Posted by Michael Le on December 24, 2006 at 01:32:36:
Personally for me I just figure I can get 10.5% off stocks over the long term with not much to worry or think about. A 12-13% return doesn’t seem that attractive at that point if I have to put all this time and energy into researching and managing, etc, this property. Something around 20% will give me something to show for all the stuff I do.
Market value of Apartment building??? - Posted by Kip Hamilton
Posted by Kip Hamilton on December 22, 2006 at 08:46:44:
I have a question reqarding placing a mkt. value on an apartment building. There is a good rule of thumb that states that a building is worth about monthly gross rents / .02. But I’m wondering how that really works. For example, I am looking at a 10-unit building listed for $650K. Each unit is $550/mo. Gross monthly rent is $5500 / .02 = $275K. Market value using the 2% rule… Now, I truly believe that the asking price is too high, but the building is sitting on 2 lots in the “downtown” part of the city it’s in. Small, old SFH around it are going for $250K - $325K. I know that its apples to oranges comparison and if the building were out in the middle of a cornfield, then it might only be $275K, but even though the gross rents are $5500, its sitting on a valuable piece of ground in a good location. I know its worth what the market makes it worth and what someone will pay for it blah, blah, blah, but when you are evaluating an apartment building, does the 2% rule really work? How do you account for the location of the building in computing it’s value? In my real worls case, I know its not worth $650K and I believe it’s more than $275K. How do I figure out what to offer?
Thanks guys!
Kip
Re: Market value of Apartment building??? - Posted by ray@lcorn
Posted by ray@lcorn on December 22, 2006 at 17:17:14:
Kip,
The only use for thumbs in valuation is to hold the actual financial statements that show the property’s historical operating data. Your 2% “rule” is just a variation on GRM, both of which tell you exactly nothing about net operating income.
For example, your deal has $5500 mo. rent. If that’s all you know, then you can get a rough estimate of value using an average expense ratio of 40% and say a 9% cap rate (if that’s appropriate, more in a moment).
5500 x 12 = 66000 gross
x 40% expense = 26400
NOI = 39600
39,600 / 9% cap = $440,000
But that’s a very rough ballpark number without knowing the actual income & expenses and the appropriate cap rate based on actual property condition, property- and borrower-specific finance terms, and your return requirements.
For more on how to properly calculate cap rates, see this article: http://www.real-estate-online.com/articles/art-216.html
Once you have the actual NOI and the appropriate cap rate you’re still not finished. The income approach is ony one of three measures of value, and should be compared with replacement cost and comp sale data to complete the process.
ray
DON;T USE GROSS RENTS - Posted by Gary
Posted by Gary on December 22, 2006 at 15:55:11:
An analysis based solely on gross rents is faulty. It is extremely important that expenses be caluculated into the equation (particularly on commercial or apartment projects). This is why appraisers will almost exclusively use a capitalization rate (usually between 9% and 12%) based on the property condition, location, and demand for such a property.
The formula is I/R=V
I represents net income. Net income is gross annual income minus annual expenses, minus annual vacancy factor (usually 5-10%).
R represents the Cap rate. You might consider asking an appraiser or Realtor what the current Cap rate is for your area.
V represents the Value. This is what you will solve for.
I hope this helps. Also, you will want to consider triple-net leases, minimizing or eliminating your expenses. Also, is there CAM charges (Common Area Maintenance)? If not, you may want to consider this as well. LOL
Re: Market value of Apartment building??? - Posted by George
Posted by George on December 23, 2006 at 17:44:54:
Ray,
In your article “What’s it Worth? Deriving Your Capitalization Rate”, you determine that you want 20% cash on cash return. You then use this 20% number in your calculations. How do you come up with 20%? What factors do you consider to come up with 20%? I am sure that most investors should come up with a very similar number that they want for a cash on cash return, otherwise there would be a tremendous discrepancy in the price that a building sells for. If you want too high a return, you will never have any offer accepted. If you want too little return, then you may likely over pay for a building, which would not be nice. So, hence my question, what factors make you come up with 20% or whatever other number that is appropriate?
Thanks,
George
Re: Market value of Apartment building??? - Posted by ray@lcorn
Posted by ray@lcorn on December 26, 2006 at 14:14:35:
George,
Michael’s post below is close to my own thinking. I don’t rely on any one target number to set value. It’s a process of establishing the amount of risk and effort required to accomplish the investment plan for the property.
