Due Diligence on Apartment Building – Part 1

This article is to fulfill what I have promised on March 16th, 2009. When you start to play with 5+ unit apartment building, there are various subjects that you have to consider, which don't exist when you are in the 1-4 unit game. Since it is impossible to cover everything in a blog, I will only touch few important subjects.

Today, we will talk about valuation method. Unlike 1-4 unit single family houses, in which sales comparison method is normally used with the most emphasis, income method is used for apartment building valuation. There are three factors here, the capitalization rate or commonly referred to as “cap rate”, net operating income (NOI) and building value.

                        Net Operating Income (NOI)
Building value = ----------------------------------------
                                    Cap Rate

The capitalization rate is determined based on the capitalization rate of apartment buildings sold recently within that particular area/neighborhood.

Net operating income is gross operating income minus operating expenses. Note that operating expenses don't include debt service, depreciation and income taxes.

What do you have to account when analyzing net operating income?

Income
• At least the last one year of monthly P&L statements
• Three to five years of annual P & L statements and income tax returns
• Rent rolls and payment history
• Copy of all lease agreements and any addendums
• Security deposit records
• Other source of income such as income from vending machine and laundry

Expense
• The last three years of property tax bills
• Insurance policy: term, exclusion, all riders
• Property management agreement
• Utility bills: gas, electric, water & sewer, trash
• Any assumable service contracts such as landscaping and wireless internet services
• Any assumable warranty from vendors

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