by Cypress Ventures Group
In the last post, we explained the difference between residential real estate – 1-4 unit investments – and commercial real estate, which is more than four units. In this article, we will explain how residential vs. commercial properties are valued.
We’re hitting the highlights to help you understand how it all works with a few easy to read articles. This is the second of these articles.
When evaluating residential real estate, you compare similar properties that have recent recorded sales within the same neighborhoods and adjust for condition and other differences like additional bathrooms, new furnaces, roofs, electrical, etc. Appraisers will take this information and give a value to the home.
Appraisals for Commercial Apartments complexes are evaluated primarily by the Net Operating Income (NOI – more on that below) of the property and secondarily by recent recorded sales per unit of similar properties in the same demographic area.
Calculate the numbers
Beyond trying to figure out if it’s a good time to buy real estate, property investing is about knowing how much monthly income you need to make the investment worth it. You have add up your estimated “total operating expenses,” accounting for maintenance, repairs, advertising, the expenses of vetting tenants, taxes and insurance.
When you calculate how much rental revenue you need to cover your total operating expenses you have to account for a little bit extra.
For example, if you know a property will cost you $2,500 each month in total operating expenses, you might decide you need to collect $4,000 a month to cover your costs and give you an extra $1,500 cushion.
The rule of thumb is 50% of the gross revenue/income, (all rents, pet fees, parking, storage, etc.) collected will be paid to cover your operating expenses. The 50% does not include your finance costs, which is the principle and interest payments for your mortgage.
Let’s assume you have found a good apartment deal and you are able to buy the apartment for cash, without financing, you would expect approximately 50% of your gross revenue/income to go to operating expenses and 50% would be your profit.
As you continue to educate yourself in multifamily real estate you will need to understand net operating income and capitalization rates.
Net operating income (NOI): What is it and how to calculate it
NOI represents the gross income minus your operating expenses. Add up the income you receive from rent and any other fees you might collect, such as parking, storage or pet fees. Then subtract costs the cost to operate the property. These costs would include professional property management, property taxes, utilities, repairs/maintenance, insurance and other costs.
Net Operating Income (NOI) Equals =
Total Revenue – Operating Expenses
Here’s an example of how to calculate NOI:
| Add up the Annual Revenue: | |
| Rental income Parking fees Laundry income Total annual revenue |
$84,000 $11,000 $ 2,000 $97,000 |
| Add up the Annual operating expenses: | |
| Professional prop mgmnt fees Property taxes Repair & maintenance Insurance Other costs-water, sewer, etc Total operating expenses |
$15,000 $13,000 $10,000 $ 4,000 $ 7,000 $49,000 |
| Net operating income (NOI) | |
| Total revenue Operating expenses Example NOI |
$97,000 $49,000 $48,000 |
Capitalization rate (cap rate): What is a cap rate? How to calculate it
The cap rate is the estimated rate of return an investor might expect on an apartment investment that is purchased at a specific price. It’s calculated as a percentage that is based on the total value/purchase price of the property.
To calculate the cap rate, you’ll simply take the NOI and divide it by the asking price OR your offer price.
For example: if the property has an annual NOI of $48,000 and the asking price of the property is $500,000, you would divide the annual NOI of $48,000 by $500,000 to get a cap rate of .096 or a 9.6 percent return on your investment.
Simply put, you are calculating exactly what the rate of return will be on the price you pay for the property. Assume you negotiate a purchase price of $400K instead of the $500K the seller is asking above, the new cap rate would be .12 or 12 percent which is $48,000 divided by $400,000.
Generally speaking, higher market cap rates indicate a higher risk than one with a lower cap rate. However, this is just one metric you can use in deciding whether or not to buy a multifamily rental property.
Next up …
In our upcoming article, we will describe the differences between a high cap rate property and a low cap rate property.
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