I am currently working with a young man who is wanting to buy a multi-unit apartment building…
And he is finding it to be a discouraging experience simply because the income doesn’t properly reflect the value.
Apartment Building Value
So how is value supposed to be determined?
The reality is that…
- The Seller will have one value
- The Buyer will have a very different value
- The lender will have a conservative value and
- The tax man will want an inflated value
However, for an apartment building, the TRUE value should simply be based upon revenues/expenses and or “highest and best use” of the property.
Highest and Best Use
With respect to the “highest and best use” value, you must determine if there is a different and better use for the property which could generate a better return on the investment.
Perhaps the location of the building makes the lot more valuable to a developer of a large condo complex, as an example.
Usually, this is not the case and the “highest and best value” would be what the property is currently being used as.
This means we should be focusing on the income and expenses to determine the value.
Calculating True Value
The value calculation is as follows:
Value = NOI / CAP rate
First, we must understand what NOI (Net Operating Income) actually is!
Net Operating Income =
Gross Operating Income – Operating Expenses
NOI = GOI – Operating Expenses
GOI is Gross Operating Income which includes ALL income from all the related sources such as:
- Laundry income
- Parking income
- Pet income, etc.
Operating expenses include every expense related to the day-to-day operation of the property and will include, but is not be limited to:
- Property tax
- Property management
- Maintenance, etc.
What is not included is the debt service (mortgage payment) and any capital improvements such as a new roof or installation of all new windows.
Check The Local Market
Next, we need to know what the CAP (capitalization) rate is for the local market. In order to determine this, you need to look at recent sales of similar properties.
You would take the NOI for a recent apartment building sold and divide it by the sale price.
And this small number, when converted into a percentage, will give you the CAP value.
A low Cap value like 3 -5% indicates a very low cash flow while a higher Cap value like 7-10% will indicate a much more acceptable and attractive cash flow.
Be Careful of Manipulation
The challenge is that all these numbers can easily be manipulated to provide the Seller with a higher valuation (= higher price for the Buyer).
- If they overstate the income then the NOI will be higher and this means a higher valuation.
- If the Seller understates the expense by using incorrect numbers and or not including all the expenses then the NOI will be higher which again means a higher valuation.
In reality, most investors while owning and operating the property will try and run some personal expenses through the property, which will inflate the expenses and therefore decrease the value.
They may also not claim all the income that they collect which again will create a lower NOI and result in a lower valuation.
Operating their property this way may work for them now by saving taxes. However, when they go to sell the property it will be a challenge to justify the high price they are asking.
However, when they go to sell the property it will be a challenge to justify the high price they are asking.
The Seller and or Agent will tell potential Buyers that the Seller skims money off the top and or runs personal expenses through the books and expect the potential Buyer simply to accept this as okay.
The REAL Numbers
As a Buyer, you want to see the real numbers and you trust that the real numbers provided to the accountant are in fact real, so this is what the Buyer uses to determine the value.
This is also how the lenders will determine the value for the purpose of lending you money to purchase the apartment building.
If the Seller wants to operate by skimming money or not using legitimate expenses in order to avoid paying tax, then this is their choice.
However, they should not expect to have it both ways and expect to sell for top dollar.
Often this is what they do.
If You’re The One Selling…
As a Seller, if you plan to sell your property, I would suggest you plan ahead and get your books in order so that they reflect the real numbers.
And do this for at least two years prior to a sale. This way you can expect and justify top dollar for your property.
As a Buyer, you may know that the property makes more money than being reported…
And you see the opportunity for the skimming and inaccurate expenses so you see the potential value.
The challenge is the bank will not recognize this and will not lend to you based on potential value.
This means you need to come up with more for the down payment and or the Seller will need to help with a VTB.
Not All Agents Understand
With my student/clients current situation, the Selling Agent became upset with us suggesting the valuation should be much lower based on the actual numbers reported for taxation.
I suspect the agent has never personally owned a property such as this and doesn’t really understand what I have just explained above.
So now if we want to continue trying to buy this property, not only is it over priced but we now need to work with a difficult agent 🙁
Hopefully you now better understand how to avoid overpriced properties and how to determine the true value of the property according to the actual income and expenses.