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How much is an apartment building worth?

This is the Income Approach. It is also one of the most widely misunderstood valuations by small investors, especially new ones.

As you get further along in real estate investing, you will likely be tempted to look at some multi family units.  It’s normal, and for someone who is buying and holding for the long term there are many advantages that I won’t get into here.  If you contact me directly in the comments section below, I will be happy to connect with you so we can talk about it.

Income property most often is not valued by comps (although an appraiser is often still involved in certain types of loans.) Instead, the property gets valued based on the net income it throws off.

There are several models that get used, so let’s start with the most basic, and most common:

I/R=V also expressed as Net Operating Income/Capitalization Rate = Value.

NOI is key here, you need to use the Net Operating Income and not the Gross Income.

  1. Start by calculating The Potential Gross Income (GI), also defined as total income from all possible sources. Include scheduled gross income; market rents for current vacancies or under-utilized space; pass through income; and any ancillary/supplemental/or additional income the property can produce (examples may be rented parking, or laundry room revenues). A quick note here, under scheduled income, you should use actual rent revenues for rental income, even if they are over or under market.  You may find out after you own the place that these can’t be changed for some reason we don’t know about yet.  As for vacancies, it is common to calculate what they would bring in if they were occupied at market rate.  The vacancy factor is covered in the very next step.
  2. Calculate credit losses, such as vacancies or bad debt (uncollectable rent). This can be a percentage of scheduled gross or a flat dollar amount. 6 -7% is commonly used.  in fact, larger landlords try to have a 5% vacancy factor.  Anything more than that means your rents are too high, and vice versa.
  3. Potential Gross minus credit losses = Effective Gross Income (money that comes in the front door and stays to be distributed by the owner or manager).
  4. Now calculate the Operating Expenses. These are all of the expenses associated with maximizing revenue and maintaining the property value. The industry uses the acronym “TIMM” which stand for “Tax, Insurance, Maintenance, Management.” Remember that this does NOT include debt service, depreciation, capital expenditures or capital improvements; or the owners personal income taxes.
  5. Effective Gross Income minus Operating Expenses equals the Net Operating Income.

Calculate your minimum return. Some people want to see as much as 12% in a lower end property (C Grade) and will go as low as 4% for a higher end property (A grade or multimillion dollar).  This is your Capitalization Rate, or Cap Rate. This rate of return measurement includes the return ON the investment in the land, plus the return ON the investment in the improvements, plus the return OF the investment in the improvements (this means depreciation, opportunity costs, etc.).  A Cap Rate by definition assumes an all cash purchase, no debt.  A higher Cap favors the BUYER.  A lower Cap favors the SELLER.  Note that as the real estate market fluctuates, average cap rates also fluctuates in any given real estate market. 

Make sure your property is sitting on cash

NOI/Cap Rate = Value

By the same token, these numbers can be rearranged in any order. If you know the property’s NOI and asking price (asserted value), you can calculate the Cap rate and see if it’s acceptable.  You can also see if the Cap and Value make sense by running the numbers backward to compare the NOI.  Generally NOI is about 50% to 60% of Potential Gross.  If these numbers are too far off, someone is likely not including some numbers.

Not all income property is mortgaged, however many are. Another term you want to know how to use properly is “Cash Flow.”  Cash Flow is simply NOI – Debt Service (Principal and Interest only, Taxes and Insurance are part of TIMM).

The next term to know is Cash on Cash Return. Simply divide the cash flow by the total cash invested (also known as the down payment).  Remember that when you are talking about cash on cash return, it is for one year only, it does not take into account future earnings, and therefore it cannot take into account possible increases in revenue.  It also does not take into account any income tax issues.

The Gross Rent Multiplier is a measurement of time, specifically how long it takes for a property to pay for itself in gross. This is defined as the value of the property divided by the gross annual rent or V/GI= GRM.  A buyer wants as low a number as possible.  The GRM represents how many years a property will take to pay for itself.

Larger institutional investors and lenders will further want to know the Internal Rate of Return, which takes everything specific to a given investor into account. This will include the investors tax situations and benefits (such as accrued losses for the investor, or other numbers specific to them).  At this level, that formula is not something we will spend time on.

If you are interested in getting into multi family units, or even retiring off of them, please contact us today.  I have many clients on a proprietary 10 year plan to retirement using this type of property.  If you purchase a multifamily unit before December 31st, we will also provide you with a free repair budget spreadsheet we have fine tuned over the last ten years for simplicity and accuracy.  But you need to act now!  Call 480 720 4040 to get started!

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