Assume that the Cap Rate in a particular market is 7 percent. A cap rate is the percentage return which an investor expects to realize on an investment. A more accurate method is to apply a Capitalization Rate (Cap Rate) to the property’s NOI. Buyers should not use these calculations. Phrases such as “10 Times Rent” are examples of this valuation method. 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. This number, referred to as the NOI, is key to determining the property’s value. This $144,000 is referred to as the property’s Net Operating Income (before debt service). Using our example above, the property with a PGI of $240,000 per year might net $144,000 after all underwritten expenses. Typically, an apartment property expense ratio will hover around 40 percent before debt service, or mortgage payments. On top of these underwritten (but often neglected) expenses, an underwriter will subtract taxes, insurance, utilities, trash and other property 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. For example, they often neglect to factor in management expenses, vacancy projections, capital repairs, maintenance and administrative expenses. Many sellers underestimate a property’s expenses when listing a property for sale. Next, an underwriter will determine the building’s operating expenses. The EGI will be used as the starting point in determining the building’s cash flow.
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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). 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. 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. The potential gross income (PGI) is the total of all potential rents and charges before any offsets or expenses. We will begin with a discussion of the property’s potential gross income. 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. Buyers are looking to buy at the lowest price possible. Sellers want to sell their properties for the highest price.