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Determining the Value of an Apartment Building Investment Using Cap Rates

by Ted Karsch on March 3, 2008 · 13 comments

  

Determining the value of an apartment building investment is one of the greatest difficulties that many new commercial real estate investors face.

Apartment Building by Beatrice MMost people who invest in apartments have some experience investing in other types of real estate, typically residential homes or duplexes and triplexes. The issue that new investors face is the fact that apartment buildings are valued by different methods than residential real estate. In fact, it is usually quite easy to find the fair value of residential estate using a comparative sales approach. The comparative sales approach simply uses the existing sales prices of similar residential properties in that particular area and determines value based on an average sales price of comparable properties. This should be very straight forward.

However, commercial real estate investors and appraisers use a variety of appraisal methods to determine the fair market value of an apartment building. These new methods should not deter the new investor because once they are understood they actually will help tremendously to locate the best apartment building for acquisition.

The first unfamiliar term that a new apartment building buyer will encounter is the capitalization rate or CAP rate for short.
As the new investor is searching for an apartment building his Realtor will supply him the CAP rate of the property. The CAP rate is a measure of the income produced by an apartment building divided by the cost of the building. For example: if an apartment building is purchased for the price of $1,000,000.00 and the property produced an annual net operating income of $100,000.00 the CAP rate of the property is 10%. (Net operating income is gross rents minus expenses.)


Net Operating Income:  $100,000.00
Purchase Price:        $1,000,000.00

CAP rate =                    10%

An investor can also use the CAP rate to determine the maximum price he can pay for a property when he knows what the net operating income is.

For example, if the investor is looking at an apartment building that is seeing a net operating income of $150,000.00 and he wants to see a CAP rate of 11% he can determine the maximum purchase price as follows:


Net Operating Income:  $150,000.00
CAP Rate:               11%

Maximum purchase price:  $1,363.636.00

This simple formula to devise the capitalization rate (CAP rate) of an apartment building is limited however. The simple CAP rate assumes that the investor will be purchasing the property for cash and does not take into account the financing terms that will affect the investor’s rate of return on the building. In other words the simple CAP rate is good number to use when comparing apartment buildings as potential investments but a little bit more analysis is necessary to determine exactly what the true rate of return will be on a particular building when using financing to purchase the property.

The goal for the individual investor is to determine what the property is worth to him or her. In other words, the investor should only be concerned with paying a price for the property that allows him to realize his sought after rate of return. The best way that I have found to determine the investment value of an apartment building is to use the “Band of Equity Investment Method”. The “Band of Equity Investment Method” of determining value will tell you the maximum price that you can pay for your apartment building and still realize the rate of return that you are looking for. The greatest advantage of this valuation formula is that it takes into consideration the terms of financing that the investor is using to purchase the property. Thankfully, this method is not that complicated and it merely requires that you know some financial information about the property and the terms of the financing that you will using.

Here is how the “Band of Equity Investment Method” is figured:

Mortgage: 	Loan To Value of Mortgage  X  Mortgage Constant =  ______

Property: 	Down Payment on Property (as a percentage)  
                                 X  Desired Rate of Return   =_______

Mortgage:        80% (.80)  X  7.99% (.0799) = 0.06
    +
Equity:          20% (.20)  X  11% (.11) = 0.02
 
Cap Rate:        0.08 = 8.0%

With this new “derived” CAP rate you can now determine your maximum purchase price for any apartment building and ensure that you will be realizing at least an 11% rate of return on your investment. For example, you are out looking at 14 unit apartment building with your realtor and he tells you that the net operating is $150,000.00. You know that your bank will give you a 30 year loan at an interest rate of 7.99%. You know that you need to see at least an 11% return on your investment. You simply divide $150,000.00 by your derived CAP rate of 8% and you get the price of $1,875,000.00. You know that you can purchase the building with a 20% down payment and a 30 year loan at 7.99% and still realize a net return of 11% on your investment.

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{ 12 comments… read them below or add one }

Joshua Dorkin March 3, 2008 at 6:07 pm

This is a fantastic post, Ted! Welcome to the team. I think you’re going to help a LOT of people with your articles.

