How to calculate NEW/Future value of apartment building?

21 Replies

I understand the NOI/Cap rate formula for valuing how much a property is worth paying for, but how does this formula work for calculating the future or NEW value of a property after 5 years of rent increases?

Since the property rents have gone up and the commercial nature of it values it based on NOI divided by the cap rate, how do you get the new cap rate to divide by when the value itself is based off the NOI/cap rate?

If I buy a 2 million dollar apartment complex with an NOI of 60K, that's a cap rate of 3% and we know the value of the building is really 2 mil.

But if after 5 years my NOI is now 120K, if I used the purchase price that I paid to calculate the cap rate, the cap rate is now at 6% so when I divide the NOI by the cap rate I'm still getting the 2 million dollar value.

Or are you supposed to use comparable sale cap rates to divide your NOI by when you go to sell?

Basically I'm trying to calculate whether I'd be better off selling 2 of my rental houses and buying 5 new houses with the equity or using it as a down payment on a 2 million dollar apartment complex. It doesn't seem that the above formula lends itself well to determining what the future value of an apartment building would be after 5 years of rent increases....

ETA: I found this article on the web that seems to agree with me that you must look at comparable sales when identifying what cap rate to use on the property when you go to sell. So in a way, commercial real estate is still driven by supply and demand pricing wise, not just NOI/Cap rate, since the demand and supply will affect the cap rate...

https://www.thebalance.com/calculating-property-value-with-capitalization-rate-2866800

@Jack B. the cap rate formula doesn't apply to rental houses an sales comps would be the best method to use.

For commercial, and as you correctly stated, to determine value you divide NOI/Cap rate.

In your example, and haven't seen many deals trade at a 3 cap, but to calculate future value you would take 120k NOI and divide by market cap rate.

You will need to make assumptions, let's assume 5 years from now the cap rate is a 4 cap so the value would be $3 million.

Make sense?

Originally posted by @Brian Adams :

@Jack B. the cap rate formula doesn't apply to rental houses an sales comps would be the best method to use.

For commercial, and as you correctly stated, to determine value you divide NOI/Cap rate.

In your example, and haven't seen many deals trade at a 3 cap, but to calculate future value you would take 120k NOI and divide by market cap rate.

You will need to make assumptions, let's assume 5 years from now the cap rate is a 4 cap so the value would be $3 million.

Make sense?

As I noted in my post, I'm trying to calculate the future value of a commercial apartment building so I can decide whether I'm  better off buying new houses or one big apartment complex. I am not using it to value single family homes.

So it does sound like that when I go to sell an apartment building, I'll have to look at market cap rates to determine the property value with the NOI/Cap Rate formula, not use the cap rate (purchase price) of the building when I bought it. How does one make an accurate assumption for property cap rates in the future? From what I've seen, as time goes on, the cap rates compress. This is due to the fact that although rents are rising, so are the property values, which thus shrinks the cap rate, thus causing the property values to go up in these scenarios. Correct?

The reason I'm going through all this is because 2 of my properties have seasoned and I'm looking at a significant extra profit if I sell them and buy 5 houses to appreciate over the next few years. The other option is to use the money to buy an apartment complex but it seems to be difficult to determine what the future value of that apartment complex would be. The one nice thing about it though is that although it's difficult to determine the future value, I'm loving the idea of 240K+ a year if I buy a couple of such complexes and raise rents over time. At that point, I'm not as worried about net worth, though net worth is always nice to be able to tap and roll into bigger and better deals, where you get the 500K cash flows and millions in equity building. I think at that point I'd retire and just do this full time. :-)

@Jack B. a cap rate of 3 is crazy low. To determine future value it depends on what Rates will be in that area in 5 years. They are likely to be higher. What seems odd to me is buying something at a 3 cap that you'll be able to double the NOI in five years. Does the property need a lot of work? If so it should trade much higher than a 3 cap. If it doesn't need a lot of work than how will you raise rents that much over five years?

@Jack B. For 5 years our projections I use a rent & expense escalator or 3% per year and then "guess" on what the Cap rate will be when we sell. Usually you sell at a lower Cap Rate when you sell. Also in that calculation you factor in vacancy and concessions to come up with your assumptions.

Then when these numbers don't work, it is not an opportunity to go after. Hope that helps.

@Jack B. As @Brian Adams you need to make some assumptions.  What are your projections as far as the increase in rent? What will be the increase or decrease in expenses? Will the market fundamentals be improving, declining, or staying the same, causing the cap rate to go down, up or stay the same?  If you can answer those questions with any certainty then you can project your future value.

In your example where your noi is $120k assuming the cap rate stayed the same, the rest is just math.

