When determining apartment market value, many buyers and sellers like to throw around cap rates like they came out of a roulette wheel. And how they apply them can be even more adventurous.

The cap rate is the net operating income divided by the sale price. It is the rate of return earned if the asset was purchased in cash. Most buyers take the actual audited income and expenses and attach a cap rate to it, which generally leads to a very low value.

Sellers, on the other hand, gross up income and pear down expenses, then apply the same cap rate in order to over inflate the value. The result is sellers with unrealistic expectations of value, and buyers who are seriously undervaluing the real estate, and potentially missing out on great deals.

Stabilizing cap rates

The root of the problem lies in how the cap rate is derived. It is not simply pulled out of thin air. Appraisers, lenders and advisors look to stabilize the income and expenses of a building, which means placing the asset in a normalized situation with proper management and standardized expenses. This is done to all the comparable data that is collected — and therefore, it is like comparing apples to apples.

Many take these quoted stabilized cap rates and apply them to their definition of net income. That said, from a buyer’s perspective it is very important to look at the actual financial statements. However, the motive of the seller is to pay as little tax as possible, and these statements will have all sorts of ‘creative accounting’ techniques in order to achieve that goal. On the flip side, sellers take all of that out, and more.

When it comes to the income side of the equation, generally most take the actual rental income at 100 per cent occupancy for the apartments. If there are vacant or employee units, those units are put in at market rent. Parking is taken as is, and laundry is generally looked at as industry standard levels.

Vacancy and ‘bad debt’ is analyzed by looking at the current and historical operations in the building. The Canada Mortgage and Housing Corporation’s levels in the area are looked at, as well as the tenant profile.

Then there is the expense side of the equation. Generally, appraisers use actual realty taxes, utilities and insurance — if the insurance is within industry levels. If there have been claims, like slip and falls, they will take this into account.

For the other expenses, the following standards are used:

Repairs and maintenance:  $700 to $900 per unit per annum

Management: 3 to 5 per cent of effective gross income

Wages: $350 to $450 per unit per annum

Other: $75 to $125 per unit per annum

Older buildings

Many buyers might argue that if the building is 50 years old, the above repairs allowance should be set higher. Many also argue that if there is no on-site superintendent, then wages should be set at $0. The reality is no. Appraisers always take a normalized approach to the pro forma.

Here is why: if a building is new, sellers will say that repairs will be $0 per unit. In an older building, buyers will say that the repairs will be $2,000 per unit. Both are correct, but for establishing a cap rate, both are, in fact, wrong. The cap rate assumes the building will be owned in perpetuity, which means forever. As such, the proper repairs number should be that in the middle of the life cycle of the building, say $800 per unit.

On another note, just because on owner spends tons of money on repairs to keep his building top notch does not mean his real net income is lower and the building is worth less. By the same token, the owner who actually spends nothing on repairs will have a higher net income — does that mean his building is worth more? Of course not.

Buyers and sellers should be cognizant of this and not over value or under offer on properties. It will only result in a huge waste of time.

Lorenzo Digiainfelice, AACI, is the broker of record at Commercial Focus Realty Inc. and a member of The Apartment Group, which has sold over $3 billion in multi-family product. He can be reached at Ldigianfelice@cfrealty.ca.