How do YOU measure fair value (using market interpolation)

[Lance Lvovsky]

Just curious, when you examine a mult-family/apartment deal, how do you allocate what the fair value of your purchase should be? In one of my accounting classes in graduate school, we are learning about fair value measurement and how to apply it to real estate transactions. I am wondering if this method (matrix pricing) can be used / or is used by folks here.

I am assuming when evaluating a deal, you look at comps and cap rate. But what if your target deal is say 33,000 square feet and has a cap rate of 8.7% and you return 4 comps of:

• 8% cap rate, 30,000 square feet, price is $1.75M
• 8% cap rate, 40,000 square feet, price is $2.25M
• 9% cap rate, 30,000 square feet, price is $2.0M
• 9% cap rate, 40,000 square feet, price is $2.5M

Using what I learned, I come up with a fair value price of $2.075M. Which makes me wonder if anyone uses this method to negotiate their deals. Here is how I came up with the solution:

• 30,000 sq. ft:
  • 2.0M-1.75M = 225,000... 250,000 * .7 = 175,000 ... 1.75M + 175,000 = $1,925,000 (fair value of 30,000 sq.ft building at 8.7%)
• 40,000 sq. ft:
  • 2.5M-2.25M = 250,000... 250,000 *.7 =  175,000 ... 2.25M + 175,000 = 2,425,000 (fair value of 40,000 sq.ft building at 8.7%)
• Now to find fair value of building w/8.7% Cap rate at 33,000 sq.ft:
  • 2.425M-1.925M = 500,000 ... 500,000 * .3 = 150,000 ... 150,000 + 1.925M = 2.075M

So this makes me wonder, do real estate investors use this when trying to determine fair value for multi-unit deals? I imagine that knowing this number can allow a REI to determine what price one should pay after taking into account vacancies, expenses, fixing up, etc.

Thoughts?

[Roy N.]

@Lance Lvovsky 

Remember, you are not purchasing a building, you are buying a business (a series of cash flows).   While commercial and industrial space is commonly priced and lease by the  square foot / m^2,  it is not really applicable to residential buildings (at lease in Canada and the U.S.A.).

However, since you are buying a cash-flow and not a building, what is really of interest is the Net Operating Income (NOI) as Doug indicated and, after debt service, CFBT.

The "fair" price will be how much you could/should pay for this cash-flow, which is determined by your required rate of return. viz, if your opportunity cost is 7%, and you are looking at a NOI of 100K/yr, then you can pay no more than 1.42 million for the cash-flow (but probably should pay no more than 1.2million). If you require a 10% return, you would pay no more than 1 million.

You probably recognise this ratio (NOI / acquisition cost) as the CAP rate. It can be useful to compare the return of different assets - provided you perform the calculations in the same manner, using the same inputs for each asset being compared - in a given market. The problem with CAP rate is its misuse - Vendors will advertise rose-coloured cap rates to promote the sale of their buildings {no two of them calculated the same}; folks try to use it as a universal ratio to compare assets in different markets {i.e. a CAP rate of 5% on a multi-unit in Manhattan may be good, but a similar building a the same CAP in Milwaukee would be overpriced}. If you search here on BP, you will find lots of intense discussions on CAP and other rule-of-thumb ratios.

Sadly, in our markets these days we are finding far to many multi-unit residential buildings which are underperforming (the cash-flow is less than its potential), yet the owner expects to be paid for the "potential" cash-flow, rather than what s/he is producing