As part of our contributor series, Steven W. Vehmeier, Appraisal Educator Emeritus, shares his insights into appraising small income properties.
The topic of this blog is two-to-four unit residential income properties. The purpose is to address common misconceptions about appraising these unique investment properties, as well as to emphasize the important factors an appraiser must consider.
Why invest in 2-4 unit properties?
SIPIWANI is a mnemonic that describes why buyers invest in 2-4 unit properties. Breaking down the acronym:
Small
Income
Property
Investors
Want
A
Net
Income
Yes, it is all about money in the investor’s pocket at the end of the year. Residential characteristics considered in single-family properties do not always apply to 2-to-4 units. For example, unless the subject’s lot is big enough, and zoning will allow for more units to be built, the typical 2-4 unit investor would not likely pay more for an extra-large lot. In fact, an extra-large lot may be seen by investors as a negative because of the additional costs involved in maintaining it. There are other factors that are normally adjusted for in single-unit appraisals which may be of little or no consideration in appraisals of 2-4 unit properties, unless those factors impact the amount of rent a tenant would be willing to pay, or the investor’s bottom line.
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How to begin when appraising small income properties
Appraisers should begin their research by:
Establishing a Gross Rent Multiplier (GRM) very, very carefully.
Establishing the subject property’s “market rent” even more carefully.
Finding out what the major factors are that appeal to prospective tenants in the market area. (I know an area dominated by 2-4 unit properties where all three-bedroom units rent for about the same amount regardless of the size of the unit. Many other possible dominant factors can come into play.)
Confirming zoning and code compliance, and making sure that the subject can be rebuilt if destroyed.
Always accessing all the units to make sure they are in rentable condition and meet market expectations for the rents utilized in the appraisal.
Verifying the existence of leases as well as verifying the actual rents is recommended, when possible.
Considering realistic vacancy rates in the subject’s market area.
Vacancy rates require special consideration and are too often not given the scrutiny warranted. In performing reviews, I’ve typically seen a 5% vacancy rate estimate on investment properties. Most rentals begin on the first of the month. When a tenant moves out there is a period of cleaning and repairing the unit, followed by a marketing period before the unit is occupied again. So, unless it is an extremely high demand market, the vast majority of cases I’ve personally observed result in at least one month that the unit is vacant. That’s one-twelfth of the year or an 8.3% vacancy rate. Net income can be notably affected by vacancy rates of 8.3% versus 5%. For example, using a potential gross income (PGI) of $100,000, a 5% deduction for vacancy would result in a loss of $5,000 or $95,000 in income. A more realistic 8.3% deduction for vacancy would be $8,300 less, resulting in $91,700 in income.
Personal observations
Personally, after owning a number of 2-4 unit properties and managing several for others over the years, I can attest that it’s all about net income. One could argue that a calculation of net operating income (NOI) would be warranted. If the investment makes little profit, or even loses money, who wants it? After discussing this in my live 2-to-4 unit appraisal courses and showing the class a sample PGI to NOI calculation form, virtually every student wanted a copy.
Many times, there are too few sales of truly compatible rental properties for statistically reliable calculations for sales comparison approach adjustments to the comparables for their differences with the subject property. Unless rents are impacted, these factors seldom have an impact on the price an investor will pay for a 2-to-4 unit property. What does the typical investor for this type of property look for when purchasing? When I was a real estate broker, I never heard anyone say, “I want to look at 2-4 unit properties that are between 3,000 and 4,000 square feet.” The focus was always about income and expenses, and the bottom line.
In some circumstances, the cost approach can be particularly effective when appropriately zoned vacant land is available nearby. In other cases, the typical investor may not be considering building new, thus developing the cost approach might not reflect the market’s considerations. Often, market area boundaries must be expanded miles beyond traditional neighborhoods to find sales of truly compatible properties. In most cases, the investor cares about the bottom line dollars, and the location is often of little or no importance.
Importance of proper training
It is often the case that new appraisers enter the profession without thorough training on appraising 2-4 unit properties. Unfortunately, some appraisers become form-fillers, letting the form guide the appraisal process rather than performing the appraisal and only using the form to communicate their results.
There are some excellent textbooks on this topic as well as courses that provide detailed guidance helping both the new and experienced appraiser with these unique appraisal assignments.
Learn more in our CE course, The Income Approach: An Overview.
Written by Steven W. Vehmeier, Appraisal Educator Emeritus. Steve retired from his appraisal and appraisal education practices after a long career specializing in writing and teaching pre-license and continuing education courses, including twenty-two years doing so for McKissock. He continues to write articles and blogs to share his knowledge and experience.
