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CAP RATE: MULTI-FAMILY INVESTMENTS

Capitalization Rate (Cap Rate) is often used to estimate the value of investment real estate, four units or more multi-family property, and most often used to determine the investment property’s fair market value by using the “fair market” cap rate for the specific type of investment real estate. It is a more accurate way of measuring value or price than simply using the multiple of gross income method or price per unit method. Cap rate method takes into account variables like vacancy factor and expenses of the investment, while the multiple of gross income or price per unit method does not. Appraisers also take into the account other factors, i.e. the overall market trend, whether the property is operating in its optimum state, deferred maintenance, etc. to determine the value.

Less than four units residential investment is often bought and sold through residential real estate agents, not taking into account certain investment principles. Still the investor needs to do the simple mathematics to ensure a positive cash flow and investment return, taking into account the terms and conditions of the financing.

The fair market price or value of the property can be calculated by dividing Net Operating Income (NOI) by the “fair market” cap rate. This is the “Income Approach”. The cap rate is expressed as a percentage. The “Fair Market” cap rate can range from 5.1% for a San Francisco 109-unit apartment sold Jan of 2004 to a 7.0% for a Rogue Valley apartment. An investor prefers to purchase with a high cap rate and the seller wants to sell at a low cap rate as indicated by the Net Operating Income of the property.

REVIEWING THE DATA:
The same investment property can have many capitalization rates. They are all valid. A competent evaluation of the data and assumptions used on the Annual Property Operating Data (APOD) worksheet and the careful due diligence through the reviewing of the leases and the condition of the property will help the investor arrive at a cap rate. A sample APOD is provided with this article.

Since the key number to compute a capitalization rate is the Net Operating Income (NOI), the time frames applied to one NOI number will result in a different capitalization rate. For example, using last year’s NOI; or last month’s NOI annualized; or from a 12 month forward and then annualized. As the NOI is the result of subtracting expenses from the adjusted gross income, it is imperative to qualify those numbers. The objective is to verify the numbers used, whether they are an accurate or a good representation of the operation of the real estate.

TIME FRAME:
The total income for the time frame used may include non-recurring income or projected income from vacant units. The time frame being applied might exclude rebates and/or discounts that the tenant is contractually entitled to. The time frame being used might not show a large number of leases expiring or any delinquent accounts receivable. If the current tenants in place are long term and have not has any rent increases for a long time, the increasing expenses will erode the NOI.

CALCULATING EXPENSES:
The expenses could appear artificially lean through time frames, accounting methods and management philosophies. If the accounting method is on a cash basis, those expenses that are not within the time frame should be identified. Property management fees may be missing or maintenance reserves excluded. There may be cash outlays that are gray on being capitalized or expensed; sometimes cash flow is just deferred maintenance. There should be an adjustment for property manager’s expenses or cost of preparing new units to be rented. Some tenants may have been given rent concessions through new capital improvements to the unit. Such capital improvements like new stoves or refrigerators, may be amortized over a period of the useful life of the items as expenses. The economic rent could be more reflective of the current market. Maintenance reserves, usually five percent of the schedule gross income, may be included as expenses. The accumulated maintenance reserve fund prepares for future roof replacement, repaving of parking lots, painting of the property and the like.

REASONS FOR PURCHASING A PROPERTY WITH A LOWER CAP RATE:
Some investors may purchase at a lower cap rate for the following reasons:

1. Supply and demand on good multi-family investment
2. Obtaining a low interest rate loan to increase the internal rate of return (IRR)
3. Capital appreciation in future years
4. The investment is not in its optimized operating state

CAREFUL EVALUATION:
The careful evaluation of the APOD prepared by the seller, the buyer’s reconstructed APOD, employing a competent commercial investment real estate professional to prepare the APOD or the use of due diligence to thoroughly understand the operation of the property will conclude an accurate capitalization rate.

©Sam Fung, CCIM, Oregon Commercial, LLC