Commercial Investment Real Estate September/October 2018

FINANCING FOCUS Valuing Rentals Properly calculated cap rates can reliably value rental properties. by Bryan T. Mohler W Capitalization Rate Basics Capitalization rate represents the net operating income of a prop- erty divided by its current market value. It is commonly under- stood that comparable properties in the same geographic area 14 September | October 2018 have the same cap rate; thus, a given market’s prevailing cap rate usually is well-known and easy to calculate using data from recent market transactions. Market value of the property is determined by dividing NOI (equal to annual gross rents less annual operat- ing expenses) of the building by the market cap rate. Take, as an example, a 55-unit rental building in lower Man- hattan achieving an average of $5,650 monthly rent per unit, equal to $310,750 gross rents per month and $3,729,000 per year. If the annual operating expenses are $1,566,180, then the NOI for the building is $2,162,820. Using a market cap rate for the area of 3.8 percent, the current market value of the prop- erty is calculated by dividing $2,162,820 by 3.8 percent, totaling $56,916,315.79. Challenges for Urban Buildings While the appeal of this straightforward valuation method is easy to see, it is only as useful as the data underlying the calculations. If the calculation of NOI is wrong, that will lead to an inaccurate assessment of the market value for the property. The risk of an erroneous calculation is heightened in urban areas such as New York City and Los Angeles, where rent stabilization COMMERCIAL INVESTMENT REAL ESTATE hen potential buyers seek financing to acquire a multifamily rental building in an urban area, the obvious first question is the value of the underlying asset. Prospective borrowers and lenders deter- mine this value using different methods, but a widely accepted method is to use a capitalization rate. Use of a cap rate allows parties to efficiently evaluate whether the asking price for a property is justified by the income it gen- erates. As contrasted with the other traditional approaches to valuing real property, such as the cost approach and the sales comparison approach, using the cap rate method does not require the same level of time-intensive research on replacement costs, depreciation, and comparable sales. When using this approach, however, prospective borrowers need to be mindful of certain issues that make multifamily rental buildings in urban areas par- ticularly difficult to value.

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