Multi-Family Valuation and Depreciation Expense

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We attended an event that had renowned author, podcaster, and 2000 plus door owner, Rod Khleif. During his presentation, he made a point of why multi-family was so exciting that caught my ear. He spoke about the valuation metric used in multi-family vs residential. Residential, as you know, is valued by comps or sales of comparable houses. But multi-family properties (over 4 units) are valued much differently. They are valued off of a cap-rate of NOI. "Wow" you say, "but what does it all mean?" It means that all other things being equal, you can purchase a multi-family property with 100 doors, raise the rent $50 per unit, and your property all of a sudden increases in value by $50 x 100 doors x 12 month / 6% cap rate or an increase in value of $1,000,000. Not bad, huh?

As they say, it all looks good on paper. Unfortunately, experience tells us that the term “all other things being equal” doesn’t really exist in the real world. So let’s dive into what isn’t held to be equal and what you can do about it.

The million dollar increase isn't really calculated on the increase in rent. It is calculated on NOI or Net Operating Income. NOI is a measure of a property's ability to generate income. NOI is calculated by taking all the revenue and subtracting out the operating expenses. Interest payments and depreciation are excluded from the calculation.

Here is an example that illustrates why they exclude interest and depreciation. Let's say you own a property with a 90% LTV or loan to value. I am interested in purchasing your property, but I will be paying cash. If I included the interest payments you have, the net income would be much lower than I would receive without any payments. Advantage me, disadvantage to you.

What we need is an apples to apples number so the buyer can evaluate alternative properties. If we just looked at the rent received, the amount we receive would likely stay the same with new ownership, but the costs to run the property may change. Take two properties with $1,000,000 annual rents. One property costs $700,000 per year to operate and the other costs $300,000 per year. Are these properties equal? Obviously not and the famous line of "it's not what you make, it's what you keep" comes to mind. Ok, so NOI is a good measure of value for property and I am value seeking individual, now what?

Here is where depreciation comes in. If you permit me, we will have to dive into the income statement to determine what is, and what isn't included in NOI. Let's start with the assumption that as a property owner, the higher NOI the more valuable the property will be.

i.e. $50,000 NOI at 6% cap rate is $833,333;

$60,000 NOI at a 6% cap rate is $1,000,000

Now that we have establish our goal of a high NOI, let's figure out what makes it go up and what makes it go down. Below is a chart to help:

+ Revenue – rents, deposits, pet rent, etc

- Operating expense - insurance, property management fees, utility expenses, property taxes, janitorial fees, snow removal and other outdoor maintenance costs, and supplies


So far this is pretty simple -- try to bring in as much money while keeping expenses down. Here’s a wrinkle. What about taxes?

It always comes down to taxes. In order to calculate your tax number we have to finish our equation:


- General and administrative expenses

- Depreciation and amortization expense

- Taxes

= Net Income

For illustrative purposes, let's assume that the G&A expenses and the depreciation expense are zero. As you know, taxes are a percentage of the income left over. If NOI is high, both the tax rate and the dollar amount are high. Conversely if NOI is low, the tax rate falls and so does the tax payment. For the purposes of this paper we are going to assume that the property owner would like to have a low tax bill. Therein lies the problem, we both want operating income to be high and low at the same time.

It is possible to increase the operating expenses in order to reduce the tax bill and sometimes this is a good strategy. If the property owner had an unusually high tax bill for the year it may make sense to pay for items in the current year that are allocated for the following year. As the math will show, however, this is not an advisable strategy for multiple years.

To illustrate this let’s change our example a little bit. For this example, we will assume our revenue/rents equal $3 and our operating expenses are $1. In order to save on taxes, we increase the operating expenses by $1.

