Sellers want to sell their properties for the highest price. Buyers are looking to buy at the lowest price possible. How do you accurately value an apartment property? How does a lender determine between the seller’s valuation and the borrower’s valuation? A good underwriter looks at the numbers to arrive at the most accurate value.
We will begin with a discussion of the property’s potential gross income. The potential gross income (PGI) is the total of all potential rents and charges before any offsets or expenses. For example, a 20-unit building with an average rental of $1,000 per month will have a PGI of $20,000 per month of $240,000 per year. An underwriter will look at the leases and rent roll to determine how close the property’s actual income is as compared to the PGI. Does the building have vacancies (which would lower the actual income)? Are there below market leases? Are there concessions to the rent? The vacancies and market losses will then be subtracted from the PGI to determine the Effective Gross Income (EGI). The EGI will be used as the starting point in determining the building’s cash flow.
Next, an underwriter will determine the building’s operating expenses. Many sellers underestimate a property’s expenses when listing a property for sale. For example, they often neglect to factor in management expenses, vacancy projections, capital repairs, maintenance and administrative expenses. Underwriters will usually assign industry acceptable numbers for these expenses, such as: 5 percent vacancy, 5 percent management, 2 percent reserves, and $750/unit for maintenance. On top of these underwritten (but often neglected) expenses, an underwriter will subtract taxes, insurance, utilities, trash and other property expenses. Typically, an apartment property expense ratio will hover around 40 percent before debt service, or mortgage payments. Using our example above, the property with a PGI of $240,000 per year might net $144,000 after all underwritten expenses.
This $144,000 is referred to as the property’s Net Operating Income (before debt service). This number, referred to as the NOI, is key to determining the property’s value. Whereas many sellers like to value a property based on a multiple of the gross rents (Gross Rent Multiplier Method), this valuation is very flawed as it does not take into account a property’s expenses. Phrases such as “10 Times Rent” are examples of this valuation method. Buyers should not use these calculations. A more accurate method is to apply a Capitalization Rate (Cap Rate) to the property’s NOI. A cap rate is the percentage return which an investor expects to realize on an investment. Assume that the Cap Rate in a particular market is 7 percent. The value of this property should be a little more than $2 million ($144,000 divided by 7 percent). If we use an 8 percent Cap Rate, the value drops to $1,800,000. The higher the Cap Rate, the lower the property’s value. It is important to understand what Cap Rate is in effect in the area where the property is located.
Let’s assume that this fictional property is in an area where similar properties sell at a Cap Rate of 8 percent. We can assume that our property should be worth around $1.8 million. How much of a loan will the borrower be able to receive? An underwriter will start with the common Loan-to-Value Ratio (LTV). If the underwriter customarily lends at 75 percent LTV, one could assume that the property will qualify for $1.35 million ($1,800,000 x 75 percent). There is another calculation to discuss, and that is known as the Debt Service Coverage Ratio (DSCR). The DSCR is defined as the NOI divided by the annual debt service. Let’s assume a $1,350,000 loan will have an interest rate of 4.5 percent based on a 30-year amortization. This loan would have a payment of $6,841 per month or $82,084 per year. We already determined that the NOI was $144,000. This loan has a DSCR of 1.75 ($144,000 divided by $82,084). Underwriters will usually expect to see a DSCR of at least 1.20. Since 1.75 is greater than 1.20, this loan should qualify.
To recap, before a buyer purchases an apartment property, he should calculate the potential gross income, effective gross income, net operating income, cap rate, loan to value ratio, and the debt service coverage ratio. These numbers will be crucial to obtaining a loan approval.
Stephen A. Sobin is an industry veteran with over 30 years of mortgage lending experience. He is the president and founder of Select Commercial Funding LLC, a nationwide commercial mortgage brokerage company. Sobin is a proud member InterCapital Group, a nationwide alliance of commercial mortgage professionals. You can contact Sobin at 516-596-8537 or visit his website at www.selectcommercial.com.