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Multifamily Properties – Why the Cap Rate is Insufficient for Determining Investment Value

 

In the multifamily market, the cap rate or “capitalization rate” plays a dominant role in determining the market price of a property. By definition, it is the calculation used to “determine the ability of the property to carry debt as well as for a measure of overall returns” (Miller & Geltner, 2005, p. 298). However, there are drawbacks that makes the cap rate insufficient for determining investment value. Firstly, the cap rate offers a limited perspective; it only looks at the first year forecast of cash flow; it does not take into consideration the impact of financing and taxes (CCIM Institute, 2005, p. 6.6).

These are important considerations in the overall determination of investment performance. Among investors, it is a “common misconception when using the term ‘cap rate’ that some investors assume the overall cap rate is equal to the return on their invested capital; this is rarely the case” (CCIM Institute, 2005, p. 6.6). Yet, investors continue acquiring properties at 4% – 5% cap rates. It is keeping the price of properties inflated in certain markets. An investor that buys an apartment building at a 7% cap rate could still find themselves earning very low returns–or losing value–if the property does not cash flow as anticipated. Therefore a cap rate is insufficient, because it does not include important considerations such as investor preference, capital investment, or material financial information that would impact how a property performs over the term of the anticipated holding period.

A true reflection of investment value also takes into account the total cost of the property, which includes capital investments, the cost of capital, and the impact of taxes. A cap rate does not accomplish this. It may offer a starting point as to understanding market sentiment; but in order to make an accurate determination of how much a dollar truly earns while it is invested requires that an investor focus on “IRR,” or internal rate of return, instead of focusing on the cap rate. An investor must examine the cash flows that a property produces; they should also determine the perceived risk factor of those cash flows, assign a required rate of return for the level of risk assumed, and then apply that required rate when examining the cost of acquiring, renovating, operating, and maintaining the property. Otherwise, an investor may find themselves realizing paltry returns, if any return on investment at all.

Two properties in the same market might have the same market value by cap rate, but if one property has a higher cost of operation or requires a significant investment of capital to make it rent-ready, it will increase uncertainty and, thus, increase the risk of the cash flows. This increased risk should also increase an investors’ required internal rate of return, which is “the percentage rate earned on each dollar invested for each period it is invested” (CCIM Institute, 2005, p. 6.10). In a low cap-rate environment, many sellers cling to cap rate driven trends and many of them remain firm on price regardless of circumstances surrounding the property. While this is certainly a sellers’ prerogative, a savvy apartment buyer will not let emotion drive the investment decision. Apartment buyers must know up-front how their money will perform and only choose to invest in apartment buildings that will provide attractive internal rates of return—which should be in the range of 15% – 20% for multifamily properties—give or take—depending on the level of risk perceived and assumed by the investor.

Owning and operating an apartment building carries more risk than parking money in a CD or savings account; because of this risk, it should earn a higher return on investment, “To compensate an investor for more or less risk relative to other investment opportunities requires a change in the required rate of return” (Miller & Geltner, 2005, p. 336). Assuming more risk should be a factor in investors’ perception of investment value and what they ultimately pay for the property. If not careful, apartment buyers that rationalize acquiring properties at low cap rates may find themselves earning returns comparable to “safer” investment vehicles such as CDs and savings account. Savvy apartment buyers know that when “determining investment value of a property, the investor decides what to pay to achieve given performance objectives,” (CCIM Institute, 2005, p. 6.2); the sellers’ desire for top dollar does not come into play. Basing investment decisions on a market cap rate alone is the equivalent of catering to sellers; it leaves apartment buyers at risk of finding each dollar invested underperforming—or losing value.  Apartment buyers must be sufficiently compensated for the level of risk they assume, or else money is better off invested in a “safer” vehicle—not real estate.

In order to obtain a perspective that would allow an investor to make an informed decision, an investor would need to look beyond the first year using historical operating data within the context of the intended holding period (typically 5 or 10 years). A cap rate cannot do this, so a cap rate should not be used as the basis of establishing investment value. Investment value is “the amount that an investor would pay for a specific property, given that investor’s investment objectives, including target yield and tax position” (CCIM Institute, 2005, p. 6.3). Please notice that this definition of investment value does not include the involvement of seller preferences.

 

References

CCIM Institute. (2005). CI101: Financial Analysis for Commercial Investment Real Estate. Chicago: CCIM Institute.

Miller, N. G., & Geltner, D. M. (2005). Real Estate Principles for the new Economy. Ohio: South-Western.

 

Good Advice from Colorado Springs Apartment Investor: Deeper Analysis of a Potential Apartment Purchase

 

Deeper Analysis of a Potential Apartment Purchase

By Les Goss

After using a property’s annual income and expense data, combined with the local cap rate to determine value, most offerings will be set aside as the unrealistic dreams of a deluded seller. Occasionally, however, a property will pass our first scan and deserve a second look. So what are the next steps to determine if we’ve really found a keeper?

The first step is to dig more deeply into the financial reports released by the seller. The critical thing to watch for here is to separate the actual figures from the pro forma numbers. Every seller, with the help of their broker, will attempt to paint the rosiest picture possible. You’ll do the same when it’s time for you to sell.