As to how I come up with what is an acceptable return for a particular deal, I go through somewhat the same process Michael mentioned. Rather than comparing to stocks, most in the industry use bond rates as the baseline for returns because of the similarities of the income streams and risk ractors. I can get around 5% from gov’t bonds (pre-tax and pre-inflation) or so with no risk or effort on my part. After that come corporate bonds, which range from 7% to 8% without getting into junk status.
So real estate has to beat that benchmark before I’m interested at all. Single tenant, NNN deals I’ve done as low as 8.5% (and was a happy seller in the run-up to 6% caps), because there is little risk and zero effort.
But most big money in investment real estate is made in turnarounds, redevelopment, expansion and properties with some sort of problem. For those I have to show up (meaning lots of effort), and take some risk (market, competitive opportunities, capital, etc.) For these, structure becomes the driving force, not price.
When I evaluate that type of deal I will usually be driven by a rule of thumb we’ve used in our family business for years… structure the deal to get our equity capital back within three years. Why three? I don’t know, that’s just a time frame that often works for getting the property acquired, repositioned (or whatever), stabilized and qualified for a refi. Sometimes it doesn’t take that long, sometimes longer. But we use 3 years to pencil the deal.
Using the Rule of 72, (72 divided by the time required to double your money equals the return i.e. 72/3= 24% (and vice versa)) gives me the target return for the cumulative average return over the hold period (i.e. 24%). But it is rare when the returns will be even, and very rare (if ever) when it will actually produce 24% first year return. I have structured deals for a worst-case, first year break-even (meaning zero return), but hit 30% and 50% or so in years two and three. That gets me where I want to be, but the details will always be unique to the property and the plan. I use the 20% number I mentioned in the article as a proxy for a deal with an average degree of risk and effort.
A cap rate is best used as a primary valuation tool only for stabilized properties, meaning those with little to no deferred maintenance and predictable income stream, i.e. stable rent roll and market outlook.
For deals like that, my thinking is that a range of 10%-15% pre-tax return would be appropriate. The lower end of the range would include those properties with professional management in place, with long-term, fixed-rate debt, below average leverage (less than 75% LTV), and a seven-year plus hold time. The higher end of the range would include those with some management required, above average leverage (greater than 80% LTV), and less-favorable terms. The idea is to fit the amount of risk and effort required to the return. What we’ve seen in the run-up of prices (low caps) is a reduction in the risk premium for real estate, attributed mainly to the low cost of capital. But as you can tell it is not an exact science.
But, and as I have written repeatedly, there is no magic bullet for valuation. A cap rate is just one tool, albeit a useful one, among many, to be used in forming an overall investment plan for the property and your investment portfolio as a whole. In that sense, if the deal doesn?t fit your personal goals it doesn?t matter what the cap rate is, does it?
ray
p.s. another good topic is in assessing degrees and types of risk… I mentioned it above with no real explanation, but there are five or six sources of risk, not all of which are rated equally, and a few which actually work to our favor. Maybe a future article?
Re: Market value of Apartment building??? - Posted by Michael Le
Posted by Michael Le on December 24, 2006 at 01:14:19:
I don’t want to speak for Ray but in general the COC is just a number that represents what returns you are willing to invest your time and money for. You might think 20% is high but obviously there are plenty of people (like Ray) getting returns like that and higher. And you may not get a lot of your offers accepted at those prices so you just make a lot of offers. Plus I think there is a lot of other factors to take into consideration. I believe an expert like Ray makes his money on the terms of the deal, the creative part. I don’t think it’s a simple matter of taking the NOI and dividing the CAP rate. He can structure his deals to work towards his goal.
Re: Market value of Apartment building??? - Posted by George
Posted by George on January 02, 2007 at 21:42:28:
Ray,
Thank you for your excellent response.
As you mentioned, the other variable is ?risk?, which would impact what you would require for a return. This risk would need to be defined for various categories of property. What class of property (A, B, C) would qualify for your 20% cash on cash return requirement that you mention?
You said:
?p.s. another good topic is in assessing degrees and types of risk… I mentioned it above with no real explanation, but there are five or six sources of risk, not all of which are rated equally, and a few which actually work to our favor. Maybe a future article??
I think that would be a great idea.
Another question I have is: Does the apartment real estate cycle correlate with the SFR house real estate cycle, or is the cycle different, and if so in what way?
Thanks,
George
Re: Market value of Apartment building??? - Posted by George
Posted by George on December 24, 2006 at 01:26:43:
Michael,
It’s not that I think 20% is high. My question is why 20%? How does one come up with this number, whether it be 20%, 40%, 10%. How does one determine what this number should be?