When one wants to value property, like an apartment building, to get a feel for what it is worth, there are two different commercially recognized valuation approaches that are used. The first one is the comparable market approach analysis (CMA), which is used both for single unit residences and multi-unit properties. The second valuation approach is called the Capitalization Rate Valuation, or “Cap Rate” and it is used primarily for income producing multi-unit and other commercial properties.
The CMA valuation is about as clear-cut and straightforward as can be for estimating a property’s value. The theory is that two properties, in similar shape, in a similar area, in a similar timeframe, with similar rents, in a similar size, unit or square footage, should sell for about the same value on a per unit or per square foot basis. Voila, it’s that simple.
Approach number two is the Cap Rate methodology which is a much better valuation tool for income producing properties like an apartment building. The reason it is a much better tool is because it’s really a “cash on cash” return calculation without respect to whether or not the owner will carry a mortgage on the property. And your hope is that if your Cap Rate Calculation, based on conservative, reasonable and supportable estimates comes back really low, like 2.0%, 3.0%, or 4.0%, you’ll quickly figure out that the property is not a very fair deal and you’ll pass on the purchase.
With the “comps” method you may not notice it’s a bad deal because you are just looking at what another – possibly very unsophisticated investor – was willing to pay on the last deal, and it might be a very low return investment. So keep in mind, a property with 2.0% to 4.0% Cap Rate (or cash on cash investment returns) is not a very good deal – as I detail in this past article Property Investing – Go For The Cash Flow, Not Location, Location, Location. So avoid those low Cap Rate deals, even if they comp well.
Let’s talk about how the Cap Rate works.
The Cap rate, instead of primarily comparing the physical assets of a property, compares the cash flows the property can generate.
The basic calculation is: Net Operating Income (NOI) / Price or Value).
So if the NOI is $50,000 and the asking price is $1,000,000, that’s a 5.0% Capitalization Rate. Note: The NOI is the rental income, less all expenses, except for the mortgage.
If in a general vicinity, 12 properties sold recently at 5.0% Cap Rates, you, or an appraiser, would suspect that the next property for sale would also gravitate around a 5.0% Cap Rate. So if a 20 unit apartment building had NOI of $100,000, it would be valued, based on the Cap Rate approach, at about $100,000 divided by 5.0% (market Cap Rate) for a $2,000,000 valuation, or $100,000 per unit in this case.
Therefore, if all those recent sales did close escrow at about a 5.0% Cap Rate and the next seller was asking for a 4.0% Cap Rate (Note: the lower the Cap Rate the higher the valuation), you’d want to bargain on price to try and buy the property at a higher Cap Rate – and really the highest Cap Rate you could negotiate! That will give you the most cash flow per your investment dollar.
A final note is that Cap Rates go up and down based on investor enthusiasm and demand, and the fancy prize properties usually have the lowest Cap Rates – and hence low cash on cash returns. So watch out for those dogs and you might want to consider non-real-estate investment options if the Cap Rates are too low. Always go for the cash flow! Good luck!
Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.