Theory vs. Practice: Valuing Distinct Income Streams for a Single Property (A Multifamily Example)

This piece is intended as an "academic exploration" of real estate valuation theory and is not intended to serve as financial or investment advice. The concepts discussed are based on theoretical assumptions and, as noted below, are not necessarily reflective of market realities or practical outcomes.

A while back, I was reviewing a listing from a third-party broker for a smaller multifamily property. The property had a tenant profile primarily consisting of month-to-month leases (75%), alongside a few long-term leases (25%). The property also had an additional source of income in the form of coin-operated laundry facilities. ?

Strictly from an academic perspective, to arrive at the property’s current value [1], there was a good argument to be made that each segment of the property’s income stream should have been valued separately: (a) short-term leases, (b) long-term leases, and (c) ?ancillary income (coin-operated laundry).

In theory, the month-to-month tenancies presented increased vacancy risk, as those tenants had no contractual obligations encouraging long-term occupancy. [2] Consequently, this risk factor should have warranted the application of a higher cap rate relative to that collective income stream. [3]

Similar logic was applicable to the coin laundry income - as its revenue was directly tied to tenant occupancy; thus, any uptick in vacancy would likely have diminished this income stream (as noted – 75% of the tenants had an increased risk of future vacancy per their month-to-month leases).

In the end, however, the property sold at a price that suggested that the above distinctions had not been factored into its valuation (the property sold for a cap rate which was more in line with the risk-parameters of the long-term leases only).?

As I posted a few days ago – “the general theory of real estate, often enough, oversimplifies the complexities on the ground.” [4]

Thus, while the application of separate cap rates may have been the technically correct underwriting answer to arrive at the property’s current value (given our assumption that a property’s current value to a prospective buyer is based on the “here-and-now”) – there are many other factors (beyond the scope of this post) that a prospective buyer may need to consider (particularly, if they are going to be the winning bid on a property). [5]

All told, prospective buyers must often balance both (a) a detailed, risk-based valuation against (b) recognition of how the market actually functions (outside of theoretical constructs).

This article is a brief overview of a topic which contains substantially more nuance. The information in this article is for general informational purposes only and is not legal advice, a legal opinion, tax advice, accounting advice, or investment advice. You should seek the advice of legal counsel, tax representation, accounting representation, and any other such representation as necessary when acting in any capacity and shall hold the author harmless from your failure to do so or in the use of any of the information contained herein for any and all purposes. The author does not guarantee or provide warranties regarding the correctness of the information provided herein. You may not copy, reproduce, distribute, publish, display, perform, modify, transmit, or in any way exploit this content, nor may you distribute any part of this content over any network, sell or offer it for sale, or use such content to construct any kind of database without prior written permission from the author.

[1] This piece, rightly or otherwise, initially assumes that a property’s current value is based on the “here-and-now,” and not on “what-ifs” (e.g., a successfully executed “value-add” plan).

[2] On the other hand, to challenge the perspective of the above footnote, the month-to-month leases technically provided an opportunity to increase rents in the near future. However, without delving too deeply, it was unclear to me that these short-term leases (given the nature of the tenants) could have been easily converted to long-term tenancies without incurring prolonged vacancies and substantial capital expenditures (all factors which could also play into a property’s ultimate value).

[3] On a high-level, aside from dictating approximate yields assuming a cash purchase, cap rates also serve as a measure of risk. Generally, a higher cap rate is meant to compensate for a greater level of associated risk.

[4] As noted earlier, here, the initial theory would be that a buyer would only pay a current owner for a property’s current income stream and not a perspective increased future income stream (i.e., value-add potential that the current owner has done no work to achieve). Of course, if the underlying academic theory changed – so would the direction of this writing.

[5] Of course, numerous nuances and factors likely influenced the property's final sales price and valuation, such as (i) the historical occupancy of month-to-month tenancies relative to their likelihood of non-renewal, and (ii) the new owner's potential to replace these month-to-month leases with long-term leases – ?effectively converting a “high-risk” income stream into a “low-risk” one, among others. Moreover, as I previously noted, this writing leans more academic and, in practice, it is not necessarily the case that a seller would ?entertain a discussion on the nuances of each cash flow’s risk. Though, as always, much will depend on the specific circumstances.

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