By Tom Bukacek
The author has permitted the reprinting and redistribution of this article.
Have you ever driven past a large, beautiful apartment complex and thought “If I owned that, I’d be rich. I’d never have to work again! And then a couple of seconds later thought I’ll never be able to do that. I don’t know how and it takes too much money.” Owning an apartment complex is not as difficult as it may seem. Like any other discipline, successful investing in multi-family dwellings can be learned and private capital can be raised to acquire these units if you have the proper education. The purpose of this article is to provide you with the understanding of the basics of multi-family valuation, what capitalization rate is, and how increasing revenue or decreasing expenses can create massive amounts of equity.
The truth is that an investor will overpay for any property if he or she does not know how to establish proper value. In a single family unit, paying an extra $10,000 for a property may cause you to take a small loss but you can still recover. If you overpay for a 60 unit apartment complex, you may not be able to achieve a profitable cash flow, and this mistake can end the career of a new investor. Therefore, understanding how to determine the value of an apartment complex, and how to positively impact that value, will lead to great profits.
Determining value for apartments is different from determining value for single family units (SFU). SFU’s values are determined by comparables of like sized units with similar amenities within a close proximity. A 3 bed 2 bath house with a 2 car garage and a swimming pool with a total of 1500 sf in a neighborhood will most likely sell for the same price as the identical house within that neighborhood. However, a 30 unit apartment complex will not sell for the same price as another 30 unit apartment complex. What is the biggest difference With apartment complexes, you are not buying based on the square footage as much as you are buying based on the revenue stream the property is producing.
In order to understand how to analyze the revenue stream, it is important to the basics of value determination. The following are the basics for multi-family valuation
- Income- all revenue generated from the property
- Expenses- all expenses other than debt service & capital expenditures
- NOI- Net Operating Income (Income minus expenses)
- Debt Service- Mortgage
- CADS- Cash After Debt Service (NOI minus Mortgage)
The most important item listed above is NOI. The goal of any successful apartment owner is to impact the NOI buy increasing revenue andor decreasing expenses. The higher the NOI, the more Cash After Debt Service is available.
Also, the NOI impacts the value of a property, as the value is determined by the revenue stream through the Capitalization (cap) rate. The average cap rate in an area details the ratio of NOI to its price. To better understand the cap rate, it is important to understand its equation
Cap rate = Net Operating Income Price.
For example, if the NOI=$100k and the price=$1,000,000, the cap rate would be ($100,000 $1,000,000) =10%.
A simple way to look at the cap rate is as a return on investment. If your cap rate is higher than the average cap rate in the area, then you may make the assumptions that your return is greater because more risks are involved in owning the property. Specifically, the property may be older and not in as good condition. Therefore, rents may be lower and since more repairs and maintenance can be expected, expenses will be higher. Therefore, if you have a higher cap rate, there is more risk so it will be less of an investment to purchase the revenue stream.
Conversely, if your cap rate is lower than average in the area, then you may make the assumptions that your return is less because there are fewer risks involved in owning the property. Specifically, the property may be newer and in good condition. Therefore, rents will be higher and since less repairs and maintenance can be expected from a newer facility, expenses will be lower. Therefore, if you have a lower cap rate, there is less risk involved so it will be a greater investment to purchase the revenue stream.
Generally speaking, there are four classes of property for apartments (A, B, C, or D) that will help determine the Cap Rate you use
- Class A- Built within the past 10 years or so; good quality renters with good jobs; very little maintenance repair issues. General Cap Rate range will be between 5-7%.
- Class B- Built within the past 20 years or so; tenants mix of white and blue collar and has some deferred maint repairs. General Cap Rate range will be between 7-9%.
- Class C- Built within past 30 years or so; tenants mix of mainly blue collar workers & subsidized housing and has maint repairs. Tenants may be renters for life. General Cap Rate range will be between 10-12%
- Class D- Built 30 years plus, usually found in ‘bad’ areas filled with bad tenants. If ‘D’s are in a ‘C’ or ‘B’ area, you may reposition to higher Cap Rate. General Cap Rate range will be 12% or more.
Again, these class valuations are rules of thumbs only. You may have a 40 year old apartment complex that has been repositioned, or fixed up, and is in Class B condition. But for valuation purposes, the above information will assist you in proper value determination.
If the equation for Cap Rate is Net Operating Income divided by Price, then the equation for price, or value, must be NOI CAP. For example, if the NOI=$100k and CAP = 10%, then the value, or price=$1,000,000.
Therefore, the cap rate has a significant impact on price. The lower the cap rate, the higher the price as illustrated below
EX If the cap rate is 12%, then $100,000 .12= $833,333 value. This equation means that if you want to purchase the revenue stream of $100,000 in this older building, the cost of acquisition would be $833,333. If the cap rate is 6%, then $100,000 .06= $1,666,667 value, which means you would need to pay significantly more to acquire the same revenue stream.
