When you are considering investing in any apartment property there are several ways to determine its value. In this series, I will highlight 5 common ways multifamily apartments investor can make that determination without sacrificing too much time or effort.
Replacement Cost Approach
The Replacement Cost Approach determines value by calculating how much it would cost to replace an existing structure. This approach is very time consuming to complete as you must obtain pricing for all materials (from 2×4’s to outlet covers) used in the construction of a property and then calculate replacement cost. Because of this it is very rarely used. However, purchasing an apartment property below replacement cost can be an advantageous investment depending on the present market condition and future economic outlook.
Sales Comparison Approach
This applies more so to residential real estate and can be used for single-family houses and 2-4-unit apartment buildings. For these property types the most common approach to determining value is the Sales Comparison Approach. This approach compares similar properties that have sold within the last six months, within a certain geographical radius from the subject property (usually no more than two miles, the closer the better) to determine value. If you’re buying a 4 unit apartment building and a similar one on the next block over sold for a specific dollar amount then the property you are considering, if similar in certain respects, it should be valued around the same dollar amount.
Income Approach/Cap Rate
For six units and more, you would use the Income Approach to determine value of the property. This means that you would determine how much income the property is generating and determine its value based on that number. There are several formulas that investors can use to determine value of which the most prevalent is the Cap Rate.
The Capitalization Rate is the rate at which the Net Operating Income (the income that is left over after all the expenses are taken out) repays the purchase price on an annual basis. The calculation of the Cap Rate is as follows: Cap Rate = Net Operating Income/Value (selling price). Bonus: Knowing this formula, if you know any two of the variables, you can calculate the third: Net Operating Income = Value (selling price) x Cap Rate Value (selling price) = Net Operating Income/Cap Rate. The higher the Cap Rate, the lower the value of the property.
Income Approach/ Cash On Cash Return
The valuation that most investors are concerned about is the Cash on Cash Return. The Cash on Cash Return tells you that for every dollar that you took out of your pocket to get into the deal, how much of that dollar will you get back at the end of the first year. The equation is: Cash Flow (Net Operating Income – Debt Service) /Acquisition Costs (Down Payment + any money needed for the deal). For example, a 12% – 15% Cash on Cash Return means for every dollar you put into the deal, you get back .12 – .15 of that at the end of the year.
Income Approach/Return On Investment
After the first year of operation, you know want to look at you return on investment or ROI, this is calculated by using the following formula Net Operating Income – Debt Service + Principle Reduction/Acquisition Costs. You want to be aware of the ROI so you compare apartment properties with each other as well as other investments (such as stocks or bonds) with your real estate investment. Then you can choose the investment vehicle with the highest return.
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