Properly underwriting the value of an apartment building is critical to finding and making great deals.
Generally, a bank will use three different ways to assess an apartment asset’s value.
The sales approach – looks at other comparable properties and what they have recently sold at in the area. Like residential real estate comps.
The replacement approach looks at how much it would cost to create the building, or buildings, from scratch, given construction materials, labor costs, etc.
And income approach looks at the profitability of the asset based on income and expenses.
The income approach, however, has a very heavy weight in the value assessment because, after all, the bank is really investing in a business, not just a property.
When it comes to assessing the value of an apartment building using the income approach, there are a few key terms to know like ROI, Cap Rate and NOI. But NOI or Net Operating Income is by far the most important.
In this article, we’ll look at this key ratio — the foundation for determining the price tag or value of an apartment building.
Knowing how to make sense of NOI is basic to your profitable real estate investing enterprise.
The capitalization rate (Cap Rate) for your specific property can be calculated by dividing the NOI by the price you paid for your property. But there is another, different cap rate, you will use to calculate the market value. That cap rate is determined by other what similar properties that have sold for in your area. Your area will have a “market cap rate.” The market cap rate depends on neighborhood economic situations and market sales.
So, to get the value of your property, you must first determine the NOI or net operating income.
Here are step-by-step instructions on how to calculate an apartment’s NOI.
Add up all sources of income for the property for the year. Items can include:
For example, let’s take a 100 unit complex where each unit rents for precisely $1,000 every month – ha, wouldn’t that be nice?
The complex also has coin-operated washers and dryers and a few soda and candy vending machines that create $1,000 every month in income.
Likewise, there are additional parking spaces tenants can rent that go for $100 every year and 50 units have them for a yearly aggregate of $5,000.
So what’s the Total Income?
We can determine the NOI by subtracting Total Expenses from the aggregate income total.
Here’s a rundown of potential operating costs for the apartment complex:
Also, the mortgage payment is not included in determining NOI.
Suppose that the greater part of our yearly costs on this 100 unit apartment complex turns out to be approximately $517,000.
So what is our NOI?
$1,217,000 (Total Income) – $517,000 (Total Expenses) = $600,000 (NOI)
The NOI in this illustration is $600,000.
To determine the market cap rate, you can do three different things:
Once we have a pretty strong idea of the local cap rate (giving the bank’s assessment the highest degree of credibility), we can calculate the value.
Suppose that we’re utilizing a cap rate 10%.
To calculate the value, we divide $600,000 (the NOI) by .10 (the market cap rate) and we get $6,000,000 as the price tag or market value of the property.
Can you now see how essential NOI is? You really can’t affect market cap but you can control NOI.
If your NOI was $500,000, the property value would fall to $5,000,000. Or, if your NOI was $700,000, the property would increase to $7,000,000.
So you can see how advantageous a higher NOI is to the equity and value of your property. So, it begs the question, “How do I increase my NOI?” The answer is simple: reduce expenses and increase income!
The great advantage to investing in apartments is that you can directly “force appreciation” and value by the way you manage the property and it’s finances.
It’s all about the numbers!
Bill Manassero is the founder/top dog at “The Old Dawg’s REI Network,” a blog, newsletter and podcast for seniors and retirees, that teaches the art of real estate investing. His personal real estate investing goal, which will be chronicled at olddawgsreinetwork.com, is to own/control 1,000 units/doors in the next 6 years. Prior to that, Bill and his family lived in Haiti for 11 years as missionaries serving orphaned, abandoned and at risk children.