If you’re reading this, I assume you’re more-than-a-little-bit interested in buying apartment buildings. But what to buy? Put another way: Of all the buildings on the market, which are the “good deals”?
What’s a “good deal”? Apartment buildings aren’t like houses. You don’t buy them for the feng shui. You buy them because you place a certain value on the cash flow they produce or for the cash flow you can imagine them producing with some additional investment from you.
“OK,” you say, “but that doesn’t help me very much. I’m looking for a good deal on a building and I have no idea what a good deal looks like.”
Here’s an idea: Take the facts about the building (the number of apartments, the total rent, the square footage, etc.), apply the tools below, and process those facts into an educated opinion about its value. Then, if you can negotiate a price that’s less than the building’s value, BAM! You buy. Simple, right?
Here are the tools:
Tool 1: Gross rent multiple (GRM)
Intuitively, the more rent the building commands, the more valuable it should be. So we can look at the rents and use them to get at an approximation of its value. The simplest way to do this is called the “gross rent multiple” approach.
To get a rough estimate of a building’s value, start by adding up all the rent a building takes in in one month. So, if you have eight units each renting for $1,000 per month, the total “gross” rent is 8 x $1,000 = $8,000. Next, multiply the monthly figure by 12 months to get the annual gross rent. For our example, multiply $8,000 x 12 = $96,000 annual gross rent.
As I write this in late 2011, in Los Angeles, a reasonable range for the value of an apartment building is between 9-11 times gross rents. This is called the GRM: “Gross Rent Multiple”. So, to value our sample building above, I would multiply $96,000 x 9 = $864,000 to get the bottom of the valuation range and $96,000 x 11 = $1,056,000 to get the top end of the range. “But,” you ask, “how do I decide whether to use ‘9’ or ’11’ or some other number?”
In general, the more desirable (and, therefore, less risky) an area, the higher the GRM. So a building in the best part of Beverly Hills might go for 12-13 GRM. A run-down building in Compton might go for 7 GRM.
Ideally, you want to review the data on recent sales of comparable buildings in the target area to get a sense for the rent multiples they have sold for. To get the GRM for a given comparable building, check the price it sold for and the rents it was getting at the time. Divide the price by the gross annual rent and that’s your GRM. For example, if a similar building was getting $100,000 in annual gross rent and sold for $1,000,000 recently, divide $1,000,000 / $100,000 = 10 GRM. Then, multiply the rents on your target building by ten to get your value.
GRM is a quick and dirty way to get a valuation range for a building. But it leaves out something very important: costs! To get a more accurate sense for the value of a building, we should look to the CAP rate method, which takes costs into account.
Tool 2: CAP rate
The idea behind the CAP rate method is also pretty simple. We want to compare the actual profitability of a building to its value. To do this, we need to start by figuring out what the “net operating income” or NOI is.
You calculate NOI by taking the total annual rent and subtracting all of the costs of running the building, including property tax but NOT any mortgage payments. For example: Take your building above, the one bringing in $96,000 per year. Subtract 3% of the rents for a vacancy reserve. Then subtract the utilities, gardening, cleaning, maintenance, management, repair reserve and property taxes. Let’s say we estimate all of the following at around $33,600 per year. To get the NOI, we’d calculate $96,000 – $33,600 = $62,400. That’s the amount of net operating income the building generates.
To go from the NOI to an estimate of value, you need what’s called a capitalization rate, or a “CAP rate”. This is a ratio between the price similar buildings have sold for and the NOI they were generating. To calculate a CAP rate, you divide the
price of the building by its NOI NOI by the price of the building. So if a comparable building sold around the corner for $1,000,000 and it was generating $75,000 in NOI, the CAP rate can be calculated like this: $1,000,000 / $75,000 $75,000/$1,000,000 = .075, or 7.5%. Another way to think about this is: If you bought that building for $1,000,000, you would be earning $75,000 per year in profits, or 7.5% return on your money. Beats a bank account, huh?
In general, CAP rates in LA range from 4.5%, for great buildings in the absolute best areas, to around 9% for bad buildings in crappy areas. Let’s take our $62,400 Net Operating Income building from above. If it’s in a great area, we’d use a 4.5% cap rate on it. We would divide the NOI by the CAP rate. So, $62,400 / 0.045 = $1,386,667(!!) On the other hand, if it were in a bad area, we might put a 9% CAP rate on it, making its value $62,400 / 0.09 = $693,333. That’s a big, big difference in value… note the importance of choosing the right CAP rate!
Tools 3 & 4: Bulk buying
Some buyers ignore the cash flow entirely. Maybe they’re already rich and figure they’ll buy in a good area and hope for appreciation over time. Or maybe (like me!) they’re going to totally change the building anyway, so the existing rents and expenses are irrelevant. These buyers buy “in bulk” or “by the pound”. The two ways of doing this are by looking at the value per square foot of building and the value per unit.
Let’s look at value per square foot first. Here the buyer is saying: “I don’t really care about the rents. I figure those might change. I just want to know whether it’s cheaper to buy this existing building or go build a new one like it.” So they use a rule of thumb, like $100 per square foot. They take the square footage of the existing building and multiply it by their rule of thumb to get an approximation of value. Let’s imagine our sample building (the one generating $96,000 in rents and $62,400 in NOI) is 8,800 sq ft (including eight 1,000 sq. ft. apartments plus 800 sq. ft. of hallway, etc.). Our bulk buyer might just go: $100 x 8,800 = $880,000. Generally, in LA, the best areas can support $300-400 per square foot, while the worst areas might only support $80 per square foot.
Finally, there’s value per unit (or “per apartment” or “per door”). This is exactly what it sounds like. You take a rule of thumb for the value of each apartment and you multiply it by the number of apartments in the building. Your rule of thumb might say you won’t value any unit at more than $100,000. So your eight unit building is worth: 8 x $100,000 = $800,000. This is a very blunt tool: It doesn’t distinguish between tiny studio apartments and glorious, sprawling three bedroom units with parking. That said, some people use it. In LA, you will see some newer buildings in great areas going for more than $300,000 per unit, while in bad areas I’ve seen deals close at prices equating to $45,000 per unit.
Tying it all together
As you can see, the different tools for valuing apartment buildings can lead to vastly different estimates of value. Unfortunately, there’s no clean way to combine them all to get at one “true” estimate. As always, value ends up being mostly in the eyes of the beholder: Are you a cash flow player? Then the CAP rate value is most important to you. A re-habber? You probably buy in bulk.
If you’re smart, though, whichever kind of buyer you are, you’ll evaluate potential acquisitions with all of the tools available. What you’ll get, in the end, is a range. And somewhere in that range is a fair value for the building.