thePrivateMarket.com

As the “apartment guy” in our real estate office,  I field a lot of questions about income properties from residential agents.  The most common question is “how do I value this building?”  The agents are all very accomplished at running values using comparable sales for single family houses, and even duplexes.  But when the valuation needs to be determined from income rather than sales comps, they ask for help and advice.   Obviously there are several objective and subjective factors that determine the value of income property – location, condition, stability, unit mix,  potential, etc.  But here’s the 2 minute “quick check method”  I teach them for running rough numbers to determine if a project is worth further research or investigation:

1. Multiply the number of units by the monthly rent (e.g. 4 units at $300/month each) = $1,200
2. Multiply by 12 to determine annual Gross Potential Income (total monthly rents x 12 months) = $14,400
3. Deduct from the GPI an estimated expense structure (I use 30% as an average, so $14,400 x .7) = $10,080 NOI
4. This number is the Net Operating Income (explanation below) Divide the NOI by the capitalization rate to get the building’s value (10,080/.08) = $126,000 is the value of the example building  “at a 8 Cap” rate.

Simple Cap Rate Calculation

That valuation should take you less than two minutes to calculate, but you should strive to learn and know the reasons behind the determination of certain inputs.  How and why I use 30% expense structure and 8 capitalization rate is subjective based on certain assumptions and factors about the building.  These numbers affect the value dramatically, so you must adjust them carefully and accordingly.  Here is further explanation of the concepts of NOI and capitalization rate.

The estimated expense structure of 30% in step 3 includes vacancy, taxes, insurance, management and repairs.  It does NOT include debt service for mortgage payments.   This is an average number, and is probably low for most buildings in any state of mismanagement.  Poorly run buildings with high vacancy rates, deferred maintenance, theft, vandalism, inefficient heating/cooling etc will have higher expense structures.  Conversely, a very well run and well kept building with utility bill backs and efficient management may run leaner than 30%.

The number determined by deducting expenses from gross income (in the example $10,080) is called the Net Operating Income, usually abbreviated as NOI.  Once you have the estimated NOI (or determined in fact with the buildings financial statements), you can determine the building’s value at different capitalization rates.  The concept of capitalization rate  based on NOI is usually the aspect of income valuation that residential agents struggle to understand.    Capitalization rate is a measure of the return of a building that does not factor in leverage (mortgage and debt service).  It would be the “return on investment” to an investor if the property was paid for in cash.  Since most investors use leverage, which affects the return tremendously, cap rate is a measurement by which to compare properties, but is rarely the actual “return on investment” to the client.

Cap rates that a building will trade for move up and down depending  on supply and demand, money markets, and other non-controllable factors.  But it is also subjective to buyer and seller in a transaction and the “quality of the investment” in the eyes of the buyer.  The higher the cap rate, the better the investment the property is for the buyer, but the lower the price is to the seller.  When talking cap rates, you must reverse your normal thinking.   Income investors want to BUY at high cap rates, but SELL at low cap rates (yes, buy high sell low!).  Cap rates on buildings can range from a low about 5 to a high of about 13 in “normal” market conditions, and as you will see the effect on the value or price is dramatic.  A well kept building with stable tenants and good management might sell at a “6 cap,”  and a run down building with dead beat tenants might sell at a 12 capitization rate.  Institutional buyers tend to purchase larger properties at lower cap rates, and independent buyers tend toward smaller properties and buy at higher capitalization rates.

Here is the reason the capitalization rate is so important to income investors.  Watch how much the value changes on our example property from a 6 cap value to a 10 cap valuation:

• $10,080/.06 =  $168,000  at 6 Cap
• $10,080/.07 =  $144,000  at 7 Cap
• $10,080/.08 =  $126,000  at 8 Cap
• $10,080/.09 =  $112,000  at 9 Cap
• $10,080/.10 =  $100,800  at 10 Cap

The opportunity you should be seeing here is twofold.  As an income property investor, if you were to find a seller willing to sell at a 10 cap on existing income and find a buyer willing to pay a 6 cap on existing income, you would have a price spread $67,200!   Now that is a flip, and you didn’t even do any remodeling!  The other method of increasing value of an income property is to improve the NOI.   Suppose you purchased the above building at a 7 cap rate for $144,000.  Over the course of a year, you were able to raise rents on the building by $100 per unit to $400 per month.  You were also able to implement a utility bill back system that lowered the utilities expenses to the owner by $300 per month.  The $100/mo income increase x 4 units is $400 per month, $4800 per year.  And the expense savings of $300 per month, $3600 per year savings translates to a total of $8,400 increase in the Net Operating Income.  If you apply the 7 cap rate to $8,400 per year ($8,400/.07) you have added $120,000 to the value of the building at the same cap rate.  Welcome to income property investing!