How to value a building that needs work

Rarely do you come across an apartment building in Los Angeles that’s in truly mint condition. Everything’s got a few dings on it; that’s just part of buying older buildings. For those normal, everyday buildings, you figure out a range for the multiples of annual rent in the neighborhood, multiply the annual rents times the mid-point of that range, and boom – there’s your starting point for valuation.

But what about the real disasters? The ones where the galvanized piping’s worn out and leaking, there are holes in the roof, the floors are a uneven because the floor joists are rotten, the heaters don’t work, etc. How do you even begin to put a value on those buildings?

Here’s what I like to do: Work backwards. Imagine the building totally renovated. Now estimate the rents. Then multiply those rents times the neighborhood gross rent multiple. The resulting number is the value of the completed building. For example, say it’s a 10 unit building, all one beds that, renovated, rent for $1,500 and it’s located in Silver Lake, where those kinds of buildings trade for 12x annual rents. The fully renovated value is $1,500 x 10 units x 12 months x 12 grm = $2,160,000.

Next, total up the cost of the repairs. If you’ve done this a million times like my partner Jon Criss, you can probably estimate it on site.  If you haven’t, bring some experts you trust to help you. However you do it, get that number. In our example, let’s just assume your experts estimate the cost of renovating the entire building is $500,000.

Now, subtract the cost of the repairs from your estimate of the value of the fully-renovated building. In our example, this means $2,160,000 – $500,000 = $1,660,000. Is that the value of the building? No!

You have to account for two other factors:

  1. The cost of the money: Unless you’re rolling in cash, you’re going to have to borrow some of the money for the project. So you need to figure in some interest costs. If the renovation would take 6 months and you’re borrowing $1,000,000 (total), at 5%, that’s an extra $25,000 of interest costs you need to include.
  2. The value of your time: If this is going to take you six months to do, you need to include a reasonable amount of money to compensate you for your time and risk. This is what appraisers term the “entrepreneurial profit” – the profit that an investor would demand for taking on the risk and spending the time necessary to buy and renovate the property. In our example, let’s just peg this at $200,000.

OK, now we’re ready to estimate the value of our building: Take the fully renovated value. Subtract the cost of the renovations. Subtract the cost of the money. Finally, subtract an “entrepreneurial profit”. That’s $2,160,000 – $500,000 – $25,000 – $200,000 = $1,435,000.

So the maximum valuation we can put on the un-renovated, screwed-up, POS building is $1.435MM. If you can buy it for less, you’re doing pretty well.