Property Valuation - Apartment Building

The following excerpt is from IREM’s publication, Practical Apartment Management, Sixth Edition (IREM © 2009):

NOI is a very important number, as it is one of two primary factors in determining the value of investment real estate. If you are a real estate major, one of the first principles that you learn, and one that is on every final exam, is: 

The value of investment real estate is in direct proportion to its ability to produce the highest net operating income over the economic life of the property. 

Remember, we are talking about investment rental housing: properties that are invested in and operated in hopes of a profit. We have identified other types of housing that lack the profit motive, and their value is determined in a wholly different manner. 

Real estate investors, lenders, and appraisers project value using two factors: the property’s NOI and a percentage yield of return that is desired. This yield is referred to as the capitalization rate. The $10 term for this method is the income capitalization approach to value. Its formula looks like this: 

Net Operating Income (I)  = Value (V) 
  Capitalization Rate (R)

In most real estate training sessions, this formula will be introduced as the IRV formula to help students remember the math components. “I” represents the property’s income (NOI), “R” is for the capitalization rate (or desired yield), and “V” is for the resulting property value. 

In a given marketplace, capitalization or “cap” rates fluctuate much the same as interest rates. If there is a lot of money available to be invested, there will be downward pressure on the available yields. In other words, when investors find the profit potential better in income-producing real estate than in other alternatives, money will flow to it and cap rates will decline. With the fall of cap rates, there is a corresponding rise in the prices that will be paid for investment properties. Risk is very much a part of the capitalization rate, as it promises increased rewards to investors willing to undertake less desirable properties via lower prices. Upscale properties in stable neighborhoods are obviously less risky than deteriorating properties, so it follows that investors will accept a lesser return, and often significantly less. 

As an example, let’s assume that a property has NOI of $360,000 and the prevailing capitalization rate is 8 percent. Applying the formula, we arrive at the following estimate of value: 

$360,000 NOI  = $4,500,000 Value 
  .08 Cap Rate

Continuing the example, suppose the manager is successful in combining rent increases with a series of skillful cutbacks in operating expenses. These changes increase the NOI to $400,000 per year. Using the same cap rate of 8 percent, the property now becomes more valuable: 

$400,000 NOI  = $5,000,000 Value 
 .08 Cap Rate 

Property owners search for managers who have the ability to “create value” by instituting changes that will bring about steady and sustained increases in NOI, thereby increasing the value of their property. 

Put in simpler terms and using our same example of an 8 percent capitalization rate, every $1 increase in NOI effectively produces a $150 increase in value ($1 × 12 months = $12; and $12 ÷ .08 = $150). Of course, the opposite is true if the NOI decreases by the same $1. Things are not quite that automatic—the investor does not receive any value gain until an actual sale takes place—but the relationship of income to value is very real. 

This same formula can be modified to help determine what investors are expecting in the way of yields by simply rearranging the known factors. Assume that a property you are interested in, with an NOI of $120,000, sells to another investor for a $2,300,000 selling price (SP). You can calculate that investor’s desired yield: 

      $120,000 NOI        = 5.2% Yield (Cap Rate) 
$2,300,000 SP (Value) 

You might say that this investor’s desired yield is less than you would have accepted, or, that he paid too much for the property. Remember, in real estate, as in horse racing, each investor makes his own judgment as to risk and reward. In this example, the buyer may see an upside potential due to rents that are well below the market, a property with easily improved floorplans, or one that is just lacking some creative curb appeal. With some improvements, this property might be in a position to command much higher rents; and we have seen what each $1 net gain can do to value.