What makes a good investment?
First time investors often make the mistake of purchasing property based on a seller’s asking price or something close to it, instead of the operational performance of the apartment. In today’s investment climate, apartments often trade based on lofty projections or all-cash terms. But this strategy does not necessarily produce good investments.
The seller’s asking price is not relevant to your underwriting. You have a duty to conduct your own valuation and due diligence. With apartments your offer is based on the current cash flow of the apartment or the cash flow you imagine they will produce sometime in the future with improvements to the operation of the property.
To get the value of a property, calculate and compare one or more of the following metrics found below. Each indicator has its own weakness. All deals are unique and there is no one size fits all method in finding value.
Gross Rent Multiplier (GRM)– does not account for expenses
Capitalization Rate (CAP)– not a good indicator in rent control markets such as Oakland, Berkeley, Alameda, East Bay because it does not consider under-market rents
Price per Square Ft– does not distinguish between number of units, income, or number of bedrooms
Price per Unit– does not distinguish between income, number of bedrooms
Gross Rent Multiplier
The GRM is found by Price / Gross Rents. So to calculate the price, you take the property’s annualized income and apply a multiple. We use GRM’s when valuing smaller apartments such as four to six units. Keep in mind that two properties with the same GRM may have different expenses.
The CAP is found by NOI / Price. If properties in Oakland recently trade at 4.0% CAP rate and a property has a net income of $50,000, you can estimate a value of $1,250,000. Cap rates work well when used to compare properties across an entire submarket. However, they fail to account for under market rents or changes in value over a holding period. In rent control markets such as Oakland, most buildings have legacy tenants and long-term renters. Cap rates do not reflect what the operations of an asset with stable rents and income.
Price per pound methods do not take into account income and expense ratios. Typically you’re just using this benchmark to determine the value of an area. It’s simple yet effective when assessing buildings with below market rents.
Price per Square Foot
The price per foot is simply dividing the price of the property by the square footage. You multiply the square footage of the property by the market price per square foot to arrive at an estimate. This indicator is used often in purchasing single family homes. This approach can be used when purchasing duplexes, triplexes, and fourplexes. Also, you can use this method when looking at a building that you plan to drastically renovate and add value.
Price per Unit
Price per unit is a simple benchmark calculated by dividing the price by the number of units. To arrive at an estimated value, you multiply the number of units by the market price per unit. While a great indicator when buying larger assets, it does not distinguish between one-bedrooms and two-bedrooms. Apartments with two-bedroom units are highly desirable in Oakland’s rental market. Two different buildings may have identical price per doors, but one apartment might be made up of all studio units.
Underwriting takes experience and market knowledge of the comps. Buyers need to balance current and market cash on cash returns, cap rates, and price per pound indicators. There is no one correct price. At the end of the day, the goal is to acquire more than what you pay for. Real estate is designed to transfer wealth from the impatient to the patient.