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By: Dennis J. Noneman, CCIM Real estate can be valued or appraised using three different methods: 1. 2. 3. The Cost Approach – The cost to replace or reproduce the improvements plus land cost. This method is typically used for valuing new construction. The Sales Comparison Approach – Comparison of other recently sold properties that are comparable in size, quality, and location to the subject property. The Income Approach – An objective estimate of what a prudent investor would pay for the property based upon the net operating income the property produces.
The Income Approach is used most in estimating the value of multi-family real estate investments because they are income-producing assets owned by investors seeking financial returns on their investments. (This is also the case for other rental income property such as offices or stores.) The Income Approach is driven by the formula:
V = NOI ÷ i
V = NOI = i = Value Net Operating Income Capitalization Rate or “Cap Rate” (Return on Investment)
Net Operating Income (NOI) is the net income (before mortgage payments) derived from operating the property. The following financial statement illustrates how Net Operating Income is calculated:
Calculating a Property’s Net Operating Income
Description Gross Scheduled Rental Income (50 units x 12 months x monthly rental rate) Less: Vacancy & Credit Losses Plus: Other Income Gross Operating Income (GOI) Less: Operating Expenses Administrative Expenses Leasing Expenses Maintenance Expenses Real Estate Taxes Insurance Utilities Total Operating Expenses 15,000 15,000 30,000 50,000 5,000 10,000 $125,000 $170,000 $125,000 $45,000 15,000 15,000 30,000 50,000 5,000 10,000 $125,000 $185,000 $125,000 $60,000 $500 Ave. Rent $300,000 15,000 10,000 $295,000 $525 Ave. Rent $315,000 15,000 10,000 $310,000
Net Operating Income (NOI)
Less: Annual Debt Service (P & I) Cash Flow
Technically.00% 7.500 $1.000 $1.75% 8.75% 8.000 $25.00% 7.A Real Estate Invetor’s Guide To Valuing Multi-Family Real Estate Using Cap Rates It is important to note that Annual Debt Service (Principle and Interest) is not an operating expense.000 As cap rates decrease. The Capitalization Rate or “Cap Rate” is the percent annual return given a specific investment or property value.000.00% 8.000 • • Cap Rate 8.50% 7.00% 8.000 $100. Following are variations of the formula: NOI = Value x i i =NOI ÷ Value V = NOI ÷ i The following chart will help you understand the relationship between Value.111. it is the weighted averaged cost of capital.500 $303.00% 8.312. invested in an income producing asset.00% Value $1. values increase. It is a debt or financial expense paid from the property’s net operating income. As cap rates increase.000 $120 $240 $360 $600 $1.000 $333.250.428.500.000 $125.000 $25.600 $3. both debt and equity.581 $312.118 $12.375.500. It is the net operating income of the property divided by its value.000 $1.000 $1.667 $1.00% 8. properties can have varying levels of debt – or no debt at all.562.500 $1. Cap rates are affected by changes in mortgage interest rates and changes in required returns on equity.333 $322. .25% 8. Knowing any two of the three components of the formula V = NOI ÷ i will allow you to solve for the third. values decrease.000 $100.000.000 $1.000 $110.000 $105.00% 8.272 $14.030 $294.50% 8.666.000 $100.000 $25.00% 9.118 $1.25% 8.00% 8.000 $120.50% 7.50% 7. and Cap Rates: Net Operating Income $100.111 $1.000 $25. NOI.500 $7.000 $25.00% 10.250. Depending upon an investor’s risk tolerance level.000 $100.00% 8.200 $1.000 $100.571 $1.097 $4.00% 6.
There is no change in the interest rate.750 $18. How much value did he or she create? B. net operating income.000 B. and cap rates.000 $1.00% 10. .000 $100. An extremely well-trained and motivated maintenance team reduces maintenance costs an average of $100 per unit per year for each of its 240 apartments.000 $500. A market study shows that the rental market will pay $40 per unit more per month than is currently being achieved.000 $2.000 $5.50% $40.000 $250. Properties are selling at 8.000 $100. $320.250 $1 $18.000 $40.00% Cap Rate A. Looking at it from the opposite direction.750 $5. No value created. A property is refinanced. Properties in that marketplace are selling at 7. please complete the following chart: Value $1. dividing NOI by the market (desired) cap uses of cap rates: Invetor’s Guide rate gives an implied value for a property based on a particular return.25% cap rate? C. How much value did this maintenance team create? D.000.In summary.000 D. how much value will have been created assuming an 8. How much value did the refinance create? Answers: A.250.000 growth in NOI over the previous year.00% 7.000 $100. A Property Manager achieves a $100. if one To Valuing Multi-Family Real Estate Using Cap Rates knows the NOI and the total investment (cash & debt invested) one can determine the actual cap rate return by merely dividing the NOI by that investment.00% Net Operating Income $100. remember that there are two A Real Estate As this doc describes. When all 30 of a manager’s apartments achieve the increase.00% 9.00% cap rates. To further your understanding of the relationship between value.000.000 C.000 $250.000 5.00% 8.750 $18.000 $500.50% cap rates.00% 10. $180. but the payment is reduced since the loan is now amortized over 30 years instead of 22.000 8.000 10. $1.00% 5.