Purchase price = Net annual income / cap rate.
You determine the cape rate you need to do the deal - it is not derived in this formula. If you are okay with a 4% cap, the price will be higher. If you need a 10% cap, it will be lower.
Originally posted by @Kevin Im:
please correct me if I am wrong here. I like to look at unlevered cash flow the property will produce and use gordon growth model to come up with a NPV, which is the intrinsic value today. The discount rate I use is cap rate plus my premium. This is similar to stock valuation - my background - method and would like to know if anyone in real estate uses this method to value.
Its very similar. Discount rate-Growth Rate. =Cap Rate.
I’m not sure if a discounted cash flow analysis would really be needed for a 28-unit multi family property. Unless there will be changes in the income stream over the projected holding period I.e. large upside upon unit turn over, value add, etc... DCF Analysis is more for large retail or office where you have tenants turning over and lease-up assumptions, broker commission etc...
The income approach would be the best with secondary support from the sales comparison approach. The income approach is exactly how the other posters about describe it. @Ethan Wagner describes it perfectly. Just to expand on what the previous posters suggest. I’d also pull comps on similar apartment building sales in the area. At least 5 or 6 buildings, similar unit counts and layouts. They may even have some financial data that you can extract a market derived cap rate from. See if the value you come up with when doing the income approach falls within the range of the comparable sales. You can use this as a check to see if your paying more than other investors did on a price per unit or square foot basis. Also, if you can obtain the financials from the comps see what they are yielding in terms of net operating income per square foot and per unit and how your subject compares. Is it higher or lower and why. Do the comparables have larger units 2 - 3 bedrooms and your subject is compromised of 1-bedroom units.
Good luck !
@Kevin K. Thanks for those tips. Maybe a naive question but how might you go about this suggestion... "Also, if you can obtain the financials from the comps see what they are yielding in terms of net operating income per square foot and per unit and how your subject compares."
Sometimes the previous sales will have the data either included in the previous listing or a separate PDF attachment. You can attempt to contact the previous broker (let him know your in the market), and see if he can forward you the information.
@Immanuel Sibero well said in regards to the difference between "property cap rate" and "market cap rate." Thank you for your contribution. Great Discussion
@Immanuel Sibero - I agree more with @Rob Dahlager on this one. The question that I have for you: why should I limit myself to the Cap Rate of everyone else in the area in order to make my offer? What if the seller is desperate and would have sold for less? What if I don't want an "average" deal and want a great deal?
If I use your model, I will always get just an average deal by the definition of using the average cap rate for the area.
In my opinion, almost every property can be a great deal for me. What I mean:
If I have my own goals: say a certain cash flow per month per door, or a certain cap rate, or whatever my goal may be - I can potentially make any property fit that goal. So in the calculation, I have income and expenses:
- Charge for storage / parking
- Utility Bills
- Savings percentages (CapEx savings, Maintenance savings, Vacancy savings, PM savings)
Out of these, I have control over a limited number of options: I can raise / lower rent to increase income, or I can reduce my mortgage payment. The Bills can be split or improved, but that's more of a Value-Add opportunity.
So if my goal is cash flow, my model will be (assuming all numbers as monthly):
Cash Flow = Income - (Expenses)
Cash Flow = (Rent + Other) - (Bills + Mortgage + Insurance + Savings)
So back to my statement: Every Property can be a great deal for me. I have control over the Income and the Mortgage as the easiest variables during a deal. In theory, I can lower the mortgage payment to A Number that will provide the cash flow that I need for this to be a great deal for me. Whether the seller will agree to that number? I don't know, but why should I make an offer based on someone else's goal (market Cap) when I can make an offer based on what the property is worth to me. The key is that I'm making the offer on the property, so I will never offer more than what it's worth to me in my portfolio.
With that in mind, my offer is an algebraic formula (from above)
Cash Flow = (Rent + Other) - (Bills + Mortgage + Insurance + Savings)
Cash Flow + Mortgage = (Rent + Other) - (Bills + Insurance + Savings)
Mortgage = (Rent + Other) - (Bills + Insurance + Savings) - Cash Flow
If Mortgage Payment = L[c(1 + c)n]/[(1 + c)n - 1], L = Loan Amount, c = Monthly Interest Rate (divide interest rate by 12), n = Length of Loan (months)
My offer amount would be:
Offer = [(Rent + Other) - (Bills + Insurance + Savings) - Cash Flow] / [c(1 + c)n]/[(1 + c)n - 1]
Is it pretty? Not really. I could have simplified the equation to make it easier to read, but my math teachers always told me to show my work. Why only "almost every"? There's always exceptions: a piece of land is harder to value because of future income potential. You could take a building and change its function (school into apartments). This rule doesn't fit everything, but it fits almost everything that a new purchaser will be looking at.
"Can't I just decrease my expenses?" Sure, if you want to cheat yourself. I will always be an advocate of setting aside the percentage expenses (CapEx, Maintenance, PM, Vacancy). If you don't save for Capital Expenses or Maintenance, you will end up paying out-of-pocket at some point. If you manage yourself, isn't your time worthy of being paid? What happens if you pass management on at some point - you may as well calculate it as an expense initially. Vacancy is based on market average or personal experience - buy you'll always have some month where you experience a vacancy - add that expense into your calculations.
A lot of my deals will get rejected, and I'm alright with that. I'll always offer what the property is worth to me, and sometimes I win sometimes I lose. Either way, I'll go through this exercise and determine what I think the property is worth - I don't base my offer on the market average.
TL;DR - This was a long read. The underlying point: make an offer based on what the property is worth to you. Don't make an offer based on the average market Cap Rate.
Thank you for sharing some of the detail steps and calculations that you go through. I'm always interested in the different ways investors perform their DD and underwriting.
It may not obvious but I'm actually in agreement with you. One one of my posts, I was merely saying that the market always sets a certain price that it is willing to pay at any given time. It is important to identify this price and you find it by figuring out the market cap rate. Now, I didn't say this is what my offer would be. I did say I would still have to go through my DD and underwriting to get to the price I'm willing to offer (and these days, it's always a lot less). So it is the same process you go through... my underwriting would set what the asset is worth to ME.
In another post, I was also talking about the difference between "property cap rate" and "market cap rate" which is along the same line as what we're talking about here. In this case the property cap rate reflects MY my valuation, and the market cap rate reflects my competing investors' valuation. As you pointed out, many times my property cap rate is higher and I get rejected.
So I do have my own internal valuation, I was just pointing out the market valuation which is the OP's question.
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