To those new to the wonderful game that is real estate investing, you have a lot of options to choose from. There are single-family homes, duplexes, apartment buildings, office buildings, strip malls, etc. Similarly, there are many ways to invest: flipping, buy-and-hold, and anywhere in between. I’d like to take the time to cover the basics of investing in apartment buildings.
Unlike single family homes whose prices are very much subjective (i.e. this house is nice and it is just like another one a mile away that sold for this much!), apartment buildings are valued much more objectively. In essence, the value of an apartment building is calculated by a simple equation: Purchase Price= Net Operating Income (NOI) / Capitalization (CAP) Rate.
So, what is a CAP rate? Mathematically speaking, CAP = NOI / Purchase Price. In other words, the CAP rate is the ratio of a property’s net operating income to its purchase price. Generally in a given submarket, the CAP rates of properties will be within a narrow range. As a rule of thumb, the higher the CAP rate, the higher the risk. Inversely, the lower the CAP rate, the lower the risk. Plus, the lower the cap rate, the more of an effect changes in the NOI will have on the value of the property.
For a given CAP rate, an apartment building’s value can be increased (or decreased) exponentially by adjusting the property’s NOI. For example, let’s say an investor purchased an apartment building for $1.6 Million at a 6% CAP rate. The NOI of the building would be $96,000 (NOI = CAP * Purchase Price). Now let’s say that the market allows for a 5% increase in rents. Assuming expenses stay constant, the NOI will now be $100,800 which is an increase of $4800. While $4800 is great, the important thing to note is how this increases the value of the property. Since you’re adding an extra $4800 of value, at a CAP rate of 6% you have just increased the value of the property by $80,000 (=$4800/.06)!
To summarize the above example:
Initially, we started with a $1,600,000 property with an NOI of $9600 and CAP rate of 6%.
After a 5% increase in rents, we ended with a property value of $1,680,000, NOI of $100,800 and a CAP rate of 6%.
While the above example is overly simple, it effectively illustrates the interaction and relationship between an income property’s value, CAP rate and NOI. With effective planning and management, increasing the value of a property is possible and lucrative!