I was recently asked the question, “Do you really believe that the sale price of your building will almost double in 5 years?”
To respond to this question and for the person to accept my response, we both have to understand how to value multifamily apartment buildings.
In real estate, there are three main methods to valuing real property.
1. Replacement cost method
2. Comparable sales method, and
3. Income capitalization method
The method that holds the most weight in commercial multifamily residential apartments (buildings with 5 or more units) is method 3, the income capitalization method. For this reason, I will discuss this method in the following paragraphs.
Apartment buildings give off income streams. The income capitalization method attempts to determine the current value by converting the income streams to a single value. The actual formula is net operating income/capitalization rate = market value. You might ask “how do you get these numbers and why are they important?”
Let’s look at a scenario using a common investment type, a certificate of deposit at your local bank.
A certificate of deposit offers you a payment based on an interest rate (capitalization rate) on the amount of cash you deposit into an account. Let us say that at the four corners of an intersection there are four banks. Three of these banks are offering a one year $100,000 (market value) CD at 4% (capitalization rate). This means that if you purchase the CD, you will make $4,000 (Operating income) at the end of one year. I think that you would agree that the value of the three CD’s is the same. If you applied the formula given above, you would get a market value of $100,000 for each CD 4000/.04= 100,000 (Operating income/capitalization rate = Market value).
Now, what if you walked into Bank 4 and they said they would sell you a CD for $150,000 and give you $4,000 cash at the end of the year. Since you have read this article, you will likely tell them to buzz off. Why? Because you would apply the formula you learned silly.
The Market has a 4% cap rate. You know this because three banks in the area are offering 4%. If you apply the formula you will get $100,000, you would then proceed to tell Mr. Bank number 4 that you are selling an asset for $150,000 that has a market value of $100,000. I REFUSE to purchase this!
Now that we have an understanding of how to apply the income capitalization valuation method let's address the initial question that prompted this piece.
The Market cap rate is 7% today because this is what other apartments in the area are selling for. The net operating income is low today because of poor management and deferred maintenance. In 5 years, we will have raised rents by 25% because of improved management and upgraded apartment Units. We do not know what the cap rate will be in 5 years, but we will be conservative and use one that is higher than the one today or 7.5%. I applied the formula using the new NOI and projected cap rate in 5 years (NOI/.075=MV). The result is almost double what I purchased the property for.
To answer the question, Yes! I believe the price can almost double. It is based on the prominent valuation method used by professional appraisers in the field called the Income Capitalization Method.
I hope you found this piece helpful in understanding cap rate and how it is used to value multifamily apartments. If you are new to this asset class, I am sure you hear the term cap rate a lot more often then you have before.
Mitchell Comeau MST