How To Figure Out What Your Multifamily Property Is WorthPaul Winterowd
Have you ever wondered how to value your commercial multifamily property? Here’s the good news: it’s relatively easy to calculate. As long as you have good operating data on your property, you have all you need.
The value of commercial multifamily real estate (5+ units) is largely derived from an income approach appraisal based on a simple formula for valuing commercial real estate:
Current Market Value = Capitalization Rate / Net Operating Income
Your operating data should include annual NOI (Net Operating Income) numbers. NOI is calculated by summing gross rents and other income generated by the property and then subtracting all expenses. Expenses include any and everything required to operate the property such as:
- Property Management
- Property Taxes
- Property Insurance
- Maintenance, etc.
Any debt service or loan payments are not included in the expenses. Properties are valued as if no debt were involved. Why is this?
Because different owners will choose a wide variety of capital and debt structures to finance their property based on their goals, objectives and credit worthiness. This choice influences net cash flow to the owner(s) but does not affect the property’s value.
I would recommend using the trailing 12 (T-12) month operating totals to get the most accurate read on property value. You can also use the most recent annual numbers if that is all that is available. Either way you need an annual NOI figure for this calculation.
The second piece of the puzzle is determining what the capitalization rate (often referred to as Cap Rate) is for the market where the property is located. Commercial real estate lenders, brokers, and appraisers should have this information, especially for markets they service.
A market cap rate is the average of the cap rates for similar property types in a specific geographic region. Each property will have its own cap rate at the time of sale and is calculated using the same formula as above. Cap Rate = Purchase Price/NOI. Both the purchase price and NOI are known variables at the time of purchase, thus revealing the cap rate for that property at that moment in time. By averaging all those cap rates in a market, you are able to get a good feel of that market’s cap rate.
With this information, it’s now simple to determine the property’s value. Take the NOI and divide it by the cap rate.
Value = Cap Rate / NOI
Let’s insert numbers by way of example:
Cap Rate = 5.8% NOI = $435,900
$435,900 / .058 = $7,515,517
Property Value = $7,515,517
If the cap rate were 6.3%, it would actually decrease the value of the property to $6,919,047.
Cap Rate = 6.3% NOI = $435,900
$435,900 / .063 = $6,919,047
Property Value = $6,919,047
Those new to this methodology may think it is counter-intuitive, but it really does make sense. It is essentially a function of risk and return. Let’s take a look at why.
A property producing a higher return on investment will naturally be a more risky investment because higher returns mean there is higher risk. It only makes sense that an investment with higher risk is going to have a lower value than a low risk investment. Investors are willing to pay more for low risk because their money is more secure and there is less chance of losing that capital invested.
Similarly, cap rates fluctuate over time. Markets change and the desirability of an asset class also evolves as they become more or less secure. The last few years have been really strong for multifamily assets. This has pushed cap rates down and thus values up. This is great for owners and sellers of multifamily properties.
Savvy multifamily owners won’t just wait on the markets though, they know they can increase their property’s value by increasing NOI. That same example property through improved management could obtain a $500,000 NOI. Even at the higher cap rate of 6.3%, the value would then be $7,936,507.
Cap Rate = 6.3% NOI = $500,000
$500,000 / .063 = $7,936,507
Property Value = $7,936,507
These variables are ever-changing however a thorough understanding of how they work together will give you a quick and easy way to value multifamily real estate—even on the back of a napkin or using your smart phone calculator.