Deal or no deal

After finding the right apartment building in the right area, it's time to dig beneath the surface-level hype of the listing to uncover what type of investment the building really is.

First, keep in mind that the apartment's income and expense information from the listing are focused on enhancing the attractiveness of the building in the eyes of the purchasers.

This is typically done through demonstrating that the building is generating strong income, running at low expenses and/ or has an attractive CAP rate (which is the ratio of the building's net operating income ( gross income - expenses) to its purchase price), says Dalia Barsoum, a lending adviser with CENTUM Streetwise Mortgages.

While the listing's information represent a good starting point, as a buyer, you need to ensure the validity and completion of all items that make up the financial statement and also where they stand relative to comparable apartment buildings in the market you are investing.

For example: Is the income based on projected or actual rent charged today? Are there any missing items from the list of expenses? Are the expenses high or low and why? What is the vacancy rate for this property type in the area and has that been factored in?

Are the rents charged in line with market rents in the area? Is property management factored in (even if you are going to manage it yourself, lenders factor in 4%-5%)? This adjusted income statement combined with your knowledge of the area's prevailing CAP rate for comparable apartment buildings will help you arrive to a more realistic estimate of value that is aligned to the lender's view of value, Barsoum says.

Lenders are typically more conservative in their valuations as it is reflective of their view of the area's and property risk. The lender's valuation and not what the listing says is what will drive the financing you will be able to obtain at the end.

Reduced expenses

Sellers boost up their building's cap rate not just with potential income, though. They also use reduced expenses to make the numbers look better, says investor Becky McGee, director of business operations at Twello Property Management.

Oftentimes, McGee finds that sellers only list expenses for heating, hydro, water and taxes, leaving out maintenance, lawn care, snow removal, insurance and the vacancy allowance.

So when McGee's really serious about making a purchase, she'll ask the selling real estate agent for the owner's expense sheets to see if it lines up with the information included in the listing.

Still, even after you determine what all the expenses are, McGee says prepare to pay more than the previous owner for the same services. For example, to renew lawn care or snow removal contracts, McGee says she typically always pays more even if she goes back to the companies used by the previous owner.

"Businesses see opportunities as soon as someone new comes in. That's when they think they should increase their rates," she says. "Once you take over the property, I think you can automatically add 5% or 10% to the bills." Then think of management expenses.

Lenders estimate that property management costs 4% to 5% of the home's purchase price when determining whether the building can carry the costs of the mortgage. So you'll have to account for at least that, if not more depending on whether you'll be using a property management company or a superintendent. So it would pay to figure out right away who'll be managing the building.

You'll also have to plan to pay for utilities' deposits in many cases, which can be fairly expensive. In Ontario, for example, natural gas provides take an average of the most expensive three months of service to arrive at the deposit amount, which isn't cheap, says McGee.

In one case, she had to make a $10,000 deposit on a 22-unit building. Lastly, don't forget the municipality gets a piece of the pie when it reassesses the value of the building after the sale. McGee says the reassessment typically leads to much higher property taxes, usually in the thousands of dollars.

All of these expenses have to be included to get a realistic grasp on not only how much you'll need to set aside for expenses, but also, and more importantly, to see if the building is even a good deal in the first place. Consider that just after doing these initial checks, McGee has seen the cap rates of the buildings she's about to purchase plunge. In fact, cap rates advertised in New Brunswick at 14% fell to just 6% after she crunched some numbers. For the most part, though, the drops are about 2%, she says.

Still, keep in mind lenders may not provide financing for the building if the rate falls far enough.

Do your due diligence

Once you've gotten a decent handle on the net-income situation for the building, make sure there isn't any deferred maintenance. Overlooking major repairs can leave you broke in a real hurry, McGee says.

For instance, if you're about to buy a 50-yearold building in need of a new roof, boiler and windows, the deal may end up costing more than it's worth. But if you do identify deferred maintenance upfront, you can use it as leverage during the sales negotiations to bring down the purchase price.

At this point in the process, however, you won't probably get much more information without an accepted offer. "The seller will initially give you the least amount of information possible to draw you to the building," McGee says. "But for the most part once you submit an offer and it's accepted, you can get the information you need."

To learn how to write a winning offer and analyze diligence material, pick up a copy of our November issue, on newsstands until Nov. 7.

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