This article is part of our passive investors guide on real estate syndications, available here.
The value of every apartment community is different, and the market price of each property relies on several factors, including the supply and demand conditions at the time of appraisal.
So, how can we determine the market value of an apartment? This article will provide the resources you need to evaluate an apartment complex properly. It includes the three approaches to finding an apartment building’s market value, the best method for calculating apartment value, and how to use the three approaches to find the market value of apartment buildings.
How to Find the Market Value of an Apartment Complex?
Finding and executing excellent deals requires carefully evaluating the worth of an apartment complex. Typically, a bank will determine the value of an apartment building using three different methods.
- The income approach
- The sales approach
- The replacement approach
The income method analyzes the asset’s yield in light of its net operating income. The sales approach examines nearby comparable properties and recent sales of those similar properties. The replacement approach considers how much it would cost to construct the building, or buildings, from the ground up in light of construction costs for labor and materials, among other factors. The following is a more detailed explanation of each approach.
Related Read: How to Evaluate Rental Property Value
The Income Approach
There are a few crucial variables to understand when determining the value of an apartment complex using the income approach, including the Net Operating Income (NOI), and the Cap Rate. However, NOI is by far the most crucial.
This approach calculates value by dividing a property’s NOI by the market capitalization rate. The net amount after subtracting the property’s operating expenditures (which doesn’t include your mortgage payment) from the property’s gross income is the property’s NOI.
Once you determine the NOI, the next thing you need to find out is the market cap rate. The amount of money a typical investor would be willing to accept as a return on investment in a given market is known as the market cap rate.
The locality, the property’s state, and its nature will all affect the market cap rate. Speaking with a commercial appraiser, broker, or lender is the quickest way to determine the cap rate where the commercial property you are evaluating is located.
Once you determine the NOI and the capitalization rate, you can estimate the value. The relationship between cap rate and valuation is noteworthy because it goes both ways: the lower the capitalization rate, the higher the valuation, and vice versa.
The Sales Approach
The majority are familiar with this approach. A comparable sales approach involves considering all the asset characteristics you are attempting to evaluate. The next step is to locate recent sales that are as close to or comparable to the subject property specifications.
Find sales of reasonably similar properties that took place recently—within the past six months to a year, ideally—and in close proximity to the subject property. Since single-family homes have the most sales data, this method is relatively dependable and straightforward to utilize for them.
The Replacement Approach
The Replacement approach calculates the cost based on what it would take to construct a similar structure in the exact location today, given the current costs of materials and labor. Your property insurance provider certainly takes this approach to determine the coverage value.
Of course, using this method sometimes results in a value significantly more than the cost to acquire and renovate the property.
Based on the property’s age and other criteria, many appraisers will subtract some amount for depreciation from the replacement cost. However, their final figure naturally becomes less precise and more subjective when they do that. Despite the fact that appraisers include the cost method in their reports, they typically do not rely on it to arrive at the final value.
Instead, the income approach is the most common approach used by appraisers to find the market value of apartment buildings or commercial properties. We discuss the reasons behind this in the next section.
The Approach On How to Calculate Apartment Value
The income approach is popular for valuing apartment communities and commercial real estate. The fundamental part of the income approach is to determine the present value of a piece of real estate by dividing the net income it produces by the capitalization rate.
The income approach is the best method for determining an apartment building’s value as apartment communities/multifamily values with this approach are based on the property’s NOI.
Let’s understand this with the help of an example.
Let’s say a buyer is considering investing in a 50-unit multifamily building.
The target investment property has a specified market capitalization rate of 7% and an expected stable net operating income of $250,000. The estimated property value using these inputs is $3.57 million ($250,000 / 7%).
A cash purchase of the building at this sales price would yield a 7% annual return for the investor. They’ll probably borrow money to pay for at least some of the purchase, increasing the return on that capital much further.
While the income approach is the best way of valuing apartment buildings, other approaches can also prove helpful in evaluating property value. How all three approaches can be used to perform the valuation is discussed next.
Using All 3 Approaches to Evaluate Market Value
Each valuation technique is independent of the others. Thus an appraiser will typically choose one method over a combination of the other two when determining the value of a specific commercial property.
The lender in question may specify the approach to be taken. Additionally, each approach may lead to somewhat different appraisals, so it’s critical to understand which method your selected lender is employing. For different scenarios, different evaluation methodologies are employed.
For example, the income approach is used as a primary determinant of value, while the sales approach allows you to look at what similar properties are selling for. And the replacement approach enables you to get a gauge for buying well under what it would cost to build.
Now that you know how the three approaches can help with property valuation, let’s discuss why apartment value is growing.
Why Apartment Value Is Continuing to Grow
Apartment value continues to grow because more investors are shifting their capital to invest in apartments, and there’s only a finite amount of deals. Another reason is that cap rates are compressing.
It is known as cap rate compression when the cap rate for a specific class of commercial real estate properties in a location is lower than it has been traditionally.
Cap rate compression can result in significant gains for a multifamily property or another type of commercial real estate. Many smaller groups are being forced into the secondary and even tertiary markets due to fierce competition in some of the primary markets, causing significant cap rate compression.
Frequently Asked Questions about the Market Value of an Apartment
An apartment’s ARV (after-repair value) is calculated by determining how much net operating income can be created after renovating a property.
The fastest way to add value to an apartment is by physically improving the exterior and interior of the property, providing a better quality product that tenants will pay more to occupy.
How to Determine Market Value of an Apartment - Conclusion
We hope that this has given you a clear understanding of the various apartment valuation techniques and why the income approach is the best way to find the market value of an apartment complex.
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