In the SFH world neighborhood comps rule the day. In commercial property values are dependent on the influence of the market on the cap rate as you stated. So let's say you are in a stagnant market, not going up or down. No matter what you do to the sfh, the value will not go up much. On CRE even if the cap rate stays the same, you can increase the value by increasing the NOI. This can be done not only by raising rents, but adding income sources (covered parking, garages, vending machines, storage lockers, furniture rentals, corporate units, student housing, premier amenities) and lowering expenses.

Not sure if your question was directly answered. If you purchase a property with a $60k NOI at a 3% cap rate, the value would be $2MM. If you increase the NOI to $120K and we assume the cap rate hasn't changed, the market value would now be $4MM. However, cap rates are determined by the market so you'll hear experienced investors talk about the cap rate for the area. If the market changes and buyers are only willing to buy your property at say a 4% cap rate, the value would now be $3MM.


As @Jeff Greenberg stated, you're going to have to make assumptions, but base it off of current cap rates, current rent trends and projected interest rates. I'd suggest being conservative on the exit cap, especially if you plan on holding the property for more than a few years. 

 You also you just look at what properties are selling per unit in the area. Comparables are important if you get the performance of a property property Extremely high. investors may not be willing to pay market cap rate  for your building if that equates to a price a lot higher than the typical per unit sales price.

It kind of sucks that I have to "guess" at the exit cap rate to calculate this...It's making me really re-think this Apartment complex thing. 

The numbers I used are just examples of what I've seen. I plan on raising rents $50 per unit, per month, each year. I estimate half of that will be profit and the other half will go to rising expenses, etc. So I estimate in 5 years I should have about 75K extra cash flow based on 50 units, on top of the cash flow I had when I bought it. (25x50x12x5)

I guess I will look at current cap rates, and assume those shrinking by 50% when I go to sell in five years (one of my single family homes did).

Originally posted by @Jack B.:

It kind of sucks that I have to "guess" at the exit cap rate to calculate this...It's making me really re-think this Apartment complex thing. 

The numbers I used are just examples of what I've seen. I plan on raising rents $50 per unit, per month, each year. I estimate half of that will be profit and the other half will go to rising expenses, etc. So I estimate in 5 years I should have about 75K extra cash flow based on 50 units, on top of the cash flow I had when I bought it. (25x50x12x5)

I guess I will look at current cap rates, and assume those shrinking by 50% when I go to sell in five years (one of my single family homes did).

Would it be a good idea to just assume the cap rate in 5 years would be half of what it is today? 

@Jack B. I hope you don't buy an apartment building with a 3% cap rate. Let's say in your example you purchased a $2 million dollar apt. complex at a 6% cap rate. Then after 5 years, your NOI has increased. You would base your new value on 6%. This is an assumption that the cap rate would stay the same, just like you are assuming that rents will be higher in 5 years. No guarantees, but you are projecting the future based on factors of today. If you actually paid a 3% cap rate now, it is not safe to assume the cap rate will stay that compressed over the next 5 years. Use a more historical cap rate that would be normal for your market and the type of property.

@Jack B. Unless the current rents are far below market, your plan to increase rents is probably unrealistic. There is a limit to how much rent people are willing/able to pay. Not to mention in 5 years, more inventory could be added to the market, which could stabilize rents. If the cap rate in your market is actually 3%, you are buying at the top of the market and in 5 years, will likely be 4 or 5%. Or you can buy in another area of the country for 6-7%.

Originally posted by @Anthony Dooley :

@Jack B. Unless the current rents are far below market, your plan to increase rents is probably unrealistic. There is a limit to how much rent people are willing/able to pay. Not to mention in 5 years, more inventory could be added to the market, which could stabilize rents. If the cap rate in your market is actually 3%, you are buying at the top of the market and in 5 years, will likely be 4 or 5%. Or you can buy in another area of the country for 6-7%.

I'm not, I was just using these numbers as examples. The properties I'm looking at are 6-8% cap rates. I'm assuming that in five years, as the values increase, the cap rates shrink, as they do when property values go up.

It sounds like what you are saying in your two posts, is to assume the cap rate stays the same when I go to sell, this way I have a "worst case" scenario and not a best case scenario that I'm basing my investment decision off of. Correct?

The area I'm looking to buy is in Las Vegas, or Nevada in general.

@Jack B. Yes, exactly correct. 5 years is not a long time. The cap rate could go down from an 8% to a 6% if you did major renovations, but the surrounding area would also affect your cap rate. If you have a C property in a B area, then the cap rate would likely drop. If it's a C property in a C area, the cap rate would likely not change even if you put high end finishes on your renovation. Public perception counts.

Originally posted by @Anthony Dooley :

@Jack B. Yes, exactly correct. 5 years is not a long time. The cap rate could go down from an 8% to a 6% if you did major renovations, but the surrounding area would also affect your cap rate. If you have a C property in a B area, then the cap rate would likely drop. If it's a C property in a C area, the cap rate would likely not change even if you put high end finishes on your renovation. Public perception counts.

