Come on, admit it… you’ve heard it all before. To determine what an apartment complex is worth, all you have to do is divide the Net Operating Income (NOI) by the cap rate. It’s so simple, it can even be done backwards – if you know the property value, all you have to do is multiply the value by the cap rate and you’ll now know what the NOI is. It can also be done sideways – divide the NOI by the value and you’ll get the cap rate. I know what you are thinking: “Hey Brian, this multifamily game is easy, no wonder a guy like you can be successful doing it.”
I’ll stipulate to the notion that the formula is simple, but my objective in this series of articles is to expose myths and either debunk or confirm them. So which is it? Myth or magic?
Now that you know the formula, it’s obviously magic because everyone reading this article can now give me the answer to the missing variable as long as they are given the other two known variables and a calculator. But wait… you guessed it. This is where it gets difficult.
I think that Donald Rumsfeld, the former US Secretary of Defense, said it best. “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”
Therein lies the trap in placing a value to multifamily properties or any other income-producing real estate. You are buying the income stream, and that income stream has value. But how much value? And how much is the income stream? No, I mean really… how much is the income stream? You may think you know, but you might not know. There unknown unknowns.
Consider these five key takeaways:
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5 Reasons Investors Think Multifamily is Easy to Value
Myth #1: Income is easily quantifiable.
The truth: Income is difficult to quantify.
What are the rents? How much below the quoted rate are they really charging (this is called “loss to lease”)? How much are they losing to physical vacancy now, and how much is expected in the future? If you decide to raise the rents, what will your vacancy rate be? Are there concession losses (ever seen those “first month free” banners)? What about units that aren’t rented because they are given to employees, used as a leasing office or model unit, or as storage? Those are called non-revenue units.
And let’s not forget that tenants have their own problems, and sometimes they skip out and leave you holding the bag for hundreds or even thousands of dollars in unpaid rent (it happens often enough to have its own name — Credit Losses). These are known unknowns. But you have to figure it out, and whatever you do, don’t be wrong. Self defense: estimate conservatively.
Myth #2: Calculating NOI is foolproof.
The Truth: It’s called NET Operating Income, remember?
NOI consists of two components: 1) gross income and 2) expenses. Subtract number two from number one, and you get NOI. But what about number 2? Expenses consist of many individual components, and some of them are easily forgotten. Make a list of expenses that you use consistently on every property that you analyze to make sure that you never forget to include an expense. A consistent approach to underwriting income and expenses will help keep you out of trouble.
Myth #3: To gauge your expenses, simply look at the seller’s.
The Truth: Your expenses will be different than the seller’s.
Whenever someone tells you to just take the seller’s trailing 12 month net income and divide that by the cap rate to get your value, ignore them. When you buy the property, it’s very likely that the tax assessor will re-assess the real estate and the taxes will go up. You have to account for that in your expenses. Next year’s utility bills will likely be higher than last year’s. (Has your rate ever gone down at home? I didn’t think so.)
The seller might be self-managing (which is usually a clear sign of trouble), but you being the professional that you are will hire an experienced management company, and it’ll cost you. Subtract that expense. The seller’s sister might be the on-site manager and work for minimum wage because she couldn’t get a job anywhere else, but you’ll have to pay an experienced manager, and that’ll cost you more. You get the idea; the list goes on and on.
Myth #4: I can determine my ideal cap rate.
The Truth: Cap rate is determined by the market.
OK, you finally got the income figured out. To complete the simple equation that I introduced you to in the intro of this article, you need to divide the income by the cap rate. But what’s the cap rate? If you tell me that you want a 10% cap rate, you’re missing the point. Cap rate isn’t about you. It’s about the market.
Don’t believe me? Wait until you’re a seller… I’ll bet you won’t tell me that you want to sell at a 10% cap rate! The cap rate is what other similar properties are trading for. You need solid comps and opinions from brokers and appraisers in that market who can tell you what they are seeing in the market in terms of cap rate.
More on cap rate.
Because it’s so important, I’ll give it two key takeaways. Cap rate is useful in determining your exit value. Almost every new multifamily investor wants to utilize cap rate to determine their acquisition price. Then they scream that all of the other buyers are crazy, paying too much, and they can’t find a deal. The reason that’s happening to them is professional buyers of multifamily properties use cap rate to underwrite their exit, and use cash-on-cash and IRR to underwrite their acquisition. This is a known known. How do I know? Because I’m one of those professional buyers, and that’s how I do it. By the time you’ve read this entire series of articles, you’ll know why.
Yes, I’m still under-promising and over-delivering, so here is takeaway #6.
Bonus Myth #6: There are no other metrics needed.
The truth: There is income from operations, but there is also income from gain on sale.
People tend to focus on cap rate, but cap rate only accounts for the income from operations. Think of cap rate as a two dimensional measurement in a three dimensional world. So how do you value income property properly? Internal Rate of Return (IRR) accounts for cash flow from operations and cash flow from the gain upon sale. It also accounts for the timing and direction of cash flows. Use cap rate to calculate your exit price, and then calculate the cash flow from the gain. Then calculate your cash flow each year and put all of that in a spreadsheet to calculate the IRR. The amount you can pay for the property is the price that gives you your desired IRR.
Remember, cap rate isn’t about you, but IRR is all about you.
Now that there are no known unknowns on the mathematics and supporting theory of calculating the value of an income producing property, it’s time to move on to the next myth: economy of scale. Stay tuned and read all about it next week.
Myth #1 is that multifamily is easy to value. Is it? Or isn’t it?
Let’s discuss in the comments section!