I was talking with a multifamily fund operator who’s been in the business for 30+ years. His firm started out buying class C multi deals and scaled up over time to raise a fund with institutional capital to acquire higher-quality, light value-add multifamily assets. The primary driver of the movement upstream was the capital-intensive nature of older vintage apartment properties. The ongoing capital needs make it difficult to hold these assets long-term and require holding significant reserves.

In real estate, ‘cap rate’ is used as a crude metric for valuation and is simply a measure of unlevered yield. The math is simple; the cap rate formula is the annual property net operating income / property purchase price.

NOI is used as the measurement basis for cap rates because it is the purest way to represent the operating income profile of the property. The NOI line sits above the debt service line in the property’s income statement, so it is not impacted by the debt structure of the property. In this way, the cap rate of a particular property reflects the attractiveness of that particular property’s expected ongoing operating cash flow stream.

However, NOI also sits above capital expenses and routine replacement expenses (RRE). Capex is true one-time capital improvements such as replacing roofs or renovating the fitness center. It would make sense that these truly one-time (or very infrequent) expense items would be eliminated from the metric used for valuation. Routine replacement expenses, on the other hand, are capital items that are recurring. This includes HVACs, water heaters, appliances (dishwasher, fridge, washer/dryer, etc.), interior flooring (carpet and vinyl plank), etc. Individual appliances and HVAC units have useful lives of 10+ years, but every year some number of appliances and HVACs will be replaced so there is always an expense.

Quantifying that ongoing routine replacement expense is a never-ending exercise, but for Atlas deals (70’s – 80’s vintage garden-style properties) the expense varies from $500/unit to $1,000/unit.  That means for a 200-unit property, we’re incurring $100,000 to $200,000 worth of routine replacement expenses annually.

These expenses hit below NOI, so they’re not typically factored into the cap rate calculation, yet they have a material impact on cash flow. Here’s an illustration of the impact of RRE on a 200-unit deal with $1M in annual NOI.   

In the example above, the deal is worth $16.66M at a 6% cap rate using the $1M in NOI. However, if you factor in $500/unit in RRE, the deal at the same 6% cap rate is only worth $15M (a full $1.66M less).

As you can see, the actual routine replacement expense has a major impact on cash flow and valuation. When we’re underwriting deals, we use $500-$750 per unit for RRE which is based on our experience operating similar deals. This allows us to realistically forecast net cash flow, distributions to investors, and projected sale price.  

Lender’s (and many buyers) typically use $250/unit for routine replacement expenses. I’ve never seen a deal operate at $250/unit, but for some reason lenders have never adjusted the required routine replacement escrow.  

So, when a buyer says they’re acquiring a deal for a 6 cap (ignoring RRE), it may be more like a ~5 cap.