Red Flags in Valuing Unit Blocks

Learn about the key red flags to watch for when valuing unit blocks, including rent levels, rent growth, exit cap rates, and replacement costs. Avoid costly mistakes by understanding these crucial factors in property investment

Andy Crebar

Founder

Founder of Yura Capital, which helps technology and finance professionals build their wealth in bigger, higher-quality real estate assets.

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There are about 20,000 unit blocks in Australia, with 300 sold each year.

Even though they are one of the best risk-adjusted investment vehicles in Australia, there are still many red flags that investors should be wary of when evaluating them.

Identifying these red flags can save you a lot of time and money.

This article covers the four biggest ones to be aware of—rent levels, rent growth, exit cap rates, and replacement costs.

Visual summary of red flags in property valuation, highlighting rent levels, rent growth, exit cap rate, and replacement cost - Yura Capital

#1. Rent Levels

Even small changes in rent levels can have large implications on an investment’s projected returns.

Rental comparables (rental comps) estimate a property's rental returns based on similar properties nearby. Factors such as property size, condition, location, and amenities are considered.

For example, to find the market rent for a two-bedroom apartment in Sydney, you would compare it with other two-bedroom apartments in the area.

Table showing rental comps for one and two-bedroom properties with details on year built, distance, square meters, rent, and rent per square foot - Yura Capital

Why are rental comps important?

Accurate Pricing: Using rental comps ensures your property is priced competitively, helping to attract and retain tenants, reducing vacancy periods and maintaining steady cash flow.
Market Trends: Rental comps reveal local market trends, allowing you to adjust rental rates and strategies accordingly to stay competitive.
Investment Decisions: Rental comps assist in making informed investment decisions by assessing potential rental income and property value appreciation.

Investors should be aware of when existing or pro-forma rents are above comparable rates without having higher quality amenities or benefits.

Lastly, while rental comps provide a useful guide, they aren't exact, as market conditions and data quality can vary.

#2. Rent Growth

Different markets will experience different levels of rent growth, plus market rent growth can be quite volatile from one year to the next.

A market experiencing outsized growth for a prolonged period will attract developers, and the new supply deliveries should bring the market back to equilibrium.

SQM data can be helpful for this, providing data on a postcode by postcode basis.

Below is the aggregate Sydney data for 2010 - 2024.

Graph showing weekly rents in Sydney from 2010 to 2024, tracking rent trends for all houses, 3-bed houses, all units, and 2-bed units - Yura Capital

If an investor is chasing rental growth in their investment, they should ensure growth rates are supported through either market growth or unit upgrades.

When investing in a newer property, there isn't much room for physical upgrades.

This means the real opportunity lies in improving the asset, enhancing management, optimising leasing, and improving operational performance. This is where value can truly be added to all properties.

#3. Exit Cap Rate

It is common practice for sophisticated investors to underwrite cap rate expansion, meaning the projected ‘exit cap’ rate should be greater than the investment’s purchase price cap rate (referred to as ‘going-in’ cap rate).

While this adjustment conflicts with long-term trends in average cap rates, it accounts for several uncertainties, including:

Declining demand for certain property types or asset classes
Future capital expenditures not included in the pro forma
Property ageing
Rising interest rates
Changes in market fundamentals

Cap rate assumptions can have significant influences on valuations.

Let's look at the expected exit valuation of a unit block investment with Net Operating Income of $1m.

At a 4% exit cap rate, the building is valued at $25,000,000
At a 6% exit cap rate, the building is valued at $17,000,000
At an 8% exit cap rate, the building is valued at $12,000,000

Chart illustrating how $1M Net Operating Income results in different property valuations at 4%, 6%, and 8% cap rates for unit blocks - Yura Capital

#4. Replacement Cost

When acquiring an existing property, it's important to understand the replacement cost of other housing that could compete with the unit block.

Replacement Cost is the expected cost to reconstruct a property at current prices for materials, labour, and other factors.

Due to inflation, this is always increasing meaning it typically becomes more expensive each year to build from scratch.

Buying above replacement cost is synonymous with overpaying, as developers can build a new property to the same specifications at a lower cost.

Land values are publicly available, and typically account for 55% of total purchase price of a unit block value.

Below is the data for all unit blocks traded in Greater Sydney from 2022 to 2024.

Bar chart showing replacement cost data for unit blocks in Greater Sydney from 2022 to 2024, crucial for assessing property valuation - Yura Capital

By taking a closer look at the residual building values compared to the actual components, investors can get a better understanding of how the valuation compares to rebuilding it from scratch.

Conclusion

Investing in unit blocks is not for new investors, and takes a mix of patience, diligence and attention to detail. We hope this guide has highlighted the key red flags to watch out for.

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