What are the key indicators if an apartment building is a good deal? This will provide the 3 main indicators and rules of thumbs to find out.
You are interested in apartment building investing, and you see a numerous of multifamily properties on sale. You are even considering of making an offer. But how do you know if the asking price is reasonable & fair? And if it’s not, what methods do you use to determine if its a fair market value?
The 3 Key Ratios for Valuing Commercial Real Estate, The are 3 main ratios for estimating the value of an apartment building are:
Key Indicator #1: The Cap Rate
The Cap Rate To determine the fair market value of a building, we need to evaluate its “cap rate” and its “NOI.”
The NOI is the net operating income, and this is the income generated after all expenses but before debt service (i.e. the mortgage payment).
The cap rate is a multiplier that is applied to the NOI to determine the value of a building. When you hear the building is valued at “10 times its net operating income.”The cap rate is the rate of return if you were to purchase the building entirely in cash. Most likely you wouldn’t do that, but this is the simpler way to measure the returns and value of a building.
Imagine you have a property that makes $100,000 per year for you after all expenses (maintenance, fixed cost, utilities) . So the NOI of this property is $100,000 per year. You then find to a group of people who are interested in acquiring your property. You ask them, “What is their offer for your property?” One buyer might say,
“One million dollars,” and you question how he came up with this number. He communicates that if he buys your property for $1M and it produces $100,000 in income, then that is a 10% cash on cash return on his money. And this sounds like an excellent investment to this investor.
Another investor increases the offer to $1.1M. The property sells for $1.2M. This generates an 8% return to the buyer if he paid in all cash.In mathematical formula, the cap rate is a ratio consisting of the NOI divided by the price (or value) of the property.In the case of the propery, the cap rate is 8% ($100,000 divided by $1,200,000).
When you are in the market of comparing properties to invest in, you could quickly compare one with another by using the cap rate. If the prevailing cap rate for property is 8%, then you can quickly calculate it’s fair market value if you know its income. Lets imagine our broker brings us a deal and tells us that “buildings in this area typically trade at an 8 cap.” This means that you can use a cap rate of 8% to calculate the fair market value of a property in this area, like this:
Suppose your broker shows your property that shows a net operating income of $50,000. Applying an 8% cap rate, our building will be worth $625,000:The cap rate is useful for determining the fair market value of a building because buildings in the same area tend to share a similar cap rate.In general, the better the area, the higher the prices and the lower the cap rates, typically 7% and under. Conversely, properties in not-so-nice areas have lower prices and therefore have higher cap rates.
How do you determine the cap rate?
The cap rate requires information of the NOI and sales price of comparable properties in the area. The key people who know about both of these are commercial real estate brokers and appraisers.Start by obtaining from the listing agent what the prevailing cap rate is for buildings of this kind and in this area. Utilize that cap rate. If it gets more serious (i.e. you’re going to make an offer), then get a second opinion from several other brokers. Its best to call an appraiser; it’s their business to determine the value of buildings every day, and they’ll be able to give you an unbiased opinion.
What cap rate should you look for?
The rule thumb is to purchase properties at a cap rate of 8% or higher in our current market environment. Note that this is only a rule of thumb, as cap rates can vary from area to area.
Also be aware that for the cap rate to give you an accurate value, you have to base it on ACTUAL financials. Many times you see a marketing package advertising the deal at a 9% cap rate (great!), but then you discover that the expenses are low.
Well, shoot, what value is the cap rate if the expenses aren’t accurate?
That’s why I advise that you use the “50% Rule” for expenses: Assume the actual expenses are at least 50% of the reported rental income. Use that figure and you’ll get closer to the truth.
Key Indicator #2: Cash on Cash Return
Cash flow is always king, and the cash on cash return measures how much cash you’re generating every month based on how much cash you invested.The cash on cash return is the cash flow after ALL expenses (including debt service) divided by the total cash invested. So if our annual cash flow after expenses is $20,000 and we put $200,000 into the deal, then our cash-on-cash return is 10%.
How do you determine if this is a good Return on investment (ROI)?
It depends on your investment criteria, but you should seek for properties with at least a 12% return after you’ve “stabilized” the property.“Stabilized” means that it has an occupancy of at least 90%. This means you could buy a deal with only a 5% cash on cash return in the first year, but your target is at least 12% after you’ve filled up all the units.
Key Indicator #3: Debt Service Coverage Ratio
This is a ratio most often utilized banks to determine the risk level of the building if they were to grant a loan to you. The debt service coverage ratio (DSCR) measures the ratio of net operating income to the amount of annual debt service you need to pay. Typically, banks look for a debt coverage ratio of at least 1.25.
Lets assume that the net operating income is $50,000 and that the annual debt service (principal and interest) is $40,000.
Since we’re above the bank’s minimum debt coverage ratio of 1.25, then 1.3 looks good.
You should look for deals where the DSCR is at least 1.5, which is more conservative and is more likely to keep you out of trouble.
ConclusionNow you know the 3 main indicators for figuring out if an apartment deal is a good one or not. Stick to these 3 metrics, and it will help you narrow down the field of deals and give you a margin for error.
BUT having said that, these 3 metrics (and the rules of thumb) are a bit of an over-simplification of the process of evaluating apartment building deals. That’s because if you buy a value-add deal, for example, where the vacancy rate is low or expenses are high, your 3 indicators may be low, but it may still be a good deal overall. In other words, if we’re going to evaluate a “value-add” deals, we may have to break our rules of thumb for the 3 key indicators.