Over the past few years of living in the low interest rate environment, especially for apartment buildings, lenders have begun to reduce their exposure by tinkering with income and expense estimates in order to value the real estate. In the past, no one expected anything less than a mortgage of at least 75 per cent of the value of the apartment building. Sometimes this would even go as high as 85 per cent. These ratios still exist, but the estimate of ‘value’ has changed.
How market value is estimated
The methodology used to estimate an apartment building’s market value is the same as always. Appraisers, investors and lenders are able to determine the total gross potential income using an existing rent roll.
Market rents for vacant units and employee units are attributed to determine the gross rent on 100 per cent occupancy. Actual figures are used for parking and laundry. From this number, vacancy and bad debt are estimated using Canada Mortgage and Housing data and historical building operations. Rental levels and tenant profiles are also considered.
When determining expenses, actual realty taxes are used. Lenders look at the current value assessment and where the actual maximum taxes should be. In the GTA, realty taxes should be 17–22 per cent of the total gross income. Actual insurance rates are also used, however if they appear low (i.e. due to multiple building ownership) then industry standards are used. Apartment building insurance should be between $130 and $170 per unit per annum. For utilities, actual numbers for the past 12 months are used. Reductions will only be used in a minority of cases where the owner has recently added energy conservation measures.
For the remaining expense items — repairs and maintenance, management, wages and benefits, and miscellaneous — industry standard levels are used. These levels will vary given the building scale, tenant profile and location. Repairs and maintenance will range from $750 to $850 per unit per annum. Management will range from 3–5 per cent of effective gross income (gross income less vacancy and bad debt) plus HST. Wages and benefits will range from $400 to $600 per unit per annum. Miscellaneous (administration, advertising, etc.) will range from $75 to $150 per unit per annum.
Once the expenses are deducted from the income, the normalized net operating income of the building before mortgages will be determined. Normalized refers to how the building should operate under normal conditions. Comparable data is analyzed the same way, so that all capitalization rates (net income divided by the sale price) can be compared. The ‘actual’ operations of any particular building may be higher or lower, but normalized numbers must be used in order to properly estimate value.
As such, when a cap rate of, say, 6 per cent is suggested and applied to the property, it is based on supportable numbers. Many buyers, especially new ones, want to use the 6 per cent cap rate but apply it to the actual operations of the building. This cannot be done, as the cap rate is based on a total different set of parameters. If the comparable data were analyzed also using ‘actual’ numbers, then the cap rate could be 2 per cent.
Determining lending value
In many instances, given current market conditions, a building will sell with multiple offers. Let’s say a building was marketed and listed for sale at $10 million. Multiple offers are obtained and the building sells for $9.5 million. In the past, a buyer would purchase this building and expect to get a 75 per cent loan to value for a CMHC-insured first mortgage ( about $7.1 million). An appraisal would be done to support the purchase price and the mortgage would go through.
Today, the picture is much different. All the above would be the same, except now the CMHC underwriter will do their own value, notwithstanding the independent appraisal already completed. In this value they may use the actual rent roll with the vacancy already in there, or apply a higher than market level vacancy rate. Or they may use higher than typical industry standard levels for repairs and maintenance, management, wages and benefits, and miscellaneous.
The result will be a much lower projected net income. They will also have internal policies of what cap rate to use depending on the location. For example, the market cap rate might be 5 per cent (supported by comparable data), but the underwriter might only be able to go as low as 6 per cent.
The result of the above — lower net income and higher cap rate — means a much lower lending value. In the example, the property might be underwritten at a value of $7.5 million. Given that the underwriter has removed the risk from the loan, they will go as high as 85 per cent loan to value (about $6.3 million).
This is the new normal, and it hurts the lower end of the market. First time entrants into the apartment market generally purchase buildings under $2.5 million. These investors also have limited funds, so every dollar counts.
No matter how hard you try to educate them, the inevitable always happens: they tie up a building for say $2 million, having $500,000 to put into the deal. The lender then indicates that the loan will be based on a value of $1.5 million and they will need another $275,000 to do the deal. Firstly, the additional funds are not there. Secondly, when they see the value of $1.5 million and they paid $2.0 million, they believe they have overpaid.
It is the agent’s job to fully inform buyers and sellers of the reality of the market. This includes values and current financing practices.
Lorenzo Di Gianfelice, BA, is broker of record and owner of Commercial Focus Realty Inc., and team leader of The Apartment Group. The group has been involved in over $100 million worth of real estate deals in 2013.
