Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
One of the most common questions our students and clients ask is, “How do I know what I should pay for an apartment building?” The answer to this question is one of the most consequential decisions a multifamily investor can make. A property could be perfect in every way, but if an investor pays too much, it can be difficult to achieve the desired return.
Fortunately, the valuation calculation is fairly simple, even if the intuition behind it is a bit more complex. I coach students on the income capitalization approach, which focuses on two numbers: the net operating income (NOI) and the capitalization rate (cap rate).
What Is Net Operating Income?
Whereas residential properties are valued based on comparable sales, commercial properties are valued based on the amount of NOI they produce. NOI is calculated by subtracting a property’s operating expenses from its gross income. To make sense of this equation, it can be helpful to dig into each component of it.
Gross income is the sum of all sources of income for a commercial multifamily property. While the vast majority comes from rent payments, there could also be ancillary sources of income like pet rent, application fees, parking rent, storage unit rent or laundry/vending income.
Operating expenses are the costs required to run a property on a day-to-day basis. Although the amounts vary by property, the line items are typically the same. They include things like taxes, insurance, utilities, maintenance, property management, legal and admin.
Income and expense projections are plugged into a financial pro forma for an estimated holding period and the resulting net operating income is the first key input in the valuation equation.
What Is The Cap Rate?
By definition, the cap rate is the rate of return that an investor could expect if they purchase the property with cash. The formula used to calculate it is NOI divided by property value. But, the issue with this equation when trying to decide on a purchase price is that the value is not known. So, more often than not, the cap rate needs to be estimated.
To come up with an accurate estimate, it is necessary to review the recent sales of comparable properties and to calculate their cap rate based on the NOI at the time of sale and the sales price. Next, these cap rates must be compared to the target property and current market conditions to determine the appropriate value to apply. Cap rates are driven by many factors, all of which are associated with the perceived risk in acquiring the property. If the property has more risk, the cap rate may be adjusted higher. Or, conversely, if the property is deemed to have less risk than the market, the cap rate could be adjusted lower.
Once the entry cap rate is decided, the property’s value can be determined by dividing NOI by the chosen cap rate.
Property Valuation Example
Let’s look at an example to illustrate how this works.
Suppose an investor is considering the purchase of a 50-unit multifamily property. They have reviewed the historical financial statements, created their own pro forma and documented the cap rates for recent sales of comparable properties. As a result, they have determined that the target property has an estimated stabilized net operating income of $250,000 and the selected cap rate is 7%. With these inputs, the property’s estimated value is $3.57 million ($250,000 / 7%).
At this price, the investor could expect to earn 7% annually on a cash purchase of the property. In reality, they will likely finance at least some portion of the purchase with debt, which will boost their return even higher.
Benefits And Risks To Using This Valuation Technique
The primary benefit of using the income capitalization approach to calculate value is that it is quick and easy and the inputs are widely available.
However, the downside is that this approach relies on estimates and assumptions about things like average rental rates, occupancy and income/expense growth. Herein lies one of the risks of commercial real estate investment. There is no guarantee that the valuation estimates will come to pass and the actual performance of the property could be materially different (better or worse). It is an inexact science, but the implications of getting it wrong can be very expensive.
For this reason, I recommend two things when trying to figure out a purchase price. First, it is important to acknowledge that the valuation of a multifamily asset is an estimate that can vary based on the biases of the individual performing the analysis. Some investors may take a more optimistic position, while others may see risks that aren’t readily apparent. There is no “right” answer, but there is one that is supported by data and one that is not.
Second, I always encourage students to consider a range of valuations (purchase prices) and the returns that result from them. These ranges should include a base case scenario, which is what they consider to be the most likely outcome, and best/worst-case scenarios. This way, potential investors have a better feel for how the price paid to acquire a property can ultimately impact the returns achieved.