Today's multifamily brief episode (MFB) provides an overview different valuation methods for apartment deals, to include the income approach, sales comparison approach, cost approach, gross rent multiplier approach, and the discounted cash flow method. Turns out there's more to figuring out how much an apartment is worth than just dividing NOI by cap rate...
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Originally aired on July 10, 2020.
When you talk about commercial real estate and valuations, most people are familiar with what's called the income approach, which involves taking the net operating income and dividing it by a magical number called the cap rate. This is the most common method of determining how much a property is worth, but it has its limitations and is not always the best method for determining how much a property is worth. In today's episode, I'll briefly cover some of the OTHER ways to arrive at a value. In practice, most commercial real estate appraisals will use two or more methods before arriving at a determination of value. As a buyer and seller of apartments, it's a good idea to understand these approaches…
Starting at the beginning, the most common is the income approach - this method uses the property's income (or more specifically the net operating income) as the basis for value. To really understand how this works, when you're buying a income-producing property, you're not paying for bricks and mortar. You're essentially purchasing the income stream, so the higher the income, the higher the value or purchase price. In the case of the income method, there's what's called a capitalization rate (or cap rate) that's used to get at value. Take the net operating income, divide it by the cap rate, and you get the property's value. Want to know more? I'll devote a whole episode (or more) to the income method.
There's also the sales comparison approach - much like single family, an apartment building's value depends on the recently sold comparables in the area. Many brokers that we deal with will often refer to "price per door" when discussing value, which is a reflection of this approach. For example, if a similar property to the one you're looking at recently sold at $75k per door, you should expect to pay somewhere near $75k per door. In this approach, the price per door is adjusted up or down based on features, square footage, and amenities. So, a nicer apartment with more amenities up the street could have recently sold at $85k per door.
Next, we'll talk about the cost approach which is quite simple. If it costs $2m to build the apartment building and the land is worth $500k, the cost approach would say the property is worth $2.5m. This method is used most frequently in new construction and unique properties. Your insurance agent will also use the replacement cost in determining your annual premiums too.
Now, let's talk about the gross rent multiplier approach - like the income approach, this is based on the total rents at a property. For each market, property type, and asset class, there is a gross rent multiplier that can be used to determine value. Take the total rents and apply the GRM and you have value.
Finally, for the sake of this episode, we'll talk about the discounted cash flow approach. This is a method that is uses the projected value of a property at a future time and then determines how much the property is worth NOW based on that future value. For example, If you're looking at a property that's an extreme value add and you know it will be worth, say, $5 million in 2 years after it's cleaned up and operating efficiently, you can use that information to determine how much to pay today for that future value of $5 million. Some companies that seemingly overpay for a property using the CURRENT income approach may have used the discounted cash flow approach and decided that the property is worth more than its current income indicates.
So, how much is that apartment building worth? There's much more to it than just NOI divided by cap rate. I'll boil it down to the most simple concept in a free market. It's worth the dollar amount at which a willing buyer and a willing seller agree to conduct a transaction with neither being under any compulsion to sell or buy and both having reasonable knowledge of the relevant facts.