Most consumers do not grasp the difference between the price and the value of a product or service. Price is simply the amount of money paid or charged for something. When we focus on price, we are focusing on the short-term acquisition of a product. Value, on the other hand, focuses on the long-term aspect of the purchase.
Price is what a buyer spends, and value is what they receive in the transaction. When a buyer has received more value from a product than what they spent, this purchase is viewed as possessing great value. If a buyer values your product and can find a solution to his problem with your product more than he values his money, then he will purchase your product. People who focus on cost focus on the total cost of ownership, but people who focus on value focus on the total picture and how the product will create a solution.
Now, how can we compute value in real estate and specifically multifamily real estate? There are basically three methods of calculating real estate value: the cost approach, the sales approach, and the income approach. The sales approach is widely used in valuing single family homes, and the cost approach is utilized for properties that have few comps and for new properties (such as a church or school). Let’s focus on the income method, which utilizes the net operating income and cap rates to determine the property’s value. This is by far the best method to analyze apartments.
Before we dive into analyzing the value of a multifamily property, I would like to discuss the term “hyperbolic discounting” and why I think a significant amount of investors shy away from investing in multis. I was introduced to this term by Gary Keller while reading the book The One Thing, and hyperbolic discounting states that the farther away a reward is, the less motivated an individual is to achieve it. If I have a choice of earning $100 in two weeks or earning $500 in 18 months, most people will choose the present reward over the future reward overwhelmingly. This impulse of instant gratification is becoming evermore popular within our society.
This may explain why strategies such as wholesaling and fix and flipping are extremely popular to investors. These strategies employ much shorter time horizons than multifamily investments. A wholesaler can earn a profit in a matter of weeks, while a multifamily investor usually needs to dedicate a much longer time horizon to execute his business plan to generate his return.
There are other challenges that investors encounter when deciding upon multifamily investments, such as lack of capital or lack of experience, but I feel that not being able to focus on the long-term dissuades many investors from multifamily investing. I sometimes wonder if our society is losing the willpower and the persistence to see things through.
If you understand the value and the various benefits that multifamily offers, the decision of delayed gratification will be a no-brainer. So what are the benefits of multifamily, and how do we determine the value?
6 Benefits of Investing in Multifamily Real Estate
Here is a list of benefits:
- Cash flow. Apartments generate monthly income, what I like to refer to as wallet money. I compare cash flow to dividends paid by stocks. The money rolls in every month.
- Control. You are the captain of your own ship. You have the ability to control every decision that affects your investment.
- Tax advantages. It’s not what you make, it’s what you keep that’s important, and real estate offers tremendous tax benefits. Why would the government create advantages for this tax class? The government realizes it does not have the ability to deliver affordable housing, and by offering these benefits, it is trying to stimulate the private sector to step in and fill the void.
- Economy of scale: This is a huge advantage when trying to scale your business. I find it much easier trying to collect rent from 30 tenants in my apartment building rather than running all across the city to collect from my single family homes. It is easier and more cost effective to have more units under one roof.
- Ability to force the appreciation: The value is not as reliant on comps as it is your ability to increase the value through growing the NOI.
- Velocity of money: This refers to the ability to refinance a property, withdraw the equity, maintain control of the asset, and invest the refinance proceeds into another property. Banks are the ideal example of “velocitizing” money. They borrow funds from their customers and lend the proceeds out to individuals looking for loans. The faster the money moves, the wealthier you become.
Multifamily Valuation: How to Calculate Value in Multifamily Investing
Now that you’ve seen the incredible benefits that the multifamily space provides, how do you calculate value? In multifamily investing, it is all about the net operating income (NOI) of the property and the fact that the investor is purchasing the property based on an income stream. Let me provide you with a few definitions:
Costs that are incurred to maintain and run a property. Some examples include trash, snow plowing, and pest control.
An expenditure for an asset that will improve or extend the useful life of an existing asset for a period to exceed one year. Some examples include water heaters, driveways, roofs and A/C units. I like to set aside $250 per unit per year in a cap ex account to address these “repairs.”
You may have to set aside a larger amount, depending upon the age and condition of the property. The cap ex figure falls below the net operating income, so it does not affect the value of the asset, but it will certainly affect your cash flow, i.e. the money you put in your pocket!
Net Operating Income
Annual income generated from a property less total operating expenses.
The rate of return on an investment property based on the income. Cap rates are specific to a market and are affected by the type of property class (A, B, C, D) you are investing in. A broker should be able to tell you the cap rate in his market.
- A Properties: Newest, shiniest asset. They contain many amenities and cater to white-collar workers. Expect low cap rates, around 2-4. This class of asset is poor at cash flowing but has the ability to appreciate greatly. I tend to think that investors choose A properties to maintain their wealth, not create it.
