How do you know if an apartment building is a good deal? In this article, I give you the 3 main indicators and rules of thumbs to find out.
THE 3 MAIN RATIOS FOR VALUING COMMERCIAL REAL ESTATE
There are 3 main ratios for estimating the value of an apartment building. Here they are:
- Capitalization Rate (aka the “cap rate”);
- Cash on Cash return; and the
- Debt Service Coverage Ratio
Let’s talk about each in return. I’ll cover what they are, how to use them, and what value to look for in a good deal.
KEY INDICATOR # 1: THE CAP RATE
In order to know the fair market value of a building, we need to know its “cap rate” and its “NOI”.
The NOI is the Net Operating Income and this is the income after all expenses but before debt service (i.e. the mortgage payment).
The Cap Rate is a multiplier that is applied to the NOI to determine the value of a building. It’s like saying that the building can be valued at “ten times its Net Operating Income”.
The Cap Rate is the rate of return if you were to buy the building 100% in cash. You probably wouldn’t do that, but this is the standard way to measure the returns and value of a building.
Cap Rate is such an abstract concept that an example is in order.
Imagine you have an ATM machine that makes $100,000 per year for you after all expenses (your cost to lease the space, to pay someone to maintain it for you, repairs, etc). So the NOI of this ATM machine is $100,000 per year.
You then ask a potential group of people who are interested in acquiring your ATM machine. You ask them, “what would you be willing to pay for this ATM machine?”. One buyer might say “One million dollars”, and you ask him how he came up with this number. He says that if he buys your ATM machine for $1M and it produces $100,000 in income, then that is a 10% cash on cash return on his money. And this sounds like an excellent investment to this investor.
Another investor ups the offer to $1.1M. The ATM finally sells for $1.2M. This would produce an 8% return to the buyer if he paid in all cash.
In mathematical terms, the Cap Rate is a ratio consisting of the NOI divided by the price (or value) of the property.
In the case of our ATM machine, the Cap Rate is 8% ($100,000 divided by $1,200,000).
If you’re in the market of buying ATM machines, you could quickly compare one with another by using the cap rate. If the prevailing cap rate for ATM machines is 8%, then you can quickly calculate it’s fair market value if you know its income.
Applying this to commercial real estate, let’s say our broker brings us a deal and tells us that “Buildings in this area typically trade at an 8 cap”. This means that you can use a cap rate of 8% to calculate the fair market value of a property in this area, like this:
Suppose the marketing package you get from your broker shows a Net Operating Income of $50,000. Applying an 8% cap rate, our building should be worth $625,000:
The cap rate is useful for determining the fair market value of a building because buildings in the same area tend to share a similar cap rate.
In general, the nicer the area, the higher the prices and the lower the cap rates, typically 7% and under. Conversely, properties in not-so-nice areas have lower prices and therefore have higher cap rates.
How do you determine the cap rate?
Glad you asked! The cap rate requires knowledge of the NOI and sales price of comparable properties in the area. The best people who know about both of these are commercial real estate brokers and appraisers.
Start by asking the listing agent what the prevailing cap rate is for buildings of this kind and in this area. Use that cap rate. If it gets more serious (i.e. you’re going to make an offer), then get a second opinion from several other brokers. Better yet, call an appraiser; it’s their business to value buildings every day, and they’ll be able to give you an unbiased opinion.
What Cap Rate Should I Look For?
The rule thumb is to purchase properties at a cap rate of 8% or higher in our current market environment. Note that this is only a rule of thumb, as cap rates can vary from area to area.
Also be aware that for the cap rate to give you an accurate value, you have to base it on ACTUAL financials. Many times you see a marketing package advertising the deal at a 9% cap rate (great!) but then you discover that the expenses are low.
Well, shoot, what value is the cap rate if the expenses aren’t accurate?
That’s why I advise that you use the “50% Rule” for expenses: Assume the actual expenses are at least 50% of the reported rental income. Use that figure and you’ll get closer to the truth.
Let’s talk about the second key indicator, the Cash on Cash return.
KEY INDICATOR # 2: CASH ON CASH RETURN
Cash flow is king, and the cash on cash return measures how much cash you’re getting back each month based on how much cash you invested.
The cash on cash return is the cash flow after ALL expenses (including debt service) divided by the total cash invested.
So if our annual cash flow after expenses is $20,000 and we put $200,000 into the deal, then our cash-on-cash return is 10%.
Is that a good return?
It depends on your investment criteria, but you should look for properties with at least a 12% return after you’ve “stabilized” the property.
“Stabilized” means that it has an occupancy of at least 90%.
This means you could buy a deal with only a 5% cash on cash return in the first year, but your target is at least 12% after you’ve filled up all the units.
KEY INDICATOR # 3: DEBT SERVICE COVERAGE RATIO
This is a ratio most often used by banks to determine the risk level of the building if they were to grant a loan to you. The Debt Service Coverage Ratio (DSCR) measures the ratio of net operating income to the amount of annual debt service you need to pay. Typically banks look for a Debt Coverage Ratio of at least 1.25. Here is the formula:
Assume that the Net Operating Income is $50,000 and that the annual debt service (principal and interest) is $40,000. Then the Debt Service Coverage Ratio is:
Since we’re above the bank’s minimum debt coverage ratio of 1.25, then 1.3 looks OK.
You should look for deals where the DSCR is at least 1.5, which is more conservative and is more likely to keep you out of trouble.
Now you know the 3 main indicators for figuring out if an apartment deal is a good one or not. Stick to these 3 metrics, and it will help you narrow down the field of deals and give you a margin for error.