There are 3 main ratios for estimating the value of an apartment building. Here they are:
- Capitalization Rate (a.k.a. the “Cap Rate”)
- Cash on Cash Return
- Debt Service Coverage Ratio
Let’s talk about each in turn. I’ll cover what they are, how to use them, and what value to look for in a good deal.
Key Indicator: The Cap Rate
In order to know the fair market value of a building, we need to know its “cap rate” and its “NOI.”
The NOI is the net operating income, and this is the income after all expenses but before debt service (i.e. the mortgage payment).
The cap rate is a multiplier that is applied to the NOI to determine the value of a building. It’s like saying that the building can be valued at “10 times its net operating income.”
The cap rate is the rate of return if you were to buy the building 100 percent in cash. You probably wouldn’t do that, but this is the standard way to measure the returns and value of a building.
Cap rate is such an abstract concept that an example is in order.
Imagine you have an ATM machine that makes $100,000 per year for you after all expenses (your cost to lease the space, to pay someone to maintain it for you, repairs, etc). So the NOI of this ATM machine is $100,000 per year.
You then talk to a group of people who are interested in acquiring your ATM machine. You ask them, “What would you be willing to pay for this ATM machine?” One buyer might say, “One million dollars,” and you ask him how he came up with this number. He says that if he buys your ATM machine for $1M and it produces $100,000 in income, then that is a 10% cash on cash return on his money. And this sounds like an excellent investment to this investor.
Another investor ups the offer to $1.1M. The ATM finally sells for $1.2M. This would produce an 8% return to the buyer if he paid in all cash.
In mathematical terms, the cap rate is a ratio consisting of the NOI divided by the price (or value) of the property.