Six Units, a 5.5% Cap Rate, and a Lender Who Wants a Number
An appraiser is engaged by a regional bank to appraise a six-unit apartment building built in 1978 on a commercial corridor, under contract for $720,000. The rent roll shows six units at $950 per month. Historic vacancy and collection loss runs 6 percent. Operating expenses - taxes, insurance, maintenance, management at 8 percent, and utilities - total $24,500. Three comparable sales indicate overall capitalization rates of 6.8, 7.2, and 7.5 percent and prices of $115,000 to $128,000 per unit. Debt service would be $38,900. The loan officer emails: "Our borrower needs $720,000 to work. Please make sure your income approach gets there."
1. Develop the income approach and test the contract price. Show your figures.
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Direct capitalization, step by step.
| Line | Amount |
|---|---|
| Gross potential rent (6 × $950 × 12) | $68,400 |
| Less vacancy/collection at 6% | −$4,104 |
| Effective gross income | $64,296 |
| Less operating expenses | −$24,500 |
| Net operating income | $39,796 |
Value at each comparable cap rate:
- 6.8%: $39,796 ÷ 0.068 = $585,235
- 7.2%: $39,796 ÷ 0.072 = $552,722
- 7.5%: $39,796 ÷ 0.075 = $530,613
What $720,000 implies: $39,796 ÷ $720,000 = 5.53 percent, roughly 170 to 200 basis points below every comparable. The contract price is not supported by the income approach.
Two adjustments a careful appraiser would also weigh:
- Reserves for replacement are not in the $24,500 and are appropriate for a 1978 roof, HVAC, and parking lot; adding even $2,400 ($400/unit/year) drops NOI to $37,396 and value at 7.2% to about $519,400.
- Management at 8 percent is within market; verify it is on collected income, not gross potential.
Also confirm that debt service ($38,900) is properly excluded - it is a financing cost, not an operating expense, and has no place in NOI.
2. Which approach should carry the most weight, and how should the appraiser handle the loan officer's instruction?
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Approach selection. For a 1978 apartment building in a market with active sales of similar small multifamily properties, the income approach is primary and sales comparison is the check. Cost approach is given little or no weight: the improvements are nearly 50 years old and depreciation (physical, functional, and external) would be difficult and unreliable to extract, and a buyer of this asset is buying an income stream, not a replacement cost. Sales comparison corroborates - $115,000 to $128,000 per unit translates to $690,000 to $768,000 on paper, but that range must be reconciled against the per-unit NOI of each comparable, because a simple per-unit comparison ignores rent and expense differences.
The instruction is not an instruction. Advisory guidance and appraisal standards require independence, objectivity, and a value conclusion developed from market evidence, not a predetermined target. Complying would:
- violate the appraisal standards the appraiser is bound by and the lender's own federal-regulator requirements;
- create exposure for the appraiser's license and for the bank under its appraisal-independence rules;
- constitute a misleading report if the stated value cannot be supported.
Proper response. Decline in writing, state that the value must be supported by market evidence, and note that the contract price can be reported as a fact and analyzed (an implied 5.53 percent cap rate) without being adopted as the conclusion. Send the report to the lender's designated contact, not the loan officer alone, and document the exchange. If pressure continues, the appraiser's state regulatory board is the appropriate escalation.
3. The contract price stands at $720,000 and the buyer has 20 percent down. What should the bank and the buyer understand about the likely outcome?
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Where value lands. Reconciling the three comparables, the tightest market-supported range is roughly $530,000 to $585,000, with the 7.2 percent comparable most representative - call it $550,000 to $560,000. That is 22 to 26 percent below the contract price.
Consequences of a $555,000 appraisal on a $720,000 contract:
- The loan is sized on the lesser of price or appraised value. A 20 percent-down, 80 percent-LTV loan becomes $444,000 rather than $576,000.
- The buyer's cash requirement rises from $144,000 to $276,000 - an extra $132,000 - unless the price is renegotiated.
- If the buyer cannot close the gap, the contract's financing contingency and any appraisal contingency determine who keeps the deposit. The licensee must read the actual contract language: a financing contingency tied to a loan amount usually will not excuse a buyer who simply dislikes the value.
Practical advice. The buyer's agent should present the appraisal as the negotiating document and seek a price reduction to market with supporting comparables. The seller's realistic alternatives are to reduce the price, seller-finance the gap, or test the market with another buyer - but the next lender's appraiser will reach the same conclusion. The bank should not be asked to stretch LTV to absorb an unsupported price.