There are three ways to determine the value of an apartment building:
- Replacement Cost Approach
- Sales Comparison Approach
- Income Approach
Replacement Cost Approach
The Replacement Cost Approach determines value by calculating how much it would cost to replace an existing structure. This approach is very time consuming to complete as you must obtain pricing for all materials (from 2×4’s to outlet covers) used in the construction of a property and then calculate replacement cost. Because of this, it is very rarely used.
Sales Comparison Approach
For single-family houses and 2 – 6 unit apartment buildings, the most common approach to determining value is the Sales Comparison Approach. This approach compares similar properties that have sold within the last six months, within a certain geographical radius from the subject property (usually no more than two miles, the closer the better) to determine value.
If you’re buying a 3-family apartment and a similar one on the next block oversold for $220,000, then your property will be valued around that area.
The Income Approach
For six units and more, you would use the Income Approach to determine the value of the property. This means that you would determine how much income the property is generating and determine its value based on that number.
There are several formulas that investors use to determine value, though one is more prevalent than others; that is the Cap Rate.
You’ll hear people talk about the “Cap Rate.” It’s what most investors use when comparing one property to another.
The Capitalization Rate is the rate at which the Net Operating Income (the income that is left over after all the expenses are taken out) repays the purchase price on an annual basis. Sounds technical, doesn’t it? Don’t let it scare you.
Cap Rate = Net Operating Income/Value (selling price)
There are formulas to help you determine the Net Operating Income as well as the Selling Price. They are included with the Apartment Analyzer Worksheet, Five Page Due Diligence Checklist, and many other useful forms in our step-by-step guidebook called the Multi-Family Home Study Course.