OK, thanks, this gives me something to work with. You're right, this does make the most sense, assuming the cap rate stays the same, etc. when running calculations. 

@Jack B. cap rates on commercial property reflect two things. 

1) What interest rates can I get on comparable investments. Any type of commercial property is going to trade at a premium to "risk-free" investments like the 10 year treasury note. So for instance if I can get 3% a year "risk free" by buying 10 year treasuries, I would be a little nuts to buy for cash an apartment building in Seattle for that same return because there is all sorts of risk in an apartment building.

2) Supply and Demand for that Asset class. If say, all of the investors in China really wanted apartment buildings in Seattle regardless of their investment value that might skew the cap rate way down. On the other hand if Boeing, Microsoft and other big companies all moved out of Seattle and a new Volcano erupted in Washington state it might skew the cap rates of Seattle apartment buildings much higher.

By deciding on a 'future market cap rate' you are predicting the future in two ways, what interest rates will do and how the buyers and sellers in the market will react. Seems impossible right? And yet many investment sponsors and analysts do it every day by changing one value in their spreadsheet!

Originally posted by @Jeff Kehl :

@Jack B. cap rates on commercial property reflect two things. 

1) What interest rates can I get on comparable investments. Any type of commercial property is going to trade at a premium to "risk-free" investments like the 10 year treasury note. So for instance if I can get 3% a year "risk free" by buying 10 year treasuries, I would be a little nuts to buy for cash an apartment building in Seattle for that same return because there is all sorts of risk in an apartment building.

2) Supply and Demand for that Asset class. If say, all of the investors in China really wanted apartment buildings in Seattle regardless of their investment value that might skew the cap rate way down. On the other hand if Boeing, Microsoft and other big companies all moved out of Seattle and a new Volcano erupted in Washington state it might skew the cap rates of Seattle apartment buildings much higher.

By deciding on a 'future market cap rate' you are predicting the future in two ways, what interest rates will do and how the buyers and sellers in the market will react. Seems impossible right? And yet many investment sponsors and analysts do it every day by changing one value in their spreadsheet!

What single value would that be that they change if there are multiple factors that come into play? Or were you being facetious?

I would look at cap rates historically in your area for that type of property/area of town. If the mean cap rate is 5% and rates are now at 3%, I would say that the rate would eventually revert back to the mean of 5%. So 3% to me is too expensive. If you can buy it at a 6% cap rate in a 5% environment, I would say it's discounted and you are buying value. If I can buy a similar property with the same NOI in another market for 6%, I would buy it before I would buy a 3% cap property. That's just me. Cash flow on 3% after debt service is negative cash flow and I would just put it in a mutual fund and wait for the next correction.

@Jack B. In most financials I have seen for syndication deals they use an assumed 'exit cap rate'. That is essentially what they are guessing they will sell the property for in say 5 years. When you consider that the bulk of the investor's returns are made up of profits on the exit, that one number makes a huge difference. 

For instance if I were to buy and syndicate an apartment building and offered investors an IRR of 12% over a 5 year hold period that would be based on me saying that I could sell the property at say a 6-cap rate. If instead the market has changed and I can only sell it for an 8-cap the return the investors are going to get will be much lower or they potentially might lose money.

So, exit cap rate was the one number I was referring to they could change to make a big difference in the pro forma outcome. But there are several others like how much they assume rents will rise for instance.

@Jack B. keep your money out of apartments until you get more educated. Some good reading out there by Dave Lindahl (emerging markets and multifamily millions) and Ken McElroy (Rich Dad's Advisor Series: The Advanced Guide to Real Estate).  You need a stronger foundation before proceeding.  Take a deeper dive than what you info you receive via a forum post.

Happy Learning Sir!

I see experienced syndicates use sensitivity analysis to project exit values in 5 years as an example. Min 50 basis points higher at exit is what I see a lot. Buy at a 5.5 cap, exit at a 6 cap. Project out conservative assumptions in the model more to market norms and come up w/your NOI in year 5 / divide by the exit cap should be a good starting point. Now, the sensitivity analysis should show the exit value along this spectrum from a 5 cap to say a 7 cap and see what that does to your IRR and can you live w/that. Keep in mind you don't have to sell at a defined point (say 5 years). You should have more control over when to exit to get the best price at sale.

@David Thompson gave some great advice regarding the sensitivity analysis. An simpler alternative is laying out the range of best case, most likely case and worse case scenarios. Make sure the deal is still profitable in the worst case scenario. Part of the worst case scenario may be holding on to the property a little longer and exiting when the market is more favorable. 

Create Lasting Wealth Through Real Estate

Join the millions of people achieving financial freedom through the power of real estate investing

Start here