This article was posted on Thursday, Nov 01, 2018

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Continued from Part 36: Wrong! Capitalizing “Forecast” Rents

It is not absolutely necessary for Forecast Rents to reflect the current state of affairs. After all, they’re “forecast” to exist sometime in the indefinite future under the hypothetical conditions stipulated by the seller’s representative, so almost anything qualifies.

Emily imagined she eavesdropped on the conversation:

“Well, I don’t know. We might or might not be able to get all the rents up to market”, the buyer’s wife said.

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  The agent was not to be undone. “True, but that’s not the only special benefit of this building. See those tuck-under parking spaces? What would it take to box them in and make little “bachelor” units? There are 20 of them. That’s 20 new units! Nobody has to know! Even at a forecast $500 a month, that’s $10,000 a month to you . . . cash.”

“I heard it was hard to get permits?”

“That’s what’s special!  You’ve heard the term, bootleg units? These will be those highly desirable bootleg units you’ve heard about. Nobody bothers with permits for bootleg units. If they were permitted, they would not be bootlegged. Those are unpermitted units that bring you cash each month that nobody knows about! Every buyer wants bootleg units! If it were possible to buy an empty lot and fill it with nothing but bootleg units, it would make a fortune!

“And we’d be able to get $500 a month for each of ‘em?”

“Maybe more! Four guys in one unit the size of a one-car garage, say 200 sq. ft.,  could pay $150 each. That’d be $600 and they’d still be getting a huge bargain – where are you going to find an apartment for that price – and you’d get $600 for each bootleg unit!” Emily, who was still eavesdropping, noticed that this guy seemed to use a lot of exclamation points when he talked.

“But wouldn’t it be expensive to turn those tuck-unders  into units?”

“Not a bit! Throw some sheetrock between the parking spaces and run a water tap and a bit of electricity to each, and there you are!

“Where do they go to the bathroom?”

“A porta-potty! Just stick a porta-potty out back and let them all use it! It’ll be fine!

“Well, we still don’t know.”

“Let’s put the numbers together. You’re buying the units for $5,000,000. Your income will come from market rents netting you $335,000 a year PLUS the special bootleg units. Twenty new units at $600 a month come to $144,000 a year. Add the market rents of $335,000 (“Market” rents? “Bootleg” units? Emily saw what he did there) and you’ll be getting $479,000 a year . . . after expenses! That’s over a 9% cap rate. Where can you beat that in the current market?”

Several years ago Emily’s loan broker had taught her some of the different ways conniving people misrepresent the cap rate, and she also showed Emily some easy value checks that did not include capitalization. Emily still had her notes from those conversations and resolved to review them later that afternoon.

 Can a “Wrong” Actually Be Useful?

To purposefully misstate a capitalization rate is a vile thing to do. In Emily’s mind, it is tantamount to willful cheating. This is particularly so because many buyers, even those with multiple properties, are still bewildered by cap rates. To knowingly manipulate the data to make it appear the buyer will be receiving a better value than really will be the case, and thus to take advantage of someone’s innocence, is simply beyond the pale.

On the other hand, Emily thought, could there be more than one cap rate? What if a cap rate was clearly identified as a forecasted or projected figure? What if it was unmistakably labeled as a future possibility, given certain realistic changes? An example might be when the salesperson was comfortable that the buyer understood that the (projected) cap rate was possible only if all rents were brought to market, or if parking places became chargeable items, or in some other way the property’s net income could be increased. Under these conditions, the investor could form a reasonable opinion on how likely those hypothetical changes might be, and their benefits to him. In such a situation, wouldn’t the hypothetical future cap rate be a useful data point to the knowledgeable buyer? Emily thought that a forthright salesperson might even present a listing accompanied by multiple cap rates. For example: (a) “as is” or (b) adjusted for market rents or (c) charging separately for parking.

To be actionable, the salesperson should accompany prospective changes with some third-party evidence that the contemplated changes were possible. The data for market rents (in this example) is easy-peasy: There are two identical units in the subject building. Unit 11, with the rent controlled cat-woman who’s been there forever, rents for $176 a month. The twin unit was recently rented for $2,150. That’s pretty simple: model-matched units in the same building. If ever the cat-woman dies, the market indicates the next tenant will pay more. That’s one example.

If the additional income comes from charged parking spaces, the salesperson should present at least one similar building in the same area that charges separately for parking and the monthly parking charge should be reported.

If the building is being presented as legally capable of higher density (i.e., the purchase has a land banking component), the capability should be quantified. If a salesperson advertises an alternative cap rate, he should present some data supporting his assertion, or at least Emily thought so.


Although capitalization can be misrepresented, it remains a generally accepted “best practices” way of estimating value. Fortunately, it is not the only way. There are ways of estimating the value of a building other than capitalization. While not error-free, these can act as cross-checks to the capitalized value. Some of the more common cross-checks are (a) dollars-per-square-foot; (b) dollars-per-unit, and (c) dollars-per-bedroom.

