How Do You “Negotiate” the Rents?
What should be obvious is that the value depends on at least two things: recent sales prices and the current rent from the property in question. While accurate recent sales prices of comparables should be fairly easy to obtain (call a few agents who deal in income property), determining the true gross income from rents for a specific property can be a bit trickier.
Pam was interested in buying a low-income seven-unit apartment building. The owner was using a multiplier of 14, which was conservative for the area. The owner said all units were filled, each was rented out for $650, and the gross annual income, therefore, was $54,600. That meant the building was worth (times 14) $764,400.
Pam felt that was a reasonable price and bought. However, the first month she discovered that three of the tenants were months behind in their rent and a fourth, a brother-in-law of the owner, was living there free. By the time she kicked all of the deadbeats out and rerented, Pam found her average monthly rental only brought in $500. For seven rentals that was only $42,000 annually. When the multiplier of 14 was used, the true value of the property was only $588,000, nearly $176,400 less than she paid!
Pam’s story, unfortunately, is true more often than most people realize. Owners know that the way to inflate value is to get rents up any way they can. Too often, however, buyers find out the hard way that this has been done.
The true gross annual rent, therefore, like the gross income multiplier, is another deal point. Some investors I know use their own rule-of-thumb when negotiating here. When a seller tells them the gross annual rent is one figure, they simply discount that figure by 10 or sometimes 15 percent, then negotiate from there. They call this the “puff factor.” The owner is puffing up the rents to make the property appear more valuable than it really is.
A better way of dealing with the problem, however, is to get a true reading of the rents. This can be accomplished in several ways. A buyer can examine the cash receipts of the seller for the year, or look at the rental agreements with the tenants, or, if necessary, contact each tenant individually before concluding the sale to determine how much rent is paid and how current payments actually are.