How To Use A Market Capitalization Rate

When Determining The Value Of A Distressed Apartment Property

Applying a market capitalization rate to the NOI of a distressed apartment building will not likely leave you any further ahead in determining its value, and ultimately the best purchase price for you.

So how does capitalization rate play a part in this process?

First, let me define what I mean by a distressed rental property. In this particular example I mean an apartment building that has vacancies above 40% and is in need of a major rehabilitation, including all of the suites, common areas, roof etc.

The first thing you will have to do is construct a pro forma income statement for the building. In other words, if you were to completely fix up the property, re-rent the suites at market value rental rates, and determine as best as you can what the ongoing operating expenses would be, what would the projected NOI be?

Aside: Pro forma financial statements are typically prepared in an attempt to 'normalize' the financial picture of a business, or in this case a rental property operation. They exclude unusual and non-recurring items in both the revenue and expense sections in order to give the reader or potential investor a better idea of what a typical year's revenue and expenses would be. Click here for a more detailed discussion of real estate pro forma statements.

Once you have determined this projected NOI you can then apply a market capitalization rate to this figure, and hence determine with some accuracy what the value of the apartment property will be once it is 'turned around'.

With this value in hand you can then work backwards to determine an appropriate purchase price. Here is a simple example.

A 50 unit residential rental property is 50% vacant and in poor repair. The owner is asking $20,000 per door (apartment building values are often quoted on a 'per door' basis). The current NOI is zero. In other words, the expenses equal the revenues. Remember it is 50% vacant. The market capitalization rates for similar sized buildings in the area that are in good repair and fully rented at market rates is 8%.

Now, where should we start?

Note: Below you will find an overview of the process you would use to determine a starting point for negotiations for the hypothetical project we are discussing. If you would like a more comprehensive resource that will teach you how to get started in commercial real estate investing, I recommend this e-course called the "Commercial Real Estate Cash Flow Funding System". It's written by a 31 year veteran of the business and will give you a solid foundation of all the different aspects of commercial real estate investment.

Alright, back to our example...

First: Determine what the suites would rent for once they are rehabbed. Say, 50 suites at an average rent of $700. That's $420,000, less 5% vacancy, gives you $399,000.

Second: Determine as best you can what the operating expenses will be. The seller will be able to provide you with things like property taxes, utilities etc. The rest of the figures you will have to determine on your own. A very general rule of thumb is that expenses should be about 40% of the gross income. In this instance that gives us expenses of about $160,000.

$399,000 less $160,000 leaves us with a pro forma NOI of $239,000

Third: Applying the 8% market capitalization rate to this figure gives us a market value after upgrading of approximately $3,000,000 ($239,000 / .08 = $2,987,500 to be exact). That's $60,000 per door, which, after comparing other similar properties, you determine is a fair value.

Fourth: After getting some contractor quotes you determine that the cost to rehab the building is $20,000 per suite or $1,000,000.

Fifth: Do the math. $3,000,000, less $1,000,000 to rehab, less $1,000,000 purchase price leaves a projected profit of $1,000,000.

Sixth: Negotiate a better price!

Now I understand that this is not the type of deal that a part time or new apartment building investor would take on. However, I hope you can see that the analysis that we performed here could certainly be adapted and applied to apartment complexes that would not require as extensive a turn around.

Are you looking to get started investing in apartment buildings?

The best thing I can recommend (other than coming back to my site as often as you can and signing up for my apartment investing newsletter ), is to get your hands on a good, inexpensive introductory course on the subject. A colleague of mine has written just such a course and you can learn more about it here.



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