How to Value Multi Family Apartments Using Cap Rates
To determine the value of an apartment building you need to consider the following factors that will impact future value, which is what you’re paying for today at a reduced price to account for time value of money.
Factors that value an apartment building:
- Current Gross Rental Income
- Future Rental Income Potential (Rent Growth %)
- Operating Expenses
- Operating Expense % of Gross Rents (50% or higher is bad)
- Future Capital Expenses Needed (Roof, Structural, Plumbing System, etc)
- Net Income
- Cap Rate of Your Real Estate Market
In this video I’ll share how cap rate and net income are two of the big factors, but future value also depends on expected rent growth and your ability to reduce operating expenses of the apartment building.
What is a Cap Rate?
When valuing real estate that is not a single family home, investors will typically use a cap rate which is short for capitalization rate.
The cap rate is also another term for net return on investment. Using the net income helps multi-family investors compare different apartment buildings when they’re not apples to apples.
With single family homes, you can go find another home in the neighborhood that also has 4 bedrooms and 2 bathrooms and similar square footage.
With apartment buildings, one property may have 6 units and another might have 10 units. They both will have very different expenses for running and operating the building.
Net income becomes the standard for determining what price the building is worth.
How is Cap Rate Calculated?
Cap rate is calculated by dividing the net income by the for sale price of the property.
If a multi-family investor is running an apartment building that generates $100,000 in net income every year, he may decide to value his building at $1,000,000 and list it for sale.
To another investor paying all cash for the building, this $100k would generate a 10% return on the $1 million dollar purchase.
So the cap rate of this multi-family building would also be 10% since it is the net income versus the purchase price.
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Local City Cap Rates vs National Multi-Family Cap Rates
Every city will have different cap rates. Real estate investors tend to pay a premium for properties in the coastal cities like Miami, Los Angeles, San Francisco.
As a result of paying more money for a property in these cities that is producing the same net income as a property in another city like Des Moines Iowa, the investor gets in at a lower cap rate by default.
- Iowa = $1M ask price for $100K net income building
- Los Angeles = $2M ask price for $100k net income building
The investors in Iowa would be buying at a 10% cap rate while the Los Angeles investor would be buying the apartment building at a 5% cap rate.
Why Do Investors Buy Low Cap Rate Multi-Family Deals?
At this point, you’re probably wondering why real estate investors would pay more money for a property that’s going to produce a lower rate of return (cap rate) compared to other properties in other cities like Iowa.
Truth is, the real estate investor see’s higher future demand for housing in Los Angeles as compared to Iowa.
There is a much larger population in LA and low supply of housing which causes rents to increase at a much faster rate than rents increase in a city in Iowa.
As a result, their multi-family property is going to generate more income in the future years from an increase in rents. This will also increase their net income.
Investors in LA are willing to earn 5% return so for every $1 dollar their net income increases, the value of their property goes up $20:
- $1 / $20 = 0.05
Let’s assume over 3 years, the $100K net income of the building increases to $140,000.
Now the building just gained $800,000 in value at a 5% cap rate since that extra $40,000 of income will earn a 5% return on $800,000 of capital.
Investor could now sell the building for $2.8 million, locking in a solid profit.
Or get it appraised and refinance the money out to use for following the BRRR real estate investing strategy.
Valuing Apartment Buildings in Your Local City
The key takeaway today is to analyze your real estate market. Find out what cap rates apartment buildings are trading at to give you an idea of “average.”
The “average” cap rate of your city is your target rate you want to sell a property for, not buy it for.
On the buy side, you want to purchase at a higher cap rate, paying less money for the net income so you start out earning a better return for the risk you’re taking on.
These higher cap rate properties that stand out as above the average cap rate in your city are usually in fixer upper condition or have vacancies, taking away from the building’s net income.
Your job is to buy the building, fix it up, get it fully occupied, and get it operating efficiently so your expenses fall around 30% to 35% of your rental income.
Then decide if you want to flip the apartment building and cash out for a profit.
On the sell side, you can now ask for a lower cap rate, pushing the value of the building higher. You’ve stabilized the property and got it operating efficiently so this reduces the risk level in the eyes of the next owner taking over the investment.
A less risky investment means the new buyer is willing to pay for a lower rate of return. Make sense?
Thanks for reading today’s short article on valuing multi-family investment properties using the cap rate. Please review the YouTube video above, and don’t forget to subscribe to my channel for more helpful videos.
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