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Multifamily Valuation: How to Calculate Value in Multifamily Investing
Yesterday’s podcast we discussed the benefits which multifamily space provides. Now we’ll look at how to calculate value. In multifamily investing, it is all about the net operating income (NOI) of the property and the fact that the investor is purchasing the property based on an income stream. First we have to understand some key terms…
Operating Expenses
Costs that are incurred to maintain and run a property. Some examples include trash, snow plowing, and pest control, lawn care, elevator maintenance, pool maintenance, etc.
Capital Expenditures
An expenditure for an asset that will improve or extend the useful life of an existing asset for a period to exceed one year. Some examples include water heaters, driveways, roofs and HVAC units. Many investors budget a set amount per unit each year to cover these types of expenses.
You may have to set aside a larger amount, depending upon the age and condition of the property. The capital expenditure figure falls below the net operating income, so it does not affect the value of the asset, but it will certainly affect your cash flow, ie, the money you see in your bottom line.
Net Operating Income (NOI)
Annual income generated from a property minus the total operating expenses.
Cap Rate
The rate of return on an investment property based on the income. Cap rates are specific to a market and are affected by the type of property class (A, B, C, D) you are investing in. A broker should be able to tell you the cap rate in his market.
What is the ‘Capitalization Rate’?
The capitalization rate, often referred to as the “cap rate”, is a fundamental concept used in the world of commercial real estate. It is the rate of return on a real estate investment property based on the income that the property is expected to generate. This metric is used to estimate the investor’s potential return on his or her investment.
The capitalization rate of an investment can be calculated by dividing the property’s net operating income (NOI) by the current market value or acquisition cost of a property – expressed in the following formula:
Capitalization Rate = Net Operating Income / Current Market Value
Let’s do some math… ‘Capitalization Rate’
In the simplest of terms. the cap rate can be a useful tool when it comes to comparing similar real estate investment properties.
Let’s say that James wants to buy a investment property for $900,000 and expects that it will generate $125,000 per year after operating costs. The cap rate for this investment would be 13.89% ($125,000 / $900,000 = 0.1389 = 13.89%). As James continues to search for the right investment property, he could now use this expected cap rate to gauge the possible return generated from any comparable properties in the same price range – with all expenses considered.
The cap rate’s real world applications are much more complicated as it is only one of many factors in accessing the return on commercial real-estate property. If we build upon the example James is looking at, let us presume that he finds another property with the same net operating income as the first but with a cap rate of 7%.
It would be easy to think that James should purchase his first option based on the cap rate, right? Seems like the right move, but what if that building with the higher cap rate is an older run down apartment building with high turnover and the lower cap rate proposition is a modern office building with long-term corporate leases in a superior location?
It makes sense that the office building would have the higher appraised value due to age, possible extra amenities and the make-up of its renters.
The first option comes with added risks such as vacancy rates and possible needed renovation and updates. With the first option, you are paying less with the opportunity of a higher return because of the added risk. Just as in the world of traditional securities, the difference in return – or cap rate – can highlight a higher risk. James would have to address his risk tolerance, along with the cap rate, in making his decision.
The cap rate is a good point of origin in evaluating commercial real estate, but it is just one of many factors.
