Value for multi-family property

You may want to try to find comps sales close to the area you are looking in. Also, run the numbers (revenue and expenses) on the property and see how the profit margin may be if you are looking at holding it as a rental. Does the property cash flow all expenses and even produce an extra positive cash flow each month? Are the current rents at market rate and do you see a chance to raise the rents based on some minor/major improvements? What is the condition of the neighborhood the 4 unit is in? Is it up and coming and moving in the wrong direction? These can be all things that may impact the value of the building. I hope this helps. Good luck with this deal. Believe and Achieve! - Joe

Apt. in small town only one in town. There are a couple of duplexes in town that are rented. Owner has not had any problems renting units. All units have been redone in last year and half. Units sit on one of three main streets in town. the area is a good area with lots of traffic one block from restaurants and conveince store. Rent could be raised a little but not much more.

This could be a good deal. List out all the expenses by month and then for the year. Compare the expenses to the revenue generated. Then calculate a payment including principal, interest, insurance and property taxes. Setup a small reserve each month for repairs and other expenses such as any utilities or management fees. Also look at larger items such as roofs, furnace, central air untis, hot waters heaters, appliance (if furnished) and determine if you need a reserve account for these items. If you have a positive cash flow for a shorter mortage such as a 15 year compared to a 30 year the better. If asking price of the unit is $100k, maybe ask the seller how they arrived at that price. Their answer may surprise you. Also, see what option if any the selelr would finance or hold a second mortgage. Good luck on this potential deal. Believe and Achieve! - Joe

Starting out as an income-property investor, one of the first things I needed to learn was the correct way to calculate the maximum I should be paying for a property in order to achieve my investment goals.

One of my goals was to obtain a certain return on my investment, but I realized that the ability to attain this goal was dependent on the fact that I needed to borrow funds to purchase a property. So, in order to have an intelligent starting point for my analysis, I needed to take two things into account – my desired return on investment and the fact that I needed to borrow funds to purchase the property.

I learned that many people in the real estate business determine the value of an income property by calculating the capitalization rate, but I also learned that there are different ways to calculate this rate depending on whether or not financing was used to purchase the property.

Scenario #1
For instance, I learned that brokers and lenders mainly quote deals based on the simplest cap rate calculation:

Annual Net Operating Income/Purchase Price of the Property = Cap Rate %

But this cap rate is merely the projected annual return when the property is bought with all cash and no financing is required. So, this particular calculation did not apply to me. [Note: In this scenario, Annual NOI = Annual Revenues – Annual Operating Expenses, (and operating expense does not include debt expenses)]

Scenario #2
I learned that brokers in particular sometimes quoted a “market cap rate” that they would use as a comparison tool determining what other properties sold for on the basis of the cap rate. But I also learned that, while it’s possible a broker may have the detail of several deals in the marketplace to use as comparables and these details may provide enough information to calculate a market cap rate, few brokers are involved in enough deals during the time period of one particular market-condition to have that much information

Scenario #3
Because I had to borrow funds, I learned that I had to find a way to calculate what is commonly known as the “cash-on-cash” return on my investment using leverage (debt). I learned to calculate this by first calculating the debt service, then subtract it from the NOI, and calculate by return. If I later refinanced or changed my return requirements due to rental-market conditions, I would have to recalculate this rate. Then I found a better way to calculate the cap rate for my particular investment goals in Scenario #4.

Scenario #4
First, I try to get as accurate data as I can on the Annual Gross Income derived from the property and the Annual Operating Expenses necessary to maintain the property. When getting financing via either seller-financing or an assumable mortgage, I find it’s easier to get this information because of the relationship established with the seller with these finance options.

In any event, for Gross Income, I ask for enough data to get a picture of the amount of rent that’s currently being charged for each unit. I can then easily verify the Annual Gross Income by an analysis of Rent-Rolls that should be available at closing.

For Operating Expenses, typical expenses are pretty much the same as you would need when owning your own home, and then a few more. After identifying these expenses, I would verify as many of the expenses with third party suppliers as possible. But, note that no two real estate investors will own and operate a property the same way; so, it’s possible for two investors to come up with two different Operating Expense totals, and both are entirely plausible. In short, before accepting the NOI presented, I try to understand what is behind the numbers. I want to arrive at what is known as a normalized NOI.