Revenue = $3

Operating Expenses = $1

NOI = $2

Value = $2 / 6% cap rate = $33.33

Tax bill @ 28% = $0.56

Revenue = $3

Operating Expenses = $1+$1= $2

NOI = $1

Value = $1 / 6% cap rate = $16.67

Tax bill @ 28% = $0.28

There is a reason a property owner doesn’t want to use operating expenses to reduce their tax bill. For every dollar you add to operating expenses you save approximately $0.28 in taxes, but it costs you $16.67 dollars in value. This is not the best trade off and should be avoided for multiple year time periods.

For those of you who have already skipped ahead we can now return to our assumption of zero depreciation or G&A. You might be saying to yourself what if I had a really high NOI but also had really high G&A or depreciation expense? Wouldn't that solve my problem of having a really high NOI and reducing my tax payment? You would be correct. Let's look at an equation:

NOI = $1,000,000

G&A = $500,000

Depreciation = $500,000


Tax = $0.00

Value @ 6% cap rate = $16,666,667

This is a very solid solution. It keeps the NOI at its highest level and reduces the tax bill to zero. There is one more wrinkle that I want to throw in and that's the difference between G&A and depreciation. For this we need to look at the statement of cash flows. Think of the statement of cash flows as actual money in your pocket. The difference here is general and administrative expenses are cash charges, meaning you actually have to write a check for them or cash comes out of your pocket. Depreciation on the other hand is a non-cash charge, meaning it is taken off of the income statement but no cash exchanges hands.

To illustrate this I’m going to take our previous example but change it slightly. In example one we’re going to shift 100% of the expenses into general and administrative. In example two we will shift 100% of the expenses into depreciation. Let’s see what that looks like on the income statement first:

Example 1)

NOI = $1,000,000

G&A = $1,000,000

Depreciation = $0.00


Tax = $0.00

Value @ 6% cap rate = $16,666,667

Example 2)

NOI = $1,000,000

G&A = $0.00

Depreciation = $1,000,000


Tax = $0.00

Value @ 6% cap rate = $16,666,667

As you can see from our two examples, both the value of our property and our tax bill are identical. It’s not until we look into our wallet or checking account do we see the huge difference.

In the statement of cash flows, we start again with revenue. Assuming for our example that all revenue was collected, we then subtract the operating expenses. After that, we subtract the general and administrative expenses. Those are all of the actual cash charges that we have spent for this time period.

Remember depreciation is a non-cash charge, meaning we keep the money in our bank account. So, let's look at the statement of cash flows to see what the differences are between having your expenses in general and administrative or depreciation. For our examples revenue and operating expenses are equal so we will start at NOI. To illustrate the point even more, we are going to add a starting balance of the business checking account and an ending balance.

Example 1

Starting balance: $25,000

NOI = $1,000,000

G&A = $1,000,000

Cash Flow for the Period = $0.00

Ending Balance: $25,000

Example 2

Starting balance: $25,000

NOI = $1,000,000

G&A = $0.00

Cash Flow for the Period = $1,000,000

Ending Balance: $1,025,000

You don’t have to be a CPA to understand that having an ending balance of $1,025,000 is better than an ending balance of $25,000. This is the power of the non-cash charge.

To recap, what are the actionable items that an investor in multi-family properties can take to raise value and reduce their tax bill? A property owner wants to raise revenue, either through increasing rent or increasing occupancy. They want to lower operating expenses through improved management and bulk supplies. Also lowering G&A and raising depreciation will be excluded from the calculation of value but can lower the tax bill.

Management can work on the first three, but you cannot increase depreciation without capital investments. Depreciation rates are set by the IRS and cannot be arbitrarily changed. Because you own property there is a way to increase your depreciation expense without increasing your depreciation amount. It is called accelerated depreciation through cost segregation.

Cost segregation is the process of identifying, quantifying, and allocating assets of a property to create a faster depreciation schedule. Although there is a lot more to discuss about the details of cost segregation, we will leave that for another post.

General & Admin are normal operating expenses. They come above the line thus reducing NOI. Depreciation only affects income tax and is never used to value a property.