All of these require comparable sales (comparable: similar buildings which are equally desirable substitutes to the subject) to act as reference points, which of course is a useful cross-check by itself. If there are no similar buildings in the market area, that is the market screaming, “Danger, Will Robinson! This market doesn’t like those buildings!” If the subject building is the only one full of bachelor units (one room and a bath; no separate kitchen), that could be a clue regarding market acceptance.

Value checking, whether by capitalization or in some other way, is a matter of bracketing. Because comparable buildings in the subject’s market area are not exactly like the subject, some being cosmetically “better” and some “not as nice”, they will have sold at cap rates both slightly above and slightly below the subject building’s current cap rate.

One of the things that make dollars-per-square-foot workable is that most (certainly not all, but most) buildings were developed in accordance with the four principles of highest and best use: (a) the development must be legally permissible; (b) it must be physically possible; (c) financially feasible, and (d) maximally productive.

Obviously, the year built is a consideration because what was maximally productive in 1918 would probably be viewed very differently a century later. However, if we make broad age group distinctions (plus or minus 20 years) one of the qualifiers for compatibility, then the casual flaneur would find that most comparable buildings have the features they do because those features maximized the production of income at the time they were built. Among other qualifiers, well selected comps would bracket and support the subject by permitted living area, bedroom count, and cost per unit. These three filters plus the (approximate) year built result in a list of recently sold apartment buildings within a given market area, approximately matched for income, age, living area, bedrooms, and cost per unit.

 Cost per Square Foot

For example, the formula “price divided by permitted square footage” applied to similar recently bought properties should result in a set of relatively closely grouped quotients. Example: $300, $281, $329, $303, $296. That tells the observer that the subject property’s value is likely somewhere between $281 and $329 psf. Some of those comp properties could be better (or worse) maintained than the subject, explaining the different values. The weakness in the $/sq.ft. approach is that it doesn’t account for the possibility of “internal obsolescence”. “We don’t have that sort of floorplan any more, Buffy.” For example, the subject’s only bathroom could be directly off the living room. Or you might have to pass through one bedroom to get to another. Things like that are called “internal obsolescence” and it’s not often you see them, anymore.

 Dollars per Unit

Rather than dollars-per-square-foot, some folks find dollars-per-unit a reasonable substitute. The weakness in dollars-per-unit is that an apartment building made up of 24 Bachelor units might theoretically be compared with another building consisting of 24 three-bedroom plus den apartments. After all, they’re both 24 unit buildings, aren’t they? But comparables have to be as equally desirable as the subject, and that’s just not the case in this example. Bachelor units are not as desirable as three-bedroom plus den apartments. So for $/Unit to be a useful cross-check, the units must be equally desirable to the marketplace: they must have similar bedroom counts.

Seller’s agent: “Yes, this building consists of 15 Studios, but they comp out. That property down the street is also 15 units and it just sold for $350,000 per unit!”

Buyer:  “But, but didn’t you say those were 3 bedroom units?”

Seller’s agent:  “So?”

 Dollars per Bedroom

The comparable bedroom issue can be addressed by using Dollars-per-Bedroom as a valuation metric. Clearly, if $/bedroom is used, it should only be employed on comparable properties with similar bedroom counts or the result could be misleading. For example, if using $/bedroom to value a building of 45 Single units (living room, kitchen, bath, no bedroom) the building would have (theoretically) zero value. After all, if only bedrooms count, zero bedrooms mean zero value, doesn’t it? And we know that such a building would NOT be given away for free.

So $/bedroom would be a silly way to estimate the value of a building without bedrooms.

In another example, if the one-bedroom units sell for $200,000 on a dollars-per-bedroom basis, that doesn’t mean that a two-bedroom unit is automatically worth $400,000. Dollars-per-bedroom can be useful with closely compatible buildings, but even so it should not be the only cross-check employed.

Valuation depends on many things. Cap rates present the net yield on a stream of unleveraged income. “If I paid cash for this property, the NOI would reflect a 5.7% cash yield on my investment. How does that compare with alternative investments?”

Dollars-per-square-foot address condition and micro-location issues (“Mr. Agent, is that a power tower in the back yard?”).

Any valuation method based on the physical characteristics of the property should be followed by an interior inspection. We don’t want to be surprised by clumsy floorplans. All units should have similar utility. The kids should not be required to cross the master bedroom to get to their bedroom. (“Mommy! Mommy! Why is your door always locked after Daddy comes back from a business trip?”)

 Executive Summary

Capitalization, a financial metric, is probably the first valuation tool most people turn to, but it’s subject to misrepresentation and should be supported by one or more secondary checks based on the physical characteristics of the subject property.

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate, Klarise Yahya Commercial Mortgage Broker, BRE: 00957107  MLO: 249261 can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].