That’s why appraisers use comparable sales, replacement values, and the income approach – using due diligence when estimating a properties value. This third method, the income approach, is usually given the most weight. It addresses the return required on both Equity and Debt, and leads to what is called a Derived Capitalization Rate.

To calculate the Derived Capitalization Rate, I simply need to do three things: (1) Make sure I’m reasonably certain my normalized NOI is as accurate as possible using the steps mentioned above, (2) Know the terms of the financing available to me, and (3) determine the rate of return I desire on the property.

When I use the terms of financing for both debt and equity to indicate the value at a point in time (say, at year-end), I can calculate the derived cap rate that reflects those terms. In other words, deriving a cap rate works like a weighted average, using the known required terms of debt and equity capital.

First I start with the terms of Debt. Because I know the terms of the financing available, I can calculate the “mortgage constant” (some people also call this a “loan constant”). The mortgage constant, when multiplied by the mortgage amount, gives the total payment needed to fully repay the debt over the specified amortization period. When calculating a derivative cap rate, I must use this constant since it encompasses both the amortization and the interest rate, rather than just the interest rate.

To simplify things, lets use the following example to calculate the mortgage constant of a $75,000 10yr fixed rate loan at 6.16% starting October 15, 2009 with a maximum loan amount of 75% of the lower of cost or value for a income property with an asking price of $100,000 with the seller paying for closing costs. I personally like the payment/amortization calculator in the following link:

http://www.bankrate.com/calculators/mortgages/mortgage-calculator.aspx

The monthly payment for those terms is $838.69, which annualized becomes $10,064.28 for the Annual Debt Service. Using the formula:

Annual Debt Service/Mortgage Principal Amount = Mortgage Constant

10,064/75,000 = .13419

Under these terms, the mortgage constant would be the same regardless of the Mortgage Principal Amount. For instance, I’m currently in the process of using the principles in this blog for calculating whether I’m able to obtain my desired return on investment for the following properties that are being offered as a package, and for which I am considering for a commercial income investment – but only if the numbers are right. This is the investment I found:

Seller is offering four 8-unit 3BR properties and one 3-unit 3BR property, located next to each other on the same block with a large parking lot and garage directly across a side street. Seller is offering these properties to buyer via an assumable mortgage in the amount of $1,275,000 with a 10yr fixed-rate @ 6.16%. Since these are the same terms I used in our $75,000 loan example, the calculated mortgage constant should be the same. Let’s try it ……..

Using the link above, the monthly payment for those terms is $14,257.78, which annualized becomes $171,093.36 of Annual Debt Service. Using the mortgage constant formula above, you can see the mortgage constant remains the same:

171,093.36/1,275,000 = .13419

Note that this mortgage constant of .13419 is essentially the cap rate that the seller of this property currently has on this package of properties.

Next I need to provide for the return on Equity. Now that I have the mortgage constant, I need to calculate the “cash-on-cash” return rate for Equity that I mentioned in Scenario #3. Both the mortgage constant for debt and the cash-on-cash rate for equity are considered ‘cap rates’ because both capitalizes a single year’s income in a value (as opposed to a yield rate). The following shows why this is important.

In my first example for the $75,000 loan, let’s assume I desire a return of 20%. This percentage represents the cap rate to the equity position, and is commonly referred to as the equity constant. Because the maximum loan for this example was 75% of the asking price of the property ($100,000-which was lower than properties assessed value) and a down payment of $25,000 represents the equity I’ve put into the property, then the annual amount I desire in my pocket after paying the mortgage (but before income taxes) would have to be $5,000. In this case, .25 is the equity constant.

For the $100,000 property, the cap rates that I’ve derived – the mortgage constant and the equity constant – are then weighted based on the loan-to-value ratio of each of the Debt and Equity positions to come up with the Overall Cap Rate. Using the formula:

(LTV Debt Ratio x Mortgage Constant) + (LTV equity ratio x equity constant) = Derived Cap Rate

(.75 x .13419) + (.25 x .25) = .15064 or 15.064%

For this $100,000 property, say I calculated the normalized annual NOI to be $18,000 using the steps mentioned at the beginning of Scenario #4, then the maximum I should be paying for this property in order to achieve my investment goals would be as follows:

Normalized NOI/Overall Cap Rate = Maximum Purchase Price

$18,000/15.064% = $120,000

Congratulations to me, since the asking price is $20,000 less than the Maximum Purchase Price, this is a property that would definitely be worth hurrying to take a look at. But, as I stated in the third sentence of this blog, this valuation is a starting point in my analysis – it is not the conclusion of my analysis. I’ll explain this further, but first I want to go on so that I can finish analyzing the $1.275M package of properties mentioned previously in this blog.

