How do you evaluate a apartment building with negative cash flow?

I have a seller wanting me to purchase his 8 unit property. However, after conducting due diligence on his financials I discovered he is likely operating at $1000 a year loss.
How do you computer a capitalization rate on a negative NOI? What method would I use to determine whether his price is fair?
Even if I could get in with no money down, the property does not cash flow right now although it does have a little bit of potential. Should I just stear clear of this property entirely?
In Buying Property - Asked by Jacob C. - Jan 28, 2009
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Chris G.
Lynchburg, VA

Is there an obvious reason for the negative cash flows (i.e. vacant units, extensive repairs, existing debt structure) ? Sometimes I have found that the financials a person provides are designed to show as little profit as possible - he may be paying himself money disguised as management fees, maintenance expenses, etc. for some reason to maximize his tax benefits. I once had a client who assumed their property was not worth much because their tax statement always showed they didn't make any money. After re-evaluating their expenses, I found out that their investment property was paying a "management fee", "vehicle allowance", "repair expenses" and even "equipment rental" to them as a way to pass through money to themselves. At the end of the day, this property actually spilled off quite a bit of cash!

Jan 28, 2009
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Joe V.
Plymouth, MI

Chris G. makes many excellent points. I could only add that when a seller does show a negative cash flow they are only handing you an excuse to lower the offer you make, right? On the flip side, if this is due to a higher than normal vacancy rate, and especially if the property can be improved...shich would attract more Tennant's AND maybe even upgrade the "Class" of the building which would increase the existing rent structure, you could actually have a diamond here.

Jan 28, 2009
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Lou A.
Corporate Investor
Northlake, IL

Using the income approach is only 1 of 3 methods to value real estate. The other 2 are:
1. replacement approach (where you calculate how much it would cost to build the same building in the same spot, typically by multiplying the sq ft X price/sq ft).
2. comparable sales. you can look at comparable properties and see how much those sold for.
If your due dilligence shows a loss, I would investigate if this can be changed in your favor. Example, 3 years ago I bought a 2-unit that had $500 rent/mo from each unit. After rennovation of the 3rd vacant unit and updating the rents (within 2 years) it became a 3-unit with each unit bringing in $735/mo. Look for: increase income (add units, update units, add storage, add coin-op washer/dryer, etc.), reduce expenses (reduce taxes, improve ownership structure, factor in proper depreciation, get a better manager, improve quality of tenants, reduce vacancies, etc.).
If the numbers are still bad, walk away or make an offer that will make sense for you.

Jan 28, 2009
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Pat M.
Princeton, IL

There is no way to capitalize a negative NOI. There is something wrong with this deal. As others have said either the income is not at market or expenses are too high for some reason. I would look at taxes and insurance in particular. I am assuming that you are including the mortgage payment in the negative NOI. The mortgage is excluded in any NOI calculation. I would say that any owner will look at cashflows after mortgage payments. If you are finding that including the mortgage results in a negative NOI I would wonder if the seller has or had recently remortgaged the property and pulled out money. Has the owner gotten a mortgage for more than the value of the property. If so you need to find comparable properties and see what they sold for on a per unit basis. If he is upside down that is his and the bank's problem.

Jan 29, 2009
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Jacob C.
Washington, DC

*****Additional Info on the Question Above*****
The seller has an 8 unit building with 7 units rented at $395 each all utilities included. I am including taxes, insurance, maintenance, property management, gas (over $8k a year!), electric and water, 20% vacancy loss (units are month to month) and $500 misc. exp. With all of these expenses the property loses $1000 a year and that is BEFORE any debt service.
The seller cannot produce any verification of income or expenses and does not "do" Schedule E's.
I also agreed to pay cash for this property thinking I could refinance it in 3 months and pull out all my equity. I am assuming that although the property appraised at 100k and I was paying $85k that I would not be able to meet any lending institutions DSCR numbers because the property has negative cashflow. Am I assuming correctly? Any advice from the veterans out there?

Jan 29, 2009
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John D.
Hutchinson, MN

The vacancy seems high, especially in this economy. Here in Minneapolis area vacancies are very low. I will be bringing to market two c class properties that have had no vacancy for the last 3 years. If a unit opens, it is filled within a week with just a yard sign.
$395 for rent? Are these studios apartments in the sticks?
$8k for gas? Check and see if you can easily insulate the place, or ways to make it more energy efficient.
You will just have to see how much you will need to invest to make it operate more efficiently, and profitably, and calculate the value from there.

Jan 30, 2009
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Paul S.
Glendora, CA

If the property doesn't make money with no money down how would you expect any future value? There has to be some up side such as higher rents, development potential, something. If not you would have no reason to buy it. Ask yourself...would an institutional lender loan on it? The answer is no because it doesn't make money without a loan. Cap rate is measured off of net operating income, in this case a negative number. There is therefore no return and no cap. Remember, cap rate is the relationship of the NOI to the price (NOI divided by price).
No NOI no cap.

Feb 5, 2009
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