To value apartment buildings, many investors use the direct capitalization technique. While it is mainly used for commercial real estate, it can also be used on 2-4 unit properties. The formula is this:
V = NOI / R
V = VALUE
NOI = NET OPERATING INCOME
R = CAP RATE
The Capitalization Rate (Cap Rate) is found from looking at sold comparables where value has already been established with a sale price. CAP RATE = NOI / VALUE (Sale Price).
When you are looking at a multi-family property and you want to find out it’s fair market value, you should figure out the Cap Rate of some recently sold comps. Then with the average of those Cap Rates, you can figure out a Value of the property you are considering purchasing.
For example, let’s say you are looking at an 8-unit building that has NOI of $40,000. What you want to do first is find the Cap Rate of some recently sold multi-family properties in the area:
COMP #1: $530,000 sale price, $43,000 NOI. 43/530 = 8.1% Cap Rate
COMP #2: $427,000 sale price, $36,000 NOI. 36/427 = 8.4% Cap Rate
COMP #3: $694,000 sale price; $63,000 NOI. 63/694 = 9.1% Cap Rate
COMP #4: $671,000 sale price; $54,000 NOI 54/671 = 8.0% Cap Rate
COMP #5: $544,000 sale price; $47,000 NOI 47/544 = 8.6% Cap Rate
The average Cap Rate among these 5 listings is 8.4%. Using that for the Subject Property, along with the Net Operating Income, we can figure out Value of the Subject Property. VALUE = NOI / R = $40,000 / .084 = $476,190.
You will most likely find higher Cap Rates for properties in bad neighborhoods, and lower Cap Rates for properties in good neighborhoods. This is because an investor will pay significantly more for each dollar of income produced by a property in a prospering neighborhood.