How Professionals Value Multifamily Real Estate

On a fundamental level, operating a multifamily property is a business. The property’s tenants generate revenue when they pay their rent and other charges, which is then used to cover the operating expenses and debt payments, and any profits remaining are either distributed to investors or reinvested into the property.

The income after all operating expenses is paid is referred to as the property’s Net Operating Income (NOI), and it’s one of two important metrics professionals use to value multifamily real estate. Unlike single-family homes, whose prices are primarily driven by demand and desirability, multifamily properties are primarily valued by the cash flow they generate for investors. This is referred to as the income-based method of valuing real estate. And while there are two other common methods (sales comparison and cost approach) used, these methods serve better as supplements to the value derived from the income-based approach.

As an owner and operator of multifamily properties, IronOak focuses on strategies that enhance NOI. Because NOI eventually gets passed through to investors, a higher NOI will provide the immediate benefit of higher current income, and the long-term benefit of value appreciation.

Net Operating Income (NOI) = Revenue - Operating Expenses

The two components to NOI are revenue and expenses. NOI increased by increasing revenue and/or decreasing expenses. While this seems simple in theory, there are several components to each, and many different strategies for improving them.

Revenue includes rental charges, utility charges, and other charges to the tenants.

Operating Expenses include administrative expenses, payroll for onsite staff, repairs and maintenance, unit turnover costs, contracted services, utility expenses, insurance costs, property management fees, and property taxes.

Market Capitalization Rate (MCR)

 

Now that you understand Net Operating Income, let’s talk about the other major metric required to determine a property’s value; this is the Market Capitalization Rate (MCR). Identifying the MCR assigned to a property requires knowledge about the property’s age, physical features, and location. Unlike NOI, the MCR is an uncontrollable metric, so while it’s important, it’s not something that you can improve with a business strategy. The formula below shows how we can utilize a property’s NOI and MCR together to determine a property’s value.

 

Property Value = Net Operating Income / Market Capitalization Rate (MCR)

This formula demonstrates what we had already learned, which is that a higher NOI will yield a higher property value, but what it also shows us is that lower MCR’s create higher property values. This is why newer, well-located properties will typically have lower MCR’s than their counterparts, resulting in higher valuations for those properties. Another way to consider it is that, similar to stocks and other investments, multifamily properties are valued as a multiple of their earnings. The MCR is just an inverse formula to this.

MCR conversion to NOI Multiple

By example, a property has a Net Operating Income of $1,000,000 and the MCR for the property is 5%. By dividing the NOI by the MCR, you achieve a property value of $20,000,000. However, if we were to divide the property value ($20,000,000) by the NOI ($1,000,000), you would see that the value is a 20x multiple of the NOI. Therefore, you can expect properties with a 5% MCR to be valued at 20 times the property’s NOI.

The two most important aspects of a property that determine the MCR are the property’s physical features and location. The physical features of a property are categorized within the different asset classes (A, B, and C).

Multifamily Asset Classes

 

• Class A

  • Newly built properties with high-quality construction and enhanced amenities, catering to higher-income tenants.

  • Located in desirable neighborhoods with ease of access to major employment and shopping centers.

  • Require less ongoing maintenance repairs than the other asset classes.

  • Offer the lowest MCR values of all asset classes.

    
    

• Class B

  • Older than class A properties and lacking in some of the modern features, but still relatively well-maintained and typically well-occupied.

  • May be cosmetically outdated, but unlike Class C properties, the building systems do not require a significant capital investment for replacements.

  • Located in stable or transitioning neighborhoods with moderate rental rates, appealing to middle-class renters.

  • The MCR for these properties lies between Class A and Class C assets.

    
    

• Class C

  • Older properties with antiquated building systems such as plumbing, electrical, building materials, and ventilation systems.

  • Require a significant capital investment to update and/or replace major building components.

  • Highest MCR’s because they carry the most risk, but also offer the greatest upside potential.

    
    

IronOak invests in Class B and C multifamily assets, making the necessary capital investments required to create the most value for our investors.

Location Matters

 

Location plays a major factor in valuing multifamily real estate. Properties located next to major employment nodes with high barriers to new supply will naturally be valued higher, and this will be reflected through lower MCR’s.

An extreme example of this would be a comparison between an apartment building located in Manhattan, and the same building (construction year, size, materials, etc.) located in a rural part of New York. Obviously, it’s not a perfect example because the stylistic choice and features for an apartment building in the city will be much different than one in the countryside, but the difference in value would be so great that the stylistic details would be of little relevance. Being land-locked and extremely dense, the Manhattan property has very little threat of new supply and plenty of easily accessible employment and retail options, whereas the rural property would be lacking in these aspects, and a developer could build another apartment building right next to it with relatively fewer hurdles.

 

The Trick to Identifying the MCR: Sales Comparables

 

The best method for determining a property’s MCR is to review recent sales of comparable properties in the area. Keep in mind that it’s important to research recent data points and to have a large enough sample size to make accurate predictions. When there are few comparable sales in the market, the MCR becomes increasingly difficult to reliably determine.

Summing It All Up

 

You should now understand how Net Operating Income (NOI) and Market Capitalization Rate (MCR) work together to determine multifamily property values. For practical reasons, this is especially important during the acquisition phase, that is when a property is being analyzed as a prospective investment for purchase.

IronOak will not only review a property’s existing NOI, and thoroughly research the MCR to determine a property’s purchase price but will also review each of the components to NOI and understand how they can be improved to create value over the life of the investment. And while MCR is essential in determining a current value, it’s equally important to research how market conditions will change over the investment period to understand what the property will realistically sell for at that time, and ultimately how much total value will be captured.

If you’d like to learn how you can make your first multifamily investment, please fill out our contact form and one of our team members will reach out to you for an introductory call.