The world of commercial real estate and multifamily investing can get very complicated with all the terminology and concepts. However, the fundamentals of how a property is valued is based on math. It is quite different and less emotional (in theory) than single-family where the valuation is based on what a similar house nearby just sold for. Someone buying an apartment complex is usually buying it to make money and help other investors get a return on their capital.
Income and Expenses
There have been numerous books written on how to evaluate multifamily properties that go into great depth, but to keep it basic let us just focus on income and expenses. To increase the value of a multifamily property you need to increase income and decrease expenses. Increasing income can include but is not limited to: higher rent, parking fees, laundry fees, technology package, pet rent, etc. Decreasing expenses would include but is not limited to: lowering water bill, Ratio Utility Billing System (RUBS), reducing taxes, lowering insurance premiums, cutting down on delinquencies, etc.
Increasing income will allow your top line revenue to grow and reducing expenses will let your Net Operating Income (NOI) be higher. The Net Operating Income is one of the most important numbers in multifamily real estate and it is used to evaluate what the property is worth.
Net Operating Income
NOI is useful in determining property value and to help lenders know how much debt to provide on the property through the Debt Service Coverage Ratio (DSCR). To calculate NOI you subtract the operating expenses from the revenue generated by the property.
Example:
Revenue:
Rent—$1,450,000
Parking—$40,000
Laundry—$10,000
Effective Gross Income = $1,500,000
Operating Expenses
Property Management—$50,000
Taxes—$200,000
Insurance—$50,000
Repairs—$80,000
Payroll—$200,000
Marketing—$20,000
Utilities—$150,000
Total Operating Expenses = $750,000
Therefore NOI = $1,500,000 – $750,000 = $750,000
The cashflow models used to calculate the NOI are usually more involved than this but the basic idea of NOI is total income minus total operating expenses. It is important to note that debt service or loan payment is not included in this number.
Capitalization Rate
The capitalization rate or cap rate is another important metric used in evaluating commercial properties and it is another topic that lends itself to extensive subject matter. One of the best definitions I have heard was from a podcast where the speaker said it was like a thermometer. The lower the cap rate, the hotter the market. Right now, the market is hot, so a lot of properties are trading at a cap rate lower than 5%.
The cap rate is used to indicate the rate of return that a real estate investment is expected to generate. Divide the NOI by the property asset value and the percentage is expressed as the cap rate. You can also work backwards to determine a property value. For our example NOI of $750,000 and using a cap rate of 5% we can determine what we think a property is worth.
NOI/Cap Rate = Market Value
750,000/.05 = $15,000,000
From this example we can see that the property is worth around $15M based on the cash flow it produces and a market cap rate of 5%. If someone were to bid up the price and pay more, then the cap rate would be lower. The lowering of the cap rate or cap rate compression is happening now because people are willing to pay more money for an apartment complex based on current economic conditions.
Conclusion
Hopefully after reading this article, you get a basic idea of how commercial properties are evaluated. This is a very straightforward overview of how properties are evaluated, and it can get a lot more complicated based on the model you use for evaluation. While it can get complex, I think it is important to sometimes break stuff down into its simplest components.
