I would like to know how to appraise a commercial property. I can go into a 20 unit apartment get all the finances and say “At the asking price there will be $1,200 a month positive or $1,200 negative”. But what I can’t do is go into a 20 unit and look at the finances of a property priced at $500,000 property and say “it will appraise out at $750,000”. I am trying to find commercial properties that are less than 65% of market value. I can find a good deal, but I’m not sure how to assign a market value.
I know how to cash flow, but I don’t know how to you assign an actual value to the numbers. Does anyone have any techniques in getting an actual appraised value on commercial apartments???
What your looking for is income capitalization. It’s not something that can reasonably be taught through a forum. There have been a few threads on here with a lot of info to search through. You’ll really have to get a few books or take a class on the subject to be proficient.
There’s a technique that I read about and use that states it’s a smoking deal at 10 x the net operating income (NOI). I agree.
You can also back into it using the financing requirements as a strategy. For example, a conservative lender will require a debt service coverage ratio of 1.25. That means the NOI has to cover the debt service (mortgage payment) by 125%. So on a $500,000 purchase estimate your loan at $400,000 at 7% over 30 years (just P&I) and you get debt service of $2661/mo. This means the NOI needs to be $3326/mo.
To get 10 X the net operating income to = appraised value, you would have a good deal for sure. I need 65% or below the appraised value, so that means I need 10 X net operating income and then multiply that number by .65.
Potential Gross Income
14 units @ $900 per month x 12 months $151,200
Less: Vacancy/Collection Loss - 5% (7,560)
Effective Gross Income $143,640
Less Operating Expenses
Property Taxes (13,500)
Lawn Care (3,500)
Supplies/Maintenance (8,500)
Remodeling (3 Units annually @ $2400) (7,200)
Common Lighting (1,400)
Water & Sewer (4,600)
Hazard Insurance (7,100)
Mngmt - 10% of EGI (14,364)
Reserves (3,500)
[u](63,664) [/u]
Net Operating Income
$79,976
Capitalized" @ 10 % = Indicated Value
($79,976 / .10) = $799,760
So 65% of market value would be $799,760 X .65 = $519,844
or
2.4% rule (12,600 a month in rent / 519,844 = 2.4%)
There’s a technique that I read about and use that states it’s a smoking deal at 10 x the net operating income (NOI). I agree.[/b][/i]
That’s not a technique for commercial appraisals. A cap rate of exactly 10 happens once every 9 trillion years when the stars, moons, and plants align just right. A 20 unit building is not something to shoot from the hip from when evaluating. If evaluating a 20 unit building is “hard” when doing it an accurate and correct way, you might be in over your head.
Iron,
If you want a property at 65% of the market value, find out the market value first. I guarantee the cap rate of your market for comparable buildings will not be a flat 10%. Find out what the appraisers, lenders, realtors, etc. use or get 10-20 comp listings and determine the cap rate as you see it. Only then can you figure out what a discount is.
In the case presented by Iron Range, the NOI is $79.976 and at a cap rate of 10 the value would be $799,760. The mortgage payment on $799.760 (20 year, 8%) would be $5,868 per year or $70,416 per year. That would leave a positive cash flow of only $9,560 per year or $796 per month. That’s only $57 per unit per month! I would NOT call that a smoking deal! In fact, I wouldn’t do it!
Iron Range is absolutely right, I wouldn’t pay retail for a residential rental, not even close. Sixty Five or Seventy Percent of retail is a LOT better.
Cap rates tend to vary from state to state, town to town and even some cases, street to street, so assuming a nominal cap rate for the property you are looking at is not advised.
Income capitalization or direct capitalization is one of three appraisal techniques an investor can use to size up opportunities, and it is not that difficult to get your head around it.
V = NOI / R
V= the property’s estimated value
NOI = the property net operating income
R = Cap Rate
Using your account of operating expenses and the fictitious cap rate of 10%, the property would be valued at 636,640.
Another down and dirty way of sizing up a deal is to use what I call the min. cash flow approach.
NOI x DSCR = Min. Cash Flow Requirement for Viable Deal
NOI = Net Operating Income
DSCR: Debt Service Ratio; use 1.25 which is the industry benchmark for the min. allowable DSCR for commercial lending.
Using the same analysis techniques that your lender will use to make a funding decision is always a good idea.
My numbers are not real. I am looking for a way to show my Realtor’s what is a deal or possible deal. If I tell them the deal needs to be at or around 2.4% then that at least gives them an idea what is need for them to collect a commission on a million dollar property.
If I find a property that cash flows $4,000 a month then that seems great to me, but if it comes in at 75% than the deal is off because my HML won’t touch it. So I agree I need to have a good understanding of what the appraised value would be or I will be wasting time. Then I can come up with a simple version for the Realtor’s, who as you know are mentally retarded.
F.W.I I looked at a 34 unit property in perfect condition, bringing in $4,000 a month positive with unlimited potential for more. They were asking $179,900 (they’re retiring). A buyer put an accepted bid in Friday, I was scheduled to see the property on a Saturday. I put a back up bid in but they were able to close last month. So I missed a 4.5% deal by one day. I was very upset about missing this one deal, it would have chg’d my wife and I’s life, but now I’m moving forward to the next deal.
There are deals out there, and there is also competition. But most importantly there are deals.
The method I read about and mentioned here of 10 X NOI is more of a way to back into a max offer, I think. The debt service coverage is going to be the best way to determine value IMO.
And, yes, a cape rate of 10% IS a smoking deal. I come from the land of the 5 cap.
REI Definition: Capitalization (Cap) Rate - rate of return used to derive the capital value of an income stream, divide annual income by net operating income.
This definition makes it sound like the cap rate is annual income/net oper income, is this right? $143,640 / 79,976 = 1.79
Why is the capitalization rate different area by area?
