As we have discussed before, apartment buildings are valued based on a number of factors, but arguably one of the most important is the current income the property generates.
Current income is a factor when using a Gross Rent Multiplier to value a building. Areas trade at certain multipliers, so if the gross income of a property increases the builidings value increases at that multiple.
In rent control areas owners are only permitted to raise rents to market rates when a tenant moves out or is evicted by just cause.
Because of this, rent-control ordinances create situations where buildings have long-term tenants that pay way below market rates for their units. This is what we call rental upside potential. Upside potential can be difficult and/or nearly impossible to capitalize on but when it happens it is a big game changer.
One great example of this comes from a building in Santa Monica where a long-term tenant was paying $1,400/mo. for a 3 bed + 3 bath unit overlooking the mountains. The tenant moved out of state to be closer to family so the unit was turned over and then rented for $5,100/mo.! That is a difference of $3,700/mo. just on that one unit.
So how did that effect the value of the building? Let's look at the valuation based on GRM. (For purposes of this example let's say SM buildings trade at an 18 GRM)
Old Rent ($1,400/mo. x 12 months = $16,800 in Gross Rent) x 18 GRM = Unit Value of $302,400
New Rent ($5,100/mo. x 12 months = $61,200 in Gross Rent) x 18 GRM = Unit Value of $1,101,600
The value of that one unit went up by nearly $800K based on the new rent and what that did to the overall Gross Income of the building. Now we understand why owners are willing to pay so much in "Cash for Keys" in situations where low paying tenants are so far below market rates!