As an example, I’ll use information pulled from the most recent offer to cross my desk via Loopnet, a 28-unit C class apartment in Colorado Springs, offered at $1.3 million.

The Annual Property Operating Data (APOD) is a one-page summary of income and expenses. It calculates the Net Operating Income (NOI) as well as the cash flow before taxes. This particular APOD shows a cap rate of 8.79%, certainly within the current range of 8-9% expected for this class of apartment in this town in this year. It also lists the cash flow as $114,280 per year, or just over $9,500 per month. Assuming you paid the asking price of $1.3 million and put down 25%, or $325,000, the cash-on-cash return would be 114,280/325,000 or 35.2% So far, the numbers look promising.

But let’s look a little deeper. One of the easiest tricks to play is to merely leave some lines of the APOD blank. It’s easy to overlook something that is not even there. On this APOD there is a line for Management Services, but there is no number next to it. Even if you choose to manage it yourself, you should put a value on your time and effort. As it turns out, last year $8,300 went to this line item, which represents a 7.2% charge, reasonable in this market for this size property. Of course, underestimating your expenses, in this case by leaving one out, has the effect of increasing the NOI, which drives up the property value.

The other sin of omission occurs here by neglecting to include the annual debt service. Using the broker’s assumptions of 25% down and a 4.5% interest rate, the total mortgage payment is $60,800 per year. This is subtracted from the NOI to get the actual before-tax cash flow, which now drops to $53,480. This makes the actual cash-on-cash return 16.5%, definitely decent but less than half of what was shown on the APOD. Leaving out the management fee and the debt service has the effect of making this deal look much better than it actually is.

Now let’s look more closely at the income assumptions. The APOD has a note indicating that the current market rent for one-bedroom apartments is $495 per month. Since all the units in this apartment are one-beds, it’s easy to calculate the Potential Rental Income as $166,320 per year (495x28x12). However, in another part of the sales package labeled Income Summary, we find that less than $110,000 was actually collected in rent last year. Why the huge difference? Well, the current rent roll shows that 17 of the 28 units are paying $425 or less per month and only 2 are paying the full $495. What gives? Is the current owner asleep at the wheel, or is there something lacking in this property that prevents him from getting market rent? This is definitely something a potential buyer needs to explore in some depth. In fact, using actual numbers from last year, the cap rate at the asking price is only 4.7%!

Moving on from the financial analysis, we need to envision all the ways we can add value to the property. One of the easiest and most obvious ways is to improve the curb appeal. Potential renters won’t even slow down if the place looks like the owner fell asleep in the 70s and never woke up. A new top coat on the parking lot, well-trimmed and manicured landscaping and perhaps a new exterior paint job can make an apartment look like new almost overnight. Of course if the property has been a low-vacancy eyesore for a few years, changing the name and putting up new signage lets people know a new owner who actually cares for the property is now in charge.

Once you get a prospect inside, they will compare the perceived value to that of other apartments they’ve looked at. This is where your personal market research comes in. What amenities do other properties in your rental range have? Will you need new kitchen cabinets or will a paint job and new hardware be sufficient? Will you opt for new carpet or will you try the linoleum that looks like a hardwood floor? New lights in the kitchen and bathroom can add pizazz for very little cost.

Windows are a controversial topic among owners. If the residents are paying for utilities, it doesn’t directly help the owner to put in new ones, which is why you see so many older buildings with original windows in place. On the other hand, new double pane energy-efficient windows, along with uniform new blinds, can instantly improve the curb appeal. You can also tell prospects that their utility bills will be lower and their apartment quieter and more comfortable. It’s also one more thing the person who buys from you won’t have to pay to replace. In addition, there may be utility rebates available that lower your net cost if you choose to install them. Needless to say, all these expenses must be accurately estimated and still have all the numbers work. If a property has a lot of deferred maintenance, you must factor that into your offer or it’s not worth buying.

The bottom line for all this is how much can you raise the rents? Can you raise them enough to justify these expenditures? Can you buy it cheaply enough to allow these upgrades? You’ll definitely want an experienced member of your team to help you make these decisions when you’re first getting into this.

Finally, you need to look at the operating expenses to see if there are ways to reduce them. Running a more efficient, smarter operation can lower expenses. Do you need a full-time employee or can you outsource many of the operations? Can you charge back your residents for common area water, gas and electricity? Are they being charged for their share of trash pickup? Your market may put limits on how much of this you can do. You might also experiment with a lower rent plus these utility chargebacks versus a higher, all-inclusive rental figure to see which is more enticing to your prospects.

Once you’ve done your quick 5-minute evaluation of the numbers, most properties will be revealed as the duds they are. The ones that pass that first screening are ready for this more in-depth analysis. Once they pass this, it’s time to submit a Letter of Intent and let the negotiations begin. Have fun and good luck!

Les Goss is a real estate investor and syndicator in Colorado Springs, Colorado. You can learn more about investing in apartments and the Colorado Springs apartment market specifically by visiting his blog at http://www.ColoradoSpringsApartmentInvestor.com

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