Why would one appraiser use a 8% and one use a 5% cap rate to determine an appraised value?
First and foremost, that definition is totally wrong. One of the many ways and most common way to determine a cap rate is the NOI/ value= Cap rate.
NOI divided by Gross income gives you the “Net Income Ratio”.
The reason I suggested you really crack the books on the subject is because there is a lot involved. Market capitalization takes into account everything in a particular market; vacancy rates, absorption rates, cost of capital, required rate of return, market appeal, on and on. That is why the cap rate varies not only by the area, but also by the type and class of a property. 20 unit class C apartments in Kalamazoo will have a different cap rate than a 20 unit class B apartment building next door. A 40 unit class C apartment building across the street might still have a different cap rate. An office building down the road will still have a different cap rate. The difference of a half a point in a cap rate can be HUGE, which is why you really need to learn the game before rolling the dice when evaluating.
The DSCR is still not an appraisal technique. It would help you determine a maximum offer to get financed but that max offer might be much more than market value and you’ll feel like an idiot when your bid is 10% more than everyone else’s. There are plenty of little shortcut tricks people use to try to figure out the value, but they wouldn’t be considered “market value” by any stretch of the imagination.
An appraisal is nothing more than an “opinion” of value. No appraiser is right or wrong in their opinion, just as long as they do the process correctly. Educate yourself to where your opinion of value is a little more than a game of blind-folded pin the tail on the donkey. Seldom will two appraisers use cap rates 3 points apart on the same property.
And, yes, a cape rate of 10% IS a smoking deal. I come from the land of the 5 cap.
That’s why I don’t use cap rate in determining whether to buy a property. What I care about is how much cash flow and equity I will actually get with a building. I am not buying because the cap rate is better than someone else’s cap rate or the market cap rate. Whether anyone else makes money or not is meaningless, I MUST make an acceptable profit or I’m not doing the deal. In addition, we know that the vast majority of rental units in the United States are owned by individuals and that the vast majority fail in a short period of time. Therefore, the cap rate only tells me what the average loser paid for his property.
Lots of good info hear, thanks! I agree that the cap rate seems pointless, except I need a loan. So if the cap rate or appraisal means something to the small banks or the HML then in a sense it means something to me, only because I need their money.
I’m trying to determine the equity, which you said you care about. “What I care about is how much cash flow and equity I will actually get with a building” by Property Manager. But how do you determine the equity not just for you but also for the lenders, if not the way we have discussed?
I am not buying because the cap rate is better than someone else's cap rate or the market cap rate. Whether anyone else makes money or not is meaningless, I MUST make an acceptable profit or I'm not doing the deal.
Inadvertently you are using components of a cap rate. Cash flow and equity are both accounted for in a market cap rate. For you to want a better cap rate would mean you want more than the average gain (big surprise). The things that determine a cap rate encapsulate every detail of a market and provide a snap shot of the market conditions. If the cost of capital goes up, so does the cap rate. If vacancy rates go through the roof, investors will require a better return to hedge the risks and the cap rate will go up.
The only accurate way to know the value of a 20 unit building is with income capitalization. If you don’t know the market value, you don’t know what a discount is. You can play with your numbers to determine an investment cap rate for yourself and if you purchase properties at that rate, they will meet your investment criteria, guaranteed! You will need to know a market cap rate if your purchasing with the requirement to have “free” equity.
Here is the easiest way to calculate value to you.
Band of investments
Average Mortgage Constant(LTV) + Average Equity Return(average equity LTV) = cap rate
There are more sophisticated ways to calculate this rate but I would not worry about it right now. You can incorporate selling expenses. The former method does not account for your reversion either.
If you know what the average buyer is getting financing at, and the average required return of other investors, plug them into the equation above and you “should” be close to market value. Then if your looking for a 45% discount do this
Cap rate(1.45) = investment cap
You can then use this cap rate for your evaluations. I would only use this rate for a qualification rate and do further due diligence after your qualify the property as a possible opportunity.
I would also talk to appraisers in the market and get average unit prices. They are just a valuable as cap rates. If you know that a 2-1 gos for 40,000 and a 3-1 gos for 50,000. You can come up with a market value fast. You can also evaluate the cash flow(NOI) per unit easily this way.
With all do respect I don’t think you know what your talking about. You may want to review appraisal techniques before you make a comment like that.
I was giving the man a general approach on how to derive market value via one period capitalization. The way I stated is probably the easiest for him to get his hands around being that he is a beginner. Although, he may have an issue calculating a MC, but he can get a grid for that.
I also stated in my post the fact that after qualifying the property “generally”, he needed to do further due diligence. It is not appropriate or time maximizing to evaluate every property down to the T. For a general approach to look at “viability” he will be fine with what I stated.
With all do respect I don’t think you know what your talking about.
LOL!
Scott,
The band of investments method IS one of the many ways to calculate a cap rate. I believe the distinction was clear that the band of investments is not necessarily a market cap rate. Everything Sean said was correct, if you don’t understand, take notes.
I am quite familar with both appraisal techniques and the lending industry at large (afterall this is what I do for a living).
Cap rates can only be safely “estimated” when the investors knows the cap rates that were applied to similar properties purchased (that’s called the comparable sales approach).
What you are trying to “estimate” is the future value of today’s rent, if the two of you prefer to guess at this stuff, that is your choice.
How does loan to value determine appraised value? Loan size has no relationship to property value, period (The formula is what I took exception too).
If you want a down and dirty formula for “guessing” at the cap rate, then this is far more appropriate:
NOI / Value = Cap Rate
For the record, there are only three conventional ways to determine value for commercial real estate; cost, comparable and income cap.
Class dismissed…