How much should you pay for your Multi-family Property?

Howdy folks,

Today I’d like to discuss with you probably the toughest topic for novice investors in apartment buildings, that is ‘how much should you pay for your investment property’?

The reason it’s a difficult subject is multifold:

First, valuation is not an exact science, but rather an approach! You could almost call it an art and there’s definitely a significant element of human subjectivity, as we’ll see below in the real life example I’m giving you that I recently experienced.

Secondly, the valuation method used for multi-family properties is different that the one used for small rental properties of 1 to 4 units, which uses exclusively the ‘direct sales comparison approach’ whereas for multis the ‘income approach’ is the main method for determining the value of an apartment building in conjunction with the comparison approach.

As you already know if you invest in small rental properties the direct sales comparison approach is the method which consists in taking the property you’re looking at purchasing and comparing it to properties which recently sold in the market and which share similar characteristics such as location, size, construction type, improvements, amenities, etc.. and making adjustments, positive or negative, to the value to ensure the comparison is appropriate. This is what we call a ‘CMA’ or a comparative market analysis.

The ‘income approach’, also referred to as ‘income capitalization approach’, is the main approach used by banks and CMHC for large apartment buildings. It’s also usually used in conjunction with the sales comparison approach. The 2 values arrived at using these 2 methods are reconciled in the end.

According to the ‘income approach’ the value of the property is:

is the present worth of all the net income the property will produce for each year of its remaining useful life’

 The income approach is the process of converting the property’s annual income stream, or Net Operating Income (NOI) into a capital value using a using a market-derived “capitalization rate” (Cap Rate).  A Cap rate is essentially a rate of return on investment that is used by investors as a benchmark for determining how much they should pay for the property.

The critical step is to determine the property’s income and expenses, the subtraction of which will give you the NOI (see table below) with as much certainty as possible.

Once we have determined the NOI, next we need to calculate the cap rate for this property.  Say the above property sold for $1,700,000, the Cap rate is calculated like this:

Cap Rate = NOI ÷ Sale Price = $110,000 ÷ $1,7,000,000 = 0,0647 x 100 = 6,47%

In other words, the annual income of $110,000 represents 6,47% of the capital value of $1,7M.  The lower the property’s cap rate, the higher the property value is.

Now, we also need to know what the market-derived cap rate is. Let’s assume that several other similar income properties, or ‘comps’ have recently sold in the same area and the transaction details are as follows and the average cap rate for these sales is say 6,25%, which is pretty close to the 6,47% cap rate for the property in my example above.  In other words, we can conclude that the property is performing close to market norms.  It’s a good thing! However, if the property had a cap rate of say, 7,5%, we would conclude it’s underperforming and we’d have to find out what are the reasons why it’s not generating the average income you’d expect. If we applied the market cap rate of 6,25% to the NOI of $110,000, we would get a value of $1,760,000.

You get the gist?

Then, as I mentioned above, the next step would be use the direct comparison that would factor in non-income related things such as size, construction type (e.g. wood frame versus concrete), amenities of the property, etc. and reconcile it with the value arrived at by using the income approach and the resulting value would be presumably reasonable.

The bottom line is that the value of an apartment building is predominantly a function of the annual income (NOI) it generates and it’s supposed to be based on ‘current income’, NOT PROJECTED INCOME, hence current value of the property.

That’s the technical part of the valuation process.  Now, let’s look at real life examples where the technical rules are not necessarily applied and the human factor takes over.

As some of you may know, I personally invest in apartment buildings in the City of Edmonton and in the last six months I’ve been very actively looking at purchasing properties.  With regard to the Edmonton multi-family market, it’s currently experiencing a boom and vendors have the upper hand.  All the theory above about valuation does not hold as well as it were a balanced market, to say the least.

A month ago I bid on a foreclosed 21-unit property. It was a complete stampede as there were 8 offers on this property. The interesting thing is that because the foreclosure process had begun back in 2009, there was a lot of information on this property in the court file, including a recent appraisal that provided the property’s history, which is as follows:

  • Property sold in 2006 for $1,6M ($76,000/door)
  • Sold in 2007 for $2,7M (IT’S NOT A TYPO, IT SOLD FOR $1M over the previous year)
  • Property was appraised at $1,775,000 in August 2012
  • Property sold in November 2012 under the foreclosure process to the highest bidder for $1,932,000 ($92,000/door), that is over $150,000 over market value of $1,775,000
  • The bank (private lender) lost close to $1M on this deal

What can we conclude from the above real life example?

  • $1,6M sale price in 2006 was in line with values at that time. I know this because I owned an 18-suiter property at that time and I was underwriting lots of apartment buildings in Edmonton, which was then booming;
  • $2,7M sale price in 2007 was based on future value as the new owner intended to convert the property into individual condo units and sell them for maybe somewhere around $200,000 to $240,000 per unit. However, the condo market subsequently tanked shortly after… Instead of buying based on current income, hence current value, this investor SPECULATED what the future value might be and lost big (I guess mostly the bank lost big). In that investor’s defence, however, I must admit at that time there was a stampede of investors doing condo conversions and the foreclosure file did contain 2 appraisals with values in the $2,7M range. But it’s the human factor, that is the stampede mentality, that drove values to increase very fast…

For myself, this is not how I invest! I don’t want to take risks such as those with my investors’ money. I would not have never bought a property for a $1M over what it sold for a year earlier. That’s taking on too much risk in my opinion.

Now, what do you think about the investor that picked up the property a month ago for $1,932M ($92K/door)? He also bought the property based on future value at a premium of roughly $7,500/door! It was appraised at $1,775,000.

Well obviously the winning investor is confident that at some point in the future, his property will reach this value. But he too is clearly speculating and taking on an additional risk. Perhaps his investing horizon is longer than mine.

As for myself, I lost that bid because I was not prepared to speculate. My bid actually came in at $1,8M, which was market value based on current income and reflected current condition of the property. And no, I was not paying a $25,000 premium for the property. The August 2012 appraisal, which indicated a value of $1,775M, actually had a math error in it, which under-appraised the current value by $25,000. The appraised value should have come in at $1,8M.

At the end of the day, there is the formal approach to value and then each investor has to weigh other factors as well, such as their personal investing horizon (when do they want to see a return?) and what level of risk they willing to take on based on their belief of how well the market will perform.

I hope this posts helps you understand what goes into values of multi-family properties. Please leave some comments.

I’d love to hear from you.

To your success in all areas of your life,

Pierre-Paul

 

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