Anyone interested in multifamily investment must understand the methodologies, of which there are several, for calculating the property’s value. Besides helping you buy and sell at the best price, knowledge of value calculations is critical for making a plan to increase property values.
Kent Ritter is an experienced multifamily investor and operator helping you to build real wealth through real estate syndication. Learn More
1. The Sales Comparison Approach
The sales comparison approach is familiar to most people because of its ubiquitous use in residential real estate. However, you can apply the same method to multifamily properties—although it’s best used with smaller properties.
The sales comparison approach relies on the availability of properties, with similar characteristics in close geographic vicinity, that have sold recently. Highly similar comparison properties yield a more accurate valuation.
Depending on the market you are interested in, it may be rare for a large luxury apartment building to become available. In that situation, the sales comparison approach may be a weaker method due to the lack of comparable properties. On the other hand, most markets have a greater number of smaller buildings from which to derive accurate comparison.
How to Generate a Sales Comparison Approach Value
Software and spreadsheet templates to compare property values abound, as do local-market assignations of value to different physical elements.
The sales comparison approach centers on adjusting the subject property’s price based on its differences from the comparison properties. After adjusting the subject property’s price to each comparison property, average the three together to get the final value.
Challenges of the Sales Comparison Approach When Valuing Apartment Buildings
Assigning value to all unique elements of a property is not only time-consuming but also frustratingly qualitative. Ultimately, many elements in an apartment building are a matter of preference.
Values are most accurate when the comparable properties are very similar. Each adjustment of a variable introduces another element of subjectivity, making this approach less useful to unique properties.
While the sales comparison approach is not the perfect solution, using comparable properties exists in many of the valuation formulas. Therefore, searching out the possible best comps is always worthwhile, not only for valuation but also for analysis of the market you are entering.
2. The Income Approach
One of the most popular multifamily valuation methods is the income approach, which relies on calculating the capitalization, or cap. rate. The formula is simple: divide the net operating income by the current market value of the building:
(NOI ÷ Current Market Value = Cap Rate).
The cap rate is expressed as a percentage and is the inverse of the valuation multiple on the NOI. Said another way, the lower the cap rate the more each incremental dollar of NOI increases the value of the property. At a 5% cap rate for each $1 of NOI the value of the property increases $20; at a 4% cap rate each $1 of NOI increases the property’s value by $25.
To find the NOI, subtract the property’s expenses from its income. The net operating income is the expected annual gross income minus the costs incurred for managing and operating the property.
You have a few options for plugging in numbers for the current market value in the cap rate formula. One route is to use the purchase price, which is especially helpful if you are looking at a few different properties that you want to compare. Alternatively, use comparison properties to determine the current market value.
How to Use Cap Rates
Cap rates help us evaluate the property’s income against its value, which is preferred to looking at profit alone. Otherwise, a large or expensive building would always appear to be the best investment because it has so much money coming in. In reality, high-price buildings may bring the least profit per dollar spent.
Another way to look at the cap rate is the property’s unlevered yield (if the property was purchased for all cash. Higher cap rates are associated with more risk in the property or market and lower relative market values based on the income the property produces. As a result, investors, whose goal is cash-flow focused, search out high cap rate properties.
Additionally, you can apply the cap rates of comparable property, or the average of a few properties, to the subject property and determine whether the subject property’s price is supported by the income. To do this, divide NOI by the cap. rate to get the market value:
(NOI ÷ Cap Rate = Current Market Value)
Downsides of Using the Income Approach to Determine Value
Cap rates offer quick comparisons, but the formula is far from comprehensive. Here are a few points to keep in mind when relying on the cap rate as a measure of value:
- The cap rate is a snapshot in time, meaning it may not reflect the potential of a building under poor management.
- Cap rate calculations assume that the owner purchased the property with cash, so it does not consider debt payments or the cost of financing the project.
- The formula is backward rather than forward-looking. Therefore, it cannot account for projected market changes.
3. Gross Rent Multiplier
Investors like apartment buildings for their income-producing potential, and as a reflection of that importance, we have more than one valuation method that considers income. The gross rent multiplier (GRM) method also reflects the value based on the rents.
Assuming 100 percent occupancy, find the GRM by dividing the purchase price by annual rents:
(Purchase Price ÷ Annual Rents = GRM).
Whereas the cap rate is expressed as a percentage, the GRM is greater than 1.
Lower GRMs indicate higher cash flow related to the property’s purchase price, meaning the property could be a better investment.
GRM vs. The Capitalization Rate
Cap rates are considered more reliable than the GRM method because it has more factors, notably expenses. However, GRM still has its place because of the ease of calculation and because some investors may not care about current expenses and prefer to isolate them.
Like cap rate calculations, GRM applications benefit from the use of comparable sales.
For best results, start with the GRM of the subject property, then add the GRM of the three most similar properties available. Then, divide the total by four and multiply the resulting GRM to the annual rents of the subject property. The ending figure is the recommended value.
4. Value Per Square Foot or Unit
While apartment buildings are excellent investments for the income-producing potential, we do not always care about income when determining value. Instead, many of us look for properties with ample room for improvement, whether that is through more efficient management, better marketing, or renovations and upgrades.
Essentially, when buying a property with significant changes in mind, the current income may be irrelevant. That’s where the value per square foot or value per unit—also known as buying in bulk—comes in.
When applying this method, you determine the value per square foot by using comparable properties, or recent construction costs, as a benchmark. Then, simply multiply it for the total square footage and make an adjustment for the age, class, and condition of the subject property.
Similarly, one may determine the value for one unit and then multiply it by the total units in the building. But, of course, this fails to consider that most buildings have units of varying sizes and quality that command several tiers of rent.
Per Unit Valuation vs. the Cost Approach
Using one or two units to assign value to the entire property may sound familiar to those who have worked with the cost approach method for determining value.
The cost approach finds the replacement cost to build the property, and rather than tallying up every nail and beam, we find the replacement cost of a portion of the building and extrapolate it to the whole.
5. The Capital Asset Pricing Model
Finally, the most comprehensive valuation tool is the capital asset pricing model (CAPM). The CAPM considers the risk and opportunity cost of a property by looking at the potential return on investment (ROI) compared to other investments with little to no risk, like U.S. Treasury bonds. The model then shows whether the ROI is worth the risk entailed, considering factors like the property’s age and location.
As you might expect, the formula that represents these factors is not nearly as simple as the other methods we have covered, which is why it is not the most commonly applied. However, while its complexity may be a deterrent, it captures one of the essential premises of investing: the opportunity cost of a dollar.
The CAPM highlights the shortcomings of all of our valuation methods. We struggle to quantify the value of a building, but for investors, we must also consider whether tying our capital and time to a project is worthwhile, especially if multiple opportunities exist.
Takeaways for Investors
Most of these formulas can be prepared fairly quickly, but unfortunately, they usually yield a range of results. These high-level calculations are a good first step in your analysis and are best used in context with other information regarding the property.
These calculations serve as a starting point for the more in-depth research and analysis of the property condition and finances that come during the due diligence process. To find out more, set up a call to understand our comprehensive analysis and due diligence process.
Kent Ritter is an experienced multifamily investor and entrepreneur empowering you to build real wealth through real estate syndication. Learn More.