When potential buyers seek financing to acquire a multifamily rental building in an urban area, the obvious first question is the value of the underlying asset. Prospective borrowers and lenders determine this value using different methods, but a widely accepted method is to use a capitalization rate.
Use of a cap rate allows parties to efficiently evaluate whether the asking price for a property is justified by the income it generates. As contrasted with the other traditional approaches to valuing real property, such as the cost approach and the sales comparison approach, using the cap rate method does not require the same level of time-intensive research on replacement costs, depreciation, and comparable sales. When using this approach, however, prospective borrowers need to be mindful of certain issues that make multifamily rental buildings in urban areas particularly difficult to value.
Capitalization Rate Basics
Capitalization rate represents the net operating income of a property divided by its current market value. It is commonly understood that comparable properties in the same geographic area have the same cap rate; thus, a given market's prevailing cap rate usually is well-known and easy to calculate using data from recent market transactions. Market value of the property is determined by dividing NOI (equal to annual gross rents less annual operating expenses) of the building by the market cap rate.
Take, as an example, a 55-unit rental building in lower Manhattan achieving an average of $5,650 monthly rent per unit, equal to $310,750 gross rents per month and $3,729,000 per year. If the annual operating expenses are $1,566,180, then the NOI for the building is $2,162,820. Using a market cap rate for the area of 3.8 percent, the current market value of the property is calculated by dividing $2,162,820 by 3.8 percent, totaling $56,916,315.79.
Challenges for Urban Buildings
While the appeal of this straightforward valuation method is easy to see, it is only as useful as the data underlying the calculations. If the calculation of NOI is wrong, that will lead to an inaccurate assessment of the market value for the property.
The risk of an erroneous calculation is heightened in urban areas such as New York City and Los Angeles, where rent stabilization laws and tax abatement schemes complicate the calculation of NOI. For example, in New York, gross rents stated on a rent roll may not reflect the actual rents paid by tenants, due to arcane rules imposed on owners of buildings subject to rent stabilization laws. The only way to verify the actual rents paid is to examine all of the individual leases and riders (where the effective monthly rent should be identified), or to examine banking records for the building. While cumbersome, this additional step is necessary to ensure that the market value calculation is reliable.
The impacts of miscalculations are compounded in areas with lower cap rates.
The quantifiable impact of an erroneous calculation also is magnified in urban areas, where cap rates generally are lower. Since cap rates are inversely related to the market value of a property -- all other things being equal, as the cap rate decreases, the market value of a given property increases -- the impacts of miscalculations are compounded in areas with lower cap rates. Going back to our example, if the cap rate were doubled to 7.6 percent, the value of the building would be halved to $28,458,157.89. An inaccurate calculation of NOI also would be halved; at a 7.6 percent cap rate, if NOI were calculated erroneously as $500,000 higher than actual, it would artificially raise the value of the building by $6.5 million. Using the lower 3.8 percent cap rate more typical in urban areas, that impact would be more than $13 million.
While the cap rate valuation method is a powerful tool to evaluate a potential acquisition, prospective borrowers and lenders must employ it cautiously. There is no substitute for thorough due diligence, and foregoing traditional valuation can lead to significantly erroneous market value calculations, particularly in urban areas.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.