Jim Daly, owner of Daly Appraisal Services
As a budding real estate investor, you’ve probably heard a simple formula for calculating the property value of larger multifamily properties. It’s touted almost everywhere you look, and involves just using capitalization rate (or “cap rate”). You may have even seen residential real estate agents marketing 3-family properties by boasting that their cap rates are an attractive indication of high return-on-investment (ROI). The formula you’ll see *everywhere* states that Property Value is equal to Net Operating Income (NOI) divided by Cap Rate.
Here’s why this can be misleading: The cap rate formula above is used for only one of the three approaches that appraisers take when determining the market value of a property.
As you’ll see in the example appraisal forms below, multifamily properties containing as few as 2 and as many as hundreds of apartments are typically evaluated by all three of these methods before deciding on an overall value:
- Examining the cost to build from scratch;
- Sifting through recent comparable sales of nearby multifamily buildings and looking at rental data for nearby apartments;
- Calculating value based on income (cap rate, covered above).
Even within that third approach that looks at income produced by the property, there’s a lot more market comparison going on than many people realize. Let’s go over the cap rate formula to clarify, starting with NOI.
The Expenses Portion of NOI
First up, the “expenses” portion of NOI. Since there isn’t a third-party entity that guarantees the accuracy of an individual seller’s expense records or financial documents, we shouldn’t assume they’re correct. Even if they were, it’s unknown whether they were appropriate for the conditions of the property. For example, reported expenses could be lower than normal due to an honest accounting error, inexperienced maintenance personnel, or a conscious decision to defer routine maintenance. Operating expenses need to be “normalized” in order to figure out what an owner should expect to see in the future. Appraisers have a variety of methods to normalize values for expenses such as the cost of insurance, utilities, property management, maintenance, etc., and a good appraiser will never simply use the owner’s reported expenses when determining a multifamily property’s value. Forecasting gross income, a vacancy rate, and expenses accurately is a key way to arrive at a reasonable NOI.
Cap Rate is Determined by Unpublished Recent Sales
Another reason that simple cap rate valuation for multifamilies and apartment buildings can be misleading is that exact values for local cap rates aren’t conveniently published anywhere since they’re constantly evolving based on recent property sales, only a fraction of which have underlying data that’s made public. Most commercial properties that are sold (including larger multifamily properties) never make it to a public-facing platform such as Loopnet or MLS because they’re typically offered directly to a broker’s network of investors who have proven their ability to close on deals they commit to. As such, the financial operating data for those professionally-traded property sales is often hard to track down. The types of properties that *are* more commonly listed on public-facing websites tend to be the ones that have already been scrutinized by in-house networks of professional investors who have decided against them due to undesirable attributes or a seller’s unrealistic price expectations. The financial data for those listings are therefore not reliable indications of what to expect from the greater market, and estimates need to be made in order to determine a best guess for what the local cap rate seems to be.
In essence, the formula that divides NOI by cap rate probably *should* be specified as something like this since simply using actual expenses doesn’t paint the most accurate picture:
Here are some example appraisal forms that show how much attention is given to the three different approaches when determining the value of a multifamily property:
The Bottom Line
In general, reducing expenses or increasing net income does increase property value to a certain extent. In an example where actual owner expenses are higher than industry norms, an appraiser will at least partially skew their opinion of property value to those actual numbers, which will in turn drag the appraised value down for that purchase or refinance. In a case like that, an owner who is able to reduce those expenses to or below industry norms (with documentation) will most likely be able to increase the appraised property value by doing so as long as the external market conditions haven’t changed in the meantime. Potential investor purchasers who know what they’re doing will dig into the unique aspects of any property they’re evaluating as well, and will sometimes be willing to pay more for a property that documents a unique ability to produce a higher amount of stabilized net income, in some cases regardless of what an appraisal says. How much more they’re willing to pay, however, varies by their own investing strategy and is also not directly tied to the simple cap rate formula alone. 🏠
Questions? You can reach Jim and his team at https://www.dalyappraisal.com