Today is another AMA episode.

Today’s question was actually asked twice by two different people. The questions are virtually the same to I’ll answer it only once. Both Chad and Michelle asked

I have a portfolio of smaller multi-family properties duplexes, triplexes and some singles. I’m thinking of putting a blanket mortgage across the entire portfolio. The question is how to value to the portfolio? Should I be valuing each individual property independently or using a cap rate calculation to value the portfolio?

This is a great question.

Let’s start with discussing how an appraiser would look at valuation for a property. They use three methods.

Generally speaking, appraisers determine the value of a property using one of three methods.

  1. Replacement Cost
  2. Comparable Sales
  3. Multiples of net income

The problem exists when the three methods don’t agree, which of the three do you select? Generally, the appraiser will choose the lowest of the three. But here too they need to apply judgement and discard the one that doesn’t apply.

The biggest problem in particular for commercial real estate is that in many cases there are no truly comparable properties in the same area. In those cases, a like for like comparison is truly impossible.

If your property is a 10 unit building, there may not be any other 10 unit buildings in the area. There might a 12 unit, a 16 unit, a 20 unit. So what do you compare? Do you compare price per unit? Do you compare price per square foot? Are the properties truly comparable meaning are they of a similar vintage with similar levels of finish and attracting a similar tenant base? If not, then they’re not true comps.

The appraiser will then look at replacement cost. They will look at the finishes of the building, and make a cost per square foot estimate construct the a new version of the same building today. Often times, buildings are trading below construction cost because they might have been built some number of years ago and the increase in value has not kept pace with the rising cost of new construction.

Finally, the third method is multiples of net income. This is where a property is valued on its ability to generate profit. That is, after all why we real estate investors are in this business altogether. The appraiser will look at what, say, B class apartment buildings are trading for in the area. It might be 6.5% cap rate. They will then analyze the financials for your building and determine the income and the expenses for the property based on a bank approved model for properties in the local area.

Now your case is a little different. If all the properties are within a small radius, say, a few blocks of each other, then you can effectively treat the portfolios the same as you might a single building. If all the properties are of a similar vintage and the apartments are positioned similarly in the market, then you can compare them together as a group.

The approach you’re suggesting is something we’ve done for nearly a decade. In our case, we rebuilt a portfolio of properties in a small geographic radius of a few blocks in Philadelphia. Almost all of the units were rented to students, and they were all pretty similar. The rent for each bedroom of student housing was very similar. The lender was comfortable with putting a blanket mortgage across the portfolio.

You also need to be aware that the lender may want to look at the yield on cost instead of the cap rate. You might not be familiar with the term yield on cost. It’s a calculation which is similar to the cap rate calculation.

Some lenders like to be conservative and don’t want to lend you so much money that you cash out of your initial investment. They may want you to keep some of your own cash in the deal.  It comes down to the specifics of your deal and what your lender will allow.