Reply

rick marnon March 4, 2008 at 6:14 am

this is a huge part of analyzing commercial real estate investments. i learned this a while back when i started looking at making a investment into an apartment building. great post for the potential invester.

Reply

Anonymous March 4, 2008 at 10:18 pm

Great post Ted. I used to buy apartment buildings in my area for an 8% to 10% cap rate, but now that our local economy has heated up they are going for 4% to 5%. NOI is the same but higher prices are up pushing the cap rates down. Now rents have to play catchup!

Reply

DrJohn March 17, 2008 at 3:42 pm

Good post!

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Chad Fisher April 4, 2008 at 10:27 pm

A great follow-up post to this would be to explore different cap rates in different US cities and why there is such variety.

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Jim April 14, 2008 at 12:44 pm

Ted:

Actually, a 7.99% interest rate on a 30-year mortgage yields a mortgage constant of 0.087968, not 0.0799 as stated in the example. The mortgage constant is derived by calculating the periodic payment to repay $1 over the specified life of the loan (in this case 30 years) at the specified interest rate (in this case 7.99%), then multiplying this monthly mortgage constant by 12 (due to 12 payments in one year). If you have an HP12C calculator, input the following (on a monthly basis) 7.99% interest rate converted to monthly figure of 0.66583%, 30 year mortgage = 360 pmts, -$1 for PV and $0 for FV. Solve for PMT, which yields 0.007330676. Then, multiply by 12 for an annual indication of the mortgage constant (0.087968). The cap rate developed using your weighted average band of investment technique would actually be 0.092, or 9.2%. Capitalizing the $150,000 by 8.0% rather than by the 9.2% rate significantly overstates the value ($1,875,000 at 8% cap vs $1,630,000 at 9.2% cap). The reason the mortgage constant is higher than the interest rate on the loan is due to the compound nature of the interest the borrower pays over the life of the loan.

Jim

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Joe March 3, 2013 at 10:51 am

Jim, thank you for the details and explanation. Joe.

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John B. July 5, 2008 at 11:14 am

Ted! Bravo to you for breaking it down financial concepts
you are my Wharton School of Finance for the day.

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eugene August 4, 2008 at 1:16 pm

See http://www.incomeanalysis.com/boi.htm for the correct Annual Mortgage Constant derivation as per Jim’s comment.

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Jeffrey D. Smith February 11, 2010 at 11:31 am

I determine the cost of financing as the Annual Mortgage Constant (AMC), the highest allowable Loan to Value ratio (LTV), and a safe Debt Coverage Ratio (DCR).

Lenders are tightening their guidelines and requiring the Debt Yield (DY) to be at least 11.5%, some as high as 15%. The DY is the NOI divided by the loan amount, which I call the Present Value (PV). The PV is simply the value times the LTV ratio.

Rather than trying to squeeze financing into a purchase price, I calculate the Maximum Allowable Offer (MAO) according to the derived Capitalization Rate (CAP). I calculate the required CAP rate from the structure and cost of financing.

Debt Yield: DY = DCR * AMC
Cap Rate: CAP = DY * LTV
Maximum Allowable Offer: MAO = NOI / CAP
Return on Equity: ROE = (DCR-1)*AMC*LTV/(1-LTV)
Debt Coverage Margin: DCM = 1/DCR
Cash Flow Margin: CFM = 1-DCM
Leverage to Yield: LTY = ROE/CAP = CFM/(1-LTV)

Real estate is a borrowed money business. The value of income property is determined by the structure and cost of financing that is available to the buyer at the time of purchase. The current value has no correlation to what the seller originally paid for the property or the current debt on the property.

Two cents worth. Your mileage may vary.

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Gayla Huerta May 5, 2012 at 4:41 pm

Who do I contact for newly available $4.7mil 73 unit apt complex next to UTPA University Texas Pan American? (Gated, surveillance, no vacancies, good CF & NOI)
Any directional info appreciated. Gayla

Reply

William Turner October 16, 2013 at 4:22 am

Debt Yield: DY = DCR * AMC

How do you determine your AMC#?

Reply

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