The Challenge to Multifamily Evaluations

[Ashley Wilson]

Over the past year plus, multifamily has endured some difficult blows. Most would agree the top three are interest rates, taxes and insurance. Breaking these three down on the direct impact they have had on multifamily pricing: rising interest rates impact your cost of capital, and taxes and insurance impact your net operating income (NOI) which has a multiple effect on evaluations when using the NOI approach for assessing value.

Value, while a simple definition, is a complex concept. There are three ways in which multifamily is evaluated. The most recognizable is the comparable sales approach which uses comp properties to assess value. This is how most tax authorities determine value. The second approach is the replacement value. This is the cost of rebuilding the same product. Insurance companies use this method when determining their policy pricing. The last approach is the NOI approach which is the most common way investors buy multifamily. This method evaluates the business through taking the income minus the expenses and then dividing the NOI by the trading cap rate.

Comparing the three evaluation methods to the three challenges facing multifamily yields different changes to value. Specifically, for most properties the value on both the comparable sales approach and the replacement value has risen, but on the NOI approach it has fallen. This creates a stalemate as buyers are forced to make a decision on whether or not they want to change their approach on how they evaluate multifamily.

So far, it looks like the industry has responded by holding steadfast on their commitment to the NOI approach. But will this last? Or, will a new way emerge? Interested to hear your thoughts on evaluation methods and the future of multifamily transactions in this current environment.

[Chris Seveney]

The trend I've observed over my career, having assessed over 1000 MF transactions the focus tends to be predominantly on the Net Operating Income (NOI), rather than the replacement value of the asset. This perspective is quite common in the MF sector, especially where sales comparisons are largely based on the asset's condition and financial performance (NOI which leads to a cap rate).

When comparing two properties with similar capital expenditure needs, the industry standard is to evaluate them based on a cap rate. This method is not only practical but also reflects a deeper understanding of the property's income-generating potential.

Also, we cannot leave out banks in this equation as lending practices in the real estate sector also align with this approach. Banks typically lend based on the asset's ability to repay, which directly relates to its NOI, rather than its replacement value. This focus on NOI is a significant factor in determining the financial viability of MF investments.

But sales comps and the impact of market dynamics on property values also cannot be overlooked. For instance, in a scenario where several properties in an area are sold at a discount due to defaults, these sales set a new standard for cap rates in that area. This trend is increasingly relevant in today's MF market, posing challenges for operators with fixed debt who are looking to sell their syndicated assets and have high performing assets but now the comps crush the ability to liquidate. 

Sorry for long winded response. But based on the above I do not see a new way emerging unless the banks were to change their anaylsis.