have units of a variety of sizes and types, sometimes have more complex physical components, and, most important, they almost always have more complex leases.  The last factor is important because the terms of existing leases can greatly affect the value of a property.  The lease issues that can be of most importance, and can vary among units of same property, are:

• Who pays expenses -- landlord (gross) or tenant (NNN), with many possible variations in between

• Long duration -- typically 2 to10 years, can be longer

• Variety of scheduled increases -- tied to various rate indicators, fixed percentage

• Extension options -- typically similar to original term, with fixed or negotiable rent increases

      However, no matter how complex the property, the procedure is basically the same as that we used for the 4-plex example of this lesson.
      A full analysis will often only be possible after the offer has been accepted because that is when you will have all the necessary information.  For making your offer, you or you agent will have to ask as many questions as possible and push for as much preliminary inspection as you can get.  For some items you will have to make educated guesses.  As for the 4-plex example of this lesson, you can get a lot of information by casual inspection.  In addition to the methods previously mentioned, you can usually visit commercial units as a customer, an advantage over the normal residential deal.  Finally, as before, the valuation done prior to writing the offer may be rough because it had to be done without complete and accurate information, but it will be better than none at all.  You will have to update your analysis after obtaining more information subsequent to acceptance of your offer and if you now find that the property is worth less than your preliminary analyses had indicated, you will have to re-negotiate the price if possible or, if not possible, either walk away or, if you decide there is an adequate upside potential, continue with the deal at the original price.