When I re-position a building, the numbers often look something like this: I buy the building for $1MM, spend $500k on renovating it, and then ask a lender or buyer to believe that the building is now worth $2MM, based on the rents I am achieving from the new tenants.
Now, obviously, the lender or buyer is going to have some questions, the most important of which is: “How do you expect me to believe that this building you just bought for $1MM is suddenly worth $2MM?!”
The answer to this question is that the new valuation is justified by applying a market cap rate to the new net operating income or a market gross rent multiple to the new rents. (For more information about how this work, please click here.) So the new valuation is entirely dependent on the new rents.
The goal is to be in a position to demonstrate the true profitability of the building to a lender or potential acquirer. You do this by sending them the actual profit and loss statements (P&Ls) generated by your accounting software, often called the “actual P&Ls” or “actuals” (as opposed to “pro forma P&Ls”, which are estimates of profitability).
Why are actuals important? You’re not going to believe this, but there have been occasions where people in the real estate business have fudged those new rents. They’ve signed leases with higher rents and then kicked the tenants back cash under the table to reduce the effective rents. Or they’ve got their friends to move in and sign leases at high rents, knowing that the owner won’t evict them for non-payment. Or the owner is successful is tricking people into signing leases but the tenants break their leases and move out after living in the building for a short time because it’s not worth the money.
So, lenders and buyers are justifiably nervous about accepting the new rent roll as gospel. Instead, they want to be able to look at your actuals and see the money flowing in from the rents and out to cover the expenses for a reasonable period of time, usually 3-12 months, depending upon the lender or buyer. The more months of P&Ls you can show, the more apt they are to believe you.