- B Properties: Built within the last 20 years, this class caters to a mix of white and blue-collar workers. This type of property may show a bit of deferred maintenance, but overall, it has a nice mix of cash flow and potential appreciation. Look for cap rates around 5-7.
- C Properties: My first real estate brokers defined C properties as “crap” properties, but loved their ability to generate substantial cash flow. I tend to agree with his candid analysis. These properties are usually 30+ years old and have deferred maintenance issues. Cap rates hover between 8-10 on these properties.
- D Properties: The lowest class of property. They are usually located in inner cities where it’s difficult to collect the rent and vacancy rates are high. These properties are highly management intensive, and the tenant base is often difficult to deal with. Investors get lured into investing in these properties due to the low prices, but soon realize they got more than they bargained for.
The goal is to increase the NOI by either increasing revenues or by decreasing expenses. You are trying to force the appreciation of the asset by increasing the NOI. The term that is thrown around to accomplish this task is “reposition.” When you reposition an asset, you are adding value by changing the appearance of the property or the operations of the property, all to increase the NOI. You are focusing on the value-adds to a property.
Example of a Successful Multifamily Reposition
Let me give you a quick example of a reposition on one of our assets and different types of value-adds we instituted. We purchased a property that had rents that were well below market, and many units that were vacant. Our goal was to address desperately needed deferred maintenance, while filling the vacant units.
We eventually filled all the vacant units and increased the rent rates on the current tenants from $450 per month to $625 per month. In a span of 12 months, revenue exploded from $53,000 per month to over $90,000 per month. In this example, we were able to increase the value of the property from $4.1 million to just over $6.3 million in only 12 months!
Examples of Value-Adds
Potential value-add items might include:
- Adding upscale touches, such as two-tone paint and upgraded kitchen floors
- Offering amenities, such as a fitness center or clubhouse
- Instituting Ratio Utility Billing System (RUBS)
- Changing the zoning on a property to a more favorable use
- Generating new sources of revenue, such as laundry, pet fees, late fees, application fees and storage fees
- Renovating a property to allow the owner to increase rents
- Increasing the quality of the tenant base
- Repositioning a C Property into a B property
All of the value-adds listed above need to focus on either increasing the revenue or decreasing the expenses. If you decide to install granite countertops, but you realize that this upgrade has failed to increase revenue, this would NOT be a value-add. One of the biggest mistakes investors make is to over-improve a property without focusing on the ability of the improvement to increase revenue. (I’ve done that a couple of times. OUCH!)
This is the beauty in multifamily real estate. You have the ability to increase the value of your asset by employing sound management principles to increase the NOI, thereby increasing the value.
How to Calculate Multifamily Value Using Cap Rates
Now let’s tackle how you calculate the value of a property using cap rates. You would take the NOI of a property and divide it by the cap rate.
NOI/Cap Rate = Value
For instance, if the property had an NOI of $150,000 and the cap rate was 6, the property value would be $2,500,000 (150,000/.06). If the NOI increased to $180,000, the value would increase to $3,000,000. A $30,000 increase in NOI generated a $500,000 increase in value.
Cap rates have an inverse relationship with market value. When cap rates compress, as we are witnessing in the current real estate market, the value increases — and vice versa. It’s fantastic when you own property and cap rates are falling, but a real bummer when you are trying to invest. The formula for cap rates is:
NOI/Price = Cap Rate
For example, if the property had an NOI of $50,000 and was listed for $500,000, then the cap rate would be 10 ($50,000/$500,000).
Our strategy is to purchase assets based on actual numbers. We ask the seller to provide us with the last 12 months of income and expense figures, as well as the rent roll. Once you purchase on actuals, your job is to go to work on the NOI. In life, it’s not what you buy but what you pay that is critical to the success of any investment.
My goal in this article has been to describe what “value” is, why some investors are hesitant to jump into multifamily investing, the benefits of investing in this asset class, how to analyze a multifamily property and how to implement value-adds to an investment. Remember, at the end of the day, it’s all about the income versus the expenses.
Decide now that you are ready to invest in apartments. Seek out websites, such as BiggerPockets, to begin your education. Immerse yourself in podcasts and books that focus solely on multifamily investing. Learn how to properly underwrite (another fancy word for analyze) deals.
Begin to visit websites that list multifamily properties, such as Loopnet, Costar, and Realtor.com, to become familiar with your market and the “players” in the market. Start networking with these individuals and ask them to start sending you deals to analyze. Expect to receive subpar deals in the beginning, but don’t quit. Tell them why these deals don’t work for you, and continue to analyze more deals. Formulate a business plan and strategy on how you will create value once you begin investing.
[Editor’s Note: We are republishing this article to help out our newer readers.]
Investors: Do you choose to invest in multifamily real estate? Why or why not? Any questions about the valuation process?
Leave your questions and comments below!