We buy all types of different property for our investment purposes, including single family, small multi-family, larger multi-family, storefront, storage, parking, industrial, strip-mall, and many combinations thereof. It’s important to understand that while there are positives and negatives to all different property types, a lot of our decision is driven by the realities within the marketplace.
Valuing an Investment Property Depends on Units
Whatever type of property you decide to pursue, one thing you need to realize is that only SFR and small multi-family under 4 units can be financed with a residential conforming loan. I discussed why this is in this article. Everything else will have to be financed with some type of commercial paper.
By the way, this article is about valuing multiplex investment properties that are 5+ unit. If you’re looking for valuing other property types, check out my articles here:
- How to value single family investment properties, duplexes, and triplexes
- How to value a 4 plex investment property
As I covered in the aforementioned article, the valuation methodology has a lot to do with the applicable financing. And relative to that, Single Family and small multi-family are in one way or another financible with conforming residential loans, because it is thought that an owner-occupant could buy one of those, and move into one of the units. For this reason, the secondary market regulations allow for structures made up of 4 residential unit or less to be financed with residential paper. And, if follows that appraisals are done following those same guidelines.
How to Value a Multi Unit (5+) Investment Property
However, it is not thought of as reasonable that an owner-occupant will buy a larger building than 4 units, and move into it as a primary residence. For one thing, the skill-set needed to manage a larger building is not something that an average home-owner possesses. Secondly, the R&M and CapEx budgets are thought of too high for most home-owners. For these reasons, anything over 5 units, or anything designed and/or zoned as anything other than residential is considered commercial use, and as such are financed commercially.
Well, if you’ve been paying attention, by now you realize that the method of valuation is always underpinned by the type of financing. While SFRs are valued strictly via CMA (comparative market analysis), and small multi-family are valued via CMA and GRM (gross rent multiplier method), the value in the commercial space is generally capitalized…
Difference Between Gross Rent Multiplier and Capitalization Method
Both GRM and Capitalization Method recognize that value of income-producing assets has to be in some way a function of the income. In the most basic terms, the reason we buy income property is for the income it represents, and the more the income, the more the value of the asset.
As we previously covered, GRM uses Gross Rents as the basis of the analysis. This is barely OK in the 4 units and under space, though not really. But, it’s certainly not sufficient in the larger income arena. Why – because by only focusing on the income, and totally ignoring expenses, we can arrive at completely false assumptions. We, investors, don’t care so much about how much the building generates in gross revenue, What we want to know is how much is left in our pocket after all expenses are covered. The GRM doesn’t even attempt to look at expenses, and for this reason it’s quite misleading.
The Capitalization Approach
The Capitalization Approach uses the NOI (Net Operating Income) as the basis for its’ analysis. The NOI is what’s left of the Gross Income after all OpEx (Operating Costs) have been met. By, considering the NOI, which actually juxtaposes the income and expenses, we are able to glean a much truer picture of the income-potential of an asset. This also allows us to compare buildings in a much more apples to apples way.
The formula for the NOI is:
NOI = Gross Income – OpEx (excluding debt service)
From here, we ask the following question:
If I am willing to deploy capital so long as I am able to receive x% return on my investment, how much can I pay for this building if I know that it generates $xyz NOI?
In this case, the x% is something we call the Capitalization Rate, which I talked about here.
How to Determine How Much to Pay for a 5-Unit
Let’s say you are looking at a 5-unit apartment building, and let’s say that you are happy deploying capital at 10% Cap Rate. If this building generates $20,000 of annual NOI, you should be willing to consider paying for it $200,000 – $20,000 NOI constitutes 10% of $200,000.
If, on the other hand, you are willing to deploy for 8% Cap Rate, then the same building with the same NOI should be worth to you $250,000.
Alternatively, if you need to achieve 12% Cap Rate, then you would only be able to pay $167,000.
The value formula is:
Value = NOI / Cap Rate
Well, hopefully this illustrates the similarities and differences of projecting value of SFR vs. small multi vs. larger assets. This is only a small fraction of what you need to know. If the income is going to be a fundamental building block of value, then understanding how to project income is by far the most important element of all of this. This is what CFFU is all about – check it out!