For the $1.275M package of properties, I first need to determine what return I want on my money. I usually do not seek a return of less than 10%, and usually shoot for anywhere between 10-20%. But, because $1.275M investment mentioned above provides for the opportunity to assume the sellers mortgage at 6.16%, I am willing to accept a rate of return of 10% as a starting point in this analysis.

Since the seller will be allowing me to assume his mortgage, I will have to provide no down payment or closing costs. But I will have some relatively small buyer-realtor fees, inspector fees, mold/radon testing, attorney fees, and initial property management set-up fees. So, say I have to put in $20,000; since I desire a 10% pre-tax return, then my annual cash in my pocket after paying the mortgage (but before income taxes) would have to be $2,000. In this case, .10 is the equity constant. So, for me, that makes the purchase price $1.295M, and the loan-to-value ratio becomes 98.5%

For the $1.295M property, the cap rates that I’ve derived – the mortgage constant and the equity constant – are then weighted based on the loan-to-value ratio of each of the Debt and Equity positions to come up with the Overall Cap Rate. Again,

(LTV Debt Ratio x Mortgage Constant) + (LTV equity ratio x equity constant) = Derived Cap Rate

(.985 x .13419) + (.015 x .10) = .13368 or 13.368%

For this $1.295M property, you can now see how important it is that I previously calculated a reasonable normalized annual NOI that is as accurate as possible, since the results of the next step are so heavily dependent on an accurate normalized NOI. But in this example, I’ll estimate the normalized annual NOI to be $176,600 (remember, this excludes debt service expenses). Using the steps mentioned at the beginning of Scenario #4, then the maximum I should be paying for this property in order to achieve my investment goals would be as follows:

Normalized NOI/Overall Cap Rate = Maximum Purchase Price

$176,600/13.368% = $1,321,065

Again - Congratulations to me, since the asking price is $46,065 less than the Maximum Purchase Price; considering the fact I estimated the rental income per unit to be $100 less than what is typical for that area to account for any deferred maintenance that may come up.

But, as I stated twice now previously, this valuation is a starting point in my analysis – it is not the conclusion of my analysis. I still need to consider many other factors that can influence the value of this income property package; such as, internal/external condition of the property, tenant payment ability strengths and length of leases, and general economic/rental-market conditions in the specific area. The risk and effort involved in the continuance of the income stream of these properties must be investigated thoroughly.

Normally, as the cost of any of these factors increases, I would increase the required return on my Equity to offset the increased risk taken and the increased effort required to mitigate that risk. But, since my equity position in this $1.275M deal is so minimal, any increase to my desired equity return would have minimal impact. Also, because assuming this mortgage under these terms seems very advantageous, alternative scenarios of loan terms/rate would not produce a beneficial impact to this deals calculated mortgage constant.

You can see now why it is so important to verify the sellers existing income and expense before establishing a properties value. This exercise in what the lawyers call ‘due diligence’ determines whether you will actually succeed as a real estate investor.

I hope this helps you in finding out what a property is really worth, and allows you to obtain your desired return on the investment.

Vty,

Dan D.

Dan D's explanation is much more comprehensive than mine, but I'll share it anyway. 1. Annualize income 12 x $1,300= $15,600 subtract from that a vacancy factor since some months the units will be empty, normally use 5-10% vacancy. Subtract property taxes and insurance and a figure for on-going maintenance to get net operating income.
Gross vacancy Taxes Insurance Maintenance
$15,600- $1,560- $1,200- $1,000- $2,500= $9,340

If the NOI is $9,340 and you expect to make a 10% return on investment; divide the NOI by ten percent. That means you could pay $93,400 for that property. If you expect higher returns, you have to pay less for the property. Example: 12% return would lower purchase price to $77,833.