If you want to buy apartments, the first thing you need to know is how to value them.
The biggest mistake that inexperienced apartment investors make is paying too much for buildings to begin with. If you do this, it’s an expensive mistake that’s hard to recover from. Luckily, if you understand the simple math of how buildings should be valued, it’s a mistake you don’t have to make.
Rules of thumb like “price per door” and “gross rent multiplier” are fine for a first guess whether the asking price is reasonable, but when you get down to making a serious offer, there are only 2 important figures:
· Net Operating Income (NOI) and
· Cap Rate (CR)
With these 2 numbers in hand, you can easily figure out the important 3 variable: Purchase Price (PP).
Cap Rate is short for “Capitalization Rate.”
It’s a number, expressed as a percentage, that reflects the rate of return a building would have IF:
1. The buyer paid cash
2. There were no income tax impacts, positive or negative, to the buyer for owning it
Now you may be saying to yourself, “I’m NOT going to pay cash, and I AM going to have income taxes and depreciation, so why should I base the value of a building on a scenario that isn’t mine?”
The answer is, if every different buyer figured the value of a building based on his own financing (which could be at higher or lower rates and payments) and his own income tax impact (which is different depending on the buyer’s tax bracket), no ONE value could be set for any given building.
It must be the case that a building is worth $x no matter who the buyer is—and the Cap Rate gives us an objective way of determining what $x is.
There’s a basic, simple formula for determine what the Cap Rate on a particular property is. You don’t even need a financial calculator for this one:
CR = NOI / PP
For example, if I purchase an apartment complex for $1 million and it generates a Net Operating Income at the end of 1 year in the amount of $100K, then my Cap Rate is .1, which would be expressed as the percentage 10%.
.1 = $100,000/$1,000,000. See?
On the other hand, if the income from the property was only $90,000, my Cap Rate would drop to .9, or 9%:
.9 = $90,0000/$1,000,000
That tells us how to determine the Cap Rate when we already know the purchase price, but what about using the Cap Rate to DETERMINE the purchase price?
You simply turn the equation around:
PP=NOI/CR
So if you know that the expected cap rate for a particular kind of apartment building in a particular market is 10%, and you also know that the building your considering has a Net Operating Income of $90,000 a year, you can calculate the purchase price of $900,000 like this:
$900,000=$90,000/.1
That, of course, begs the question, “How in the world do I find out what the Cap Rate for a particular market and property type is SUPPOSED to be?”
Good question. And the answer is, “Ask”. Contact 3-4 commercial RE Brokers and/or commercial financiers in that market and ask them. Tell them the type of complex, geographical area and quality of the complex and they should be able to give you a one half to one point average.
In other words, they’ll tell you that Cap Rates range from 8%-8.5% or 9%-10% or 7.75%-8.25% or 6.5%-7.5% and so forth.
Most, if not all of the people you speak with should be in the same ballpark. However, you may find that after you speak with 3-4 people, the overall range maybe slightly broader than one half to one point. i.e. 7%-8.5% or 7.5%-8.75%. You’re just looking for an average.
One of the great things about buying apartments is that, because of the way they’re valued, you can easily raise the value of a building by raising the income and cutting the expenses. You have much more control over the value of your apartment buildings than you do single family rentals, which are worth what other people are paying for them.
So let’s say that, 5 years after buying the building in the example above for $900,000 (don’t worry, you can use other people’s money and credit to do that), you’ve RAISED the net operating income to $126,000 a year by improving the units and getting better management.
With a cap rate of 10% and an NOI of $126,000, what is the new value of your building? Don’t cheat—see if you can work it out for yourself before reading on for the answer.
See, that wasn’t so hard, was it? You raised the value of your building to $1.26 million—and increase in your net worth of $36,000 in 5 short years (during which you also collected, what, $500,000 in income?)
See, you can do this. Now all you have to know is how to find the deals and raise the money to buy them. It’s all pretty simple, you just have to learn the basics, just like you did when you were learning about single family homes, wholesaling, lease/options, and so on.
With decades of experience and over 1,000 units purchased, I can make that road a lot easier for you. Come see me at the REIAGC meeting on Thursday, March 15th and let me prove it to you. RSVP right here on this site.