Pricing a Warwick Rental Portfolio Under Rent Control and Vacancy Pressure
An investor, Ms. Bascome, is considering buying a four-unit rental building in Warwick for $2.1 million. Current gross rents total $132,000 per year, and operating expenses are $38,000, giving a net operating income of $94,000. Two units are let at rents set several years ago and are significantly below market; the other two are at market. One unit has been vacant for four months. The seller's agent markets the property at a 4.5 percent capitalization rate based on pro forma rents assuming all four units at market. Ms. Bascome's lender will underwrite on actual income, not pro forma. Local rent control rules limit increases on sitting tenants to a modest annual percentage.
1. Evaluate the seller's 4.5 percent capitalization rate and calculate a more defensible figure.
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The seller's 4.5 percent rate is derived from pro forma income, not actual income. At $2.1 million and a 4.5 percent cap rate, implied NOI is $94,500, which is close to actual NOI of $94,000. But the seller is likely using pro forma rents to justify the price, which means the stated cap rate and the price are inconsistent.
Using actual NOI of $94,000, the actual cap rate on the asking price is $94,000 / $2,100,000 = 4.48 percent, roughly the marketed figure. The real issue is whether the pro forma rents are achievable. Because two units are below market and rent control limits increases on sitting tenants, the upside is gradual and uncertain. A defensible valuation should use actual rents, adjust for the vacancy, and apply a market cap rate reflecting the controlled tenancy and vacancy risk. If market cap rates for comparable buildings are, say, 5.5 percent, the indicated value on actual NOI is about $1.71 million, well below asking.
2. How should the four-month vacancy and the two below-market tenancies be treated in the analysis?
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The vacancy should be treated as a real cost, not a temporary blip. A stabilised vacancy allowance, perhaps 5 percent, should be applied even after the unit is let, because turnover recurs. The four-month gap also means actual collected income is lower than the annualised figure, and the buyer should check arrears and the reason for the vacancy.
The two below-market tenancies are a partial opportunity and a constraint. Rent control limits annual increases on sitting tenants, so the gap can only be closed slowly, and only if the tenants remain. The buyer should model the achievable increases year by year, discount them, and not capitalise them at full value today. The pro forma assumes immediate market rents for all units, which overstates value. A realistic model applies controlled increases to the two units, market rent to the third, and a vacancy allowance to the fourth.
3. The lender will underwrite on actual income. What should Ms. Bascome conclude about the deal, and what should she do next?
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On actual income, the property supports a lower loan and a lower price than the asking figure. If the lender applies a debt service coverage ratio of, say, 1.25 and a market rate, the sustainable loan may be well below what Ms. Bascome needs at $2.1 million. She should obtain the lender's underwriting assumptions before proceeding and calculate the equity required.
She should:
- Request rent rolls, tenancy agreements, and evidence of the controlled rents.
- Ask for the vacancy history and any arrears.
- Build her own pro forma using actual rents and controlled increases.
- Make an offer based on actual NOI and a market cap rate, with a due diligence condition on the rent roll.
- Not rely on the seller's agent's pro forma, which assumes an upside that rent control may prevent.
If the numbers do not work at a defensible price, she should walk away rather than stretch to meet the asking price.