Obviously, when determining value, the two items you are required to accurately calculate is the cap rate and the NOI. The following are 8 helpful steps to assist you in properly determining the value of an apartment complex
1) Log onto your county’s property appraiser or assessor’s web site to obtain the tax assessed value of the property under consideration
2) Search your county’s property tax rolls for recent sales of 3-5 properties that are comparable in size, amenities, and features and located within 2 miles of the property under consideration
3) Analyze any comparable properties that you find, and make sale price adjustments for differences in amenities, special features, and the property’s physical condition.
4) Verify the income and expenses that are listed on the income and expense statement of the property under consideration to ensure that the NOI is accurate
5) Analyze the property’s income and expenses for the past 12 months to estimate it’s NOI POTENTIAL
6) Calculate the property’s CAP rate by dividing it potential operating income by the estimated value that you derived from analyzing recent sales of comparable properties in Step 3.
7) Estimate the property’s value by multiplying its NOI by the Cap rate you came up with for the property
8) Calculate the cost of replacing the improvements on the property using the same building materials and method of construction
Now that we understand how to properly determine the value of an apartment complex, what can we do to increase the value Remember, the equation for value, or price, is NOI CAP. Therefore, if we increase the NOI, we will increase the value of the property. The NOI is impacted by increases in revenue and decreases in expenses, so if we are able to impact either of those equations, we will increase value.
The following is an example of an apartment complex
Asking Price – $1,000,000 AREA CAP -8% UNIT 34
- Income- $180,000
- Expenses – $86,000
- NOI- $94,000
- Value= (NOI Cap) $94,000.08=$1,175,000
- Debt Service – $70,000
- Cash After Debt Service = $24,000
Based on the $2000 per month cash flow and the $175,000 of equity in the apartment, this property would qualify for an offer. The next step is to perform due diligence in order to determine if I can increase the revenue or decrease the expenses for this property.
Upon performing due diligence on this property, I found that the occupancy rate was 100%. This high rate means that the rents are too low. By raising rents only $25 per month, I would increase revenues by ($2534=) $850 per month, or just over $10,000 per year. How would $10,000 of increased revenue improve the value of my property
Ex $10,000 .08 = $125,000 ($10k was the increase in my NOI Cap rate). So by increasing rents only $25 per unit per month, I am able to add $125,000 of value to my property!
Upon performing further due diligence on this property, I found that the owner was paying about $4500 per year for cable and about $12,500 per year in water. Both of these costs could be transferred to the tenants, which would cause an increase in their costs of about $41 per month (not too unreasonable). How would passing $17,000 of expenses along to my tenants improve the value of my property
Ex $17,000 .08 = $212,500 ($17,000 was the increase in my NOI Cap rate). Suppose I could add $61 of expense to my tenants immediately and not lose more than 2 or 3 tenants. The following would be my new financials
- Income- $190,000
- Expenses – $69,000
- NOI- $121,000
- Debt Service- $70,000
- CADS- $51,000 (More than $4k per month!)
- Value= $121,000.08=$1,512,500
- Purchase price = $1,000,000
- Equity = $512,500
If you sold the property for what it was worth, you would make a pre-tax profit of $512,500. If you decided to refinance the property to pull cash out, you could do so and keep the money without paying taxes.
But what if you decided to reinvest in another apartment complex With a 1031 exchange (see your accountant to find out all the rules), you could reinvest that $512,500 into an apartment complex worth $5,125,000. What kind of cash flow could you bring in on a $5 million dollar apartment complex
In summary, this article provided you with the basics of understanding how to determine the value of apartment complexes, which is NOI Price. This article also explained how to determine value. Finally, it used an example of how adding income or reducing expenses to an apartment complex could drastically increase the overall value of an apartment complex. By further educating yourself on this strategy, you can drastically increase the monthly amount of passive income that you receive in addition to increasing your net worth. With this information, what type of legacy could you create for your family
Tom Bukacek is a real estate investor currently residing in Austin, TX. In addition to investing, Tom also has a passion for educating others on how to become successful investors as well. For more information on how to get started in multi-family units, visit Tom’s website at httpwww.austinmillionaireblueprint.com.
If you would like to take advantage of the market and learn how to invest in real estate and you are local to the Dallas Fort Worth area, I know a really great teacher and mentor here in Arlington Texas. Please take a look at his web site: DennisJHenson.com, Dennis has a great Mentoring and training program, I know because I am one of his former students. I learned a lot from his one on one teaching technique. – Michael Harman 817-457-7572 email@example.com