Apartment building appreciation: rule of thumb?

Question

Do apartment buildings appreciate in the same way single-family homes do, only at a lower percentage, or is the value of the building at the time of sale based solely on NOI and cap rate?

I'm working on a long-term buy and hold analysis spreadsheet and am not sure how to account for the building value at any given time in the forecasts.

Steve Olafson · Answer

No!!!  They barely even track together.

Obviously you have the numbers down.  The value grows exponentially as the NOI goes up.  If you trace it out on a spreadsheet it becomes apparent.

The biggest factors that affect NOI are jobs, supply, and demographics.  These track differently for houses than apartments.  Apartments tend to have larger and quicker swings.

If houses are in favor for some reason.  Then many of the good renters will begin moving out of apartments and into houses.  The flipside can occur as well where nobody wants to buy a house and more people become renters.

Apartment rents and overall income are going to be highly affected by supply.  Some locations are going to be easy and inexpensive to build.  Other areas are more cost prohibitive and new supply won't start until rents reach astronomical numbers.

Sunbelt locations seem to have more population growth these days.  Population has a big affect on both houses and apartments.  But the growth will be faster and more apparent with apartments.

I feel that I can track the good times to buy and sell apartments by watching these trends.  Much more difficult with houses.

Dennis Tierney · Answer

@Gretchen Roberts

I get brain dmage trying to do all of these long term calculations and agree with others it detracts from the real issue which is does the investment perform in the present? Many authors state correctly that you make your money on the buy. If you are interested in appreciation then look for properties for which you can force appreciation through value added improvements, then you don't have to worry about market forces to get your appreciation.

Joel Owens · Answer

All projections are is estimates. You can analyze numbers all you want but there are no absolutes.

4 units and below use the comparable sales approach for appraisal and loan purposes with values.

5 units and above more weight is on the income approach and cap rates for lending and appraisal.

Increasing the income for more NOI is the forced appreciation method. IRR is very subjective and a lot of people do not even use that metric. Most people I talk to who buy themselves as my clients for commercial or buying into a fund want to know cash on cash. How much they are putting in and what is expected to come out pre-tax. I do not run post tax evaluations for them as everyone's overall situation is very complex. I leave that to run by their tax advisor.

Hope it helps.

Jon Holdman · Answer

Ah, @Gretchen Roberts I see.  You're trying to calculate your returns on the deal, not a value.  And for that calculation, debt service does matter.

But I have a real problem with trying to do a 10 year projection of returns.  You will be making a bunch of flat out guesses in that analysis and your result is not very meaningful.  Any sales price you calculate 10 years out is nothing more than a guess.  Much safer to do you analysis on what's going on RIGHT NOW.  What will you pay?  How much rehab?  Rents right now ? Expenses right now.  Calculate your year 1 cash on cash return.  Do you like that number?  Buy it.

If you want to try to make future projections, do "scenario planning".  We did this when I worked for an oil company.  Like for oil, any projections you make five or 10 years out are nothing but guesses.  So, instead of guessing, identify a set of scenarios.  For example, assume minimal inflation and steady demand for one scenario.  Consider what if the neighborhood goes way downhill for another (cap rates increase, but rents decrease).  Of what if gentrification kicks in big time.   Compute your results in your different scenarios.  Is the property a good deal in only a few scenarios?  Think twice.  A good deal in a variety of scenarios?  Proceed.

If you're going 10 years out, you need to also consider big "black swans".  For instance, I think 10 years from now self-driving cars will be common.  They're starting to appear even now in luxury brands.  What is the world of real estate investment like if cars drive themselves?  Maybe people live further away because they can be productive while commuting.  Maybe people disperse out of cities all together.  Maybe so many jobs are eliminated (taxi, bus, delivery drivers; traffic police; traffic courts; stop sign makers, and many others) that the economy completely tanks.

What if North Korea manages to nuke its neighbor.  Or California?  Not likely, but not impossible, either.  What effect does that have on your investment?

Jon Klaus · Answer

Good question. No, cap rates can change over time, for example five years ago in the downcycle they were a couple points higher in DFW and maybe one to one and a half points higher in Los Angeles.

Steve Olafson · Answer

It depends on the area.  Some areas have much more volatility.

There was a period not long ago when the majority of the listings in Phoenix were at or close to zero caps.  That was also the time that the best deals were available.  Imagine that....  Excellent deals offered at zero cap rates!  I bought 14 small properties at this time.

Jon Holdman · Answer

@Gretchen Roberts sorry, but the cash flow doesn't factor into the value at all.  NOI does.  NOI is before debt service.   Your debt and debt service payments, as well as the debt and debt service payments of a potential buyer are irrelevant to setting a value for the property.  NOI and CAP rates are all computed without any consideration of debt service.

Prevailing CAP rates, such as they are, can change over time.  They are somewhat tied to the quality of the area and the asset.  A better asset in a better area will have a lower cap rate than a poor quality asset or a poor quality area.  So, if the area improves, cap rates go down and vice versa.  Similar for the asset.  But cap rates are also affected by demand.  Investment properties are just a commodity, like any other investment.  If investor demand for such properties is high then values will tend to rise.  If everything else remains the same, that means cap rates fall. That's why you see very low cap rates, 4-5%, for quality NNN properties in hot markets like CA.

Steve Olafson · Answer

You are correct in your over-analyzing of the system. :)

I base my entire investment process on appreciation.  Buy at the right time to catch a wave of rent growth and force the value up through repairs and efficiencies.  Bam!!  Double appreciation hit!

Gretchen Roberts · Answer

Guys, this is fantastic info. I think I'm learning a lot reading a book and then I come on here and get gold.

@Jon Holdman Love the idea of doing scenarios and that makes a lot more sense given all the variables. So I could run scenarios and then do actuals every year.

@Joel Owens I've been reading Frank Gallinelli's books and he says IRR is the most important metric because it's NOT subjective. Well, which is it? :)

Steve Olafson · Answer

I never project farther out than 5 years at a time.  The plans and projections can be modified and/or changed along the way.  Many of my investments are for 1-3 years.

You can plan on 10 year holds through financing but projections would not likely be accurate.

Apartment building appreciation: rule of thumb?

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