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