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When looking to acquire a multi family property, oftentimes there are two different rents advertised: current rents and pro forma rents. Just to complicate things further, there is also market rents and they can all vary wildly. It’s important to understand the difference. Here’s how to think about it.
Evaluating multi family properties can seem fairly straight forward. Use either a cap rate or gross rent multiplier against what the property is generating and calculate the value of the property from there. However, this doesn’t take into account disengaged landlords and Covid.
It’s not uncommon for me to see a number of properties where rents are roughly 50% below their highest and best use. Whether this is a result of a disengaged landlord who doesn’t give their tenant rent increases or the landlord was already behind and couldn’t catch up with new Rent Cap laws, sometimes rents end up below market. On the flip side, sometimes rents can be artificially inflated because the property is being rented on a short term basis. Typically when properties are being rented on a short term basis, the expenses are higher and you eventually see this in the net operating income.
To bring rents up to market, normally this means that there is significant investment on the part of the new owner to bring the property to its highest and best use. This normally includes paint, bathroom and kitchen remodels, new lighting and flooring. Trying to calculate what the difference might be to convert a short term rental property to long term is a bit of a shot in the dark. Location typically has the greatest affect, but still challenging to calculate.
Next, and this is where I really come into play, knowing how to compare current rents, pro forma rents, versus market rents. Current rents is simply what the property is currently generating. If you know the rental market, you’ll know if this owner has been working to stay close to market or if they’re just happy to have the property rented and haven’t increased rent on their tenants in years. Pro forma rents are the anticipated rents if the owner is to replace the tenants. Sometimes the listing agent is taking into account that the new owner will remodel the property such that he or she can charge market rent. However, I’m always a little skeptical of pro forma rents because you don’t want to purchase a property with a miscalculated after repair value for rent.
It’s not weird to see pro forma rents vary from the current rental income. It’s also important for you to know what the market rents are in order to know how neglected the rents are or how artificial the pro forma rates are. Also, sometimes the pro forma rates can be low in anticipation that the incoming buyer will not remodel the property to its highest and best use.
