Are you interested in investing in multifamily properties? Do you want to be able to evaluate potential deals quickly and efficiently? Discover 3 simple steps to evaluating any multifamily investment. With this method, you will be equipped with the knowledge you need to make informed decisions about pursuing any multifamily deal. So let’s dive in!
3 Simple Steps to Evaluating Multifamily Investments
To demonstrate this simple 3 step process, we are using a 12 unit multifamily property as a practical example. Here are the property details:
Purchase Price: $1 Million
Units: All units are 2 bedroom and are renting at $1,000/month
Gross Rental Income: $12,000/month or $144,000/year
Step 1: Gather Property Information
Before diving into the evaluation process, it is essential to gather basic information about the property. This includes the effective gross rental income, operating expenses, net operating income, and mortgage payments. By having this information, you can ensure an accurate evaluation.
Effective Gross Rental Income:
First you need to determine the gross rental income. Multifamily rarely remains 100% rented 100% of the time and a vacancy factor accounts for this reality. A vacancy factor gives you a more realistic number for your calculations and the industry standard for multifamily apartments is a 5% vacancy factor. Therefore you must subtract a 5% vacancy factor from the gross rental income to get what is called the effective gross income.
5% – $144,000 = $136,000/year
Operating Expenses:
Obtaining accurate operating expenses from a multifamily property seller can be extremely difficult. And while the most accurate way to calculate operating expenses is to add up all the yearly operating expenses one line item at a time, a helpful industry standard for estimating expenses for multifamily apartments is to multiply the effective gross income by 35%.
136,000 x 35% = $47,880/year
Net Operating Income:
NOI describes how much money the property earns if you owned it free and clear without any loans and it’s key to evaluating any multifamily deal. To determine the NOI, subtract your operating expenses from the effective gross income.
$136,800-47,880 = $88,920/year
Annual Debt Service:
There will be mortgage payments on the property and in the world of commercial real estate the total yearly loan payments is called “Annual Debt Service“. For this example we will use the standard default terms of 25% down payment, 6.5% interest rate and a 25-year amortization. The purchase price of our example property was $1 million, and the down payment was 25% (or $250,000). The other 75% was financed at 6.5% interest amortized over 25 years, making the monthly loan payment $5,406/month. To calculate the annual debt service, multiply the monthly payment by twelve.
$5,406 x 12 = $60,768/year
Step 2: Calculate the Multifamily Metrics
Once you have gathered the necessary information about the property, it’s time to calculate the multifamily metrics. In this step, you will calculate three crucial multifamily metrics: cash flow, cash on cash return, and cap rate. These key metrics provide critical insights into the financial viability of your investment.
Cash Flow:
Cash flow is calculated by subtracting the mortgage payments from the net operating income (NOI). This metric gives you an idea of how much profit or cash you can expect from the investment annually.
(NOI) $88,920 – $60,768 = $28,152/year
Cash on Cash Return:
Cash on cash return measures the return on your investment. To calculate this, divide the cash flow by the down payment.
$28,152 divided by $250,000 = 11.2%
Cap Rate:
Cap rate, or capitalization rate, is a measure of the property’s profitability and potential return. To calculate this, divide the NOI by the purchase price.
$88,920 divided by $1,000,000 = 8.8%
Step 3: Decision Framework
The final step in evaluating multifamily deals is to create a decision framework based on go or no-go standards. These standards serve as guidelines to determine whether the deal is worth pursuing or not. Here are the three standards to consider:
Positive Cash Flow:
The cash flow is how much money the property puts in your pocket as the owner. This is your net profit and the purpose of owning commercial real estate is to make a profit so positive cash flow is crucial. It ensures that the property generates more income than its expenses, therefore your multifamily deal must have positive cash flow. Our example deal cash flows $28,152/year, so it meets the first standard.
Cash on Cash Return Benchmark:
Cash on Cash return makes up part of your overall return on investment (ROI). This benchmark helps you compare your multifamily investment to other investment options that exist in the marketplace. The “go or no go” standard is to aim for a higher cash on cash return than what you could earn from a CD. The average return from a CD today is about 5%, meaning your deal cash on cash return needs to be greater than 5%. Our example deal meets this benchmark with a cash on cash return of 11.2%.
Deal Cap Rate vs Market Cap Rate:
Capitalization rate, or cap rate, is defined as your return on investment if you paid all cash for the property and did not get a loan. The simplest way to figure out if you are getting a great multifamily deal is to compare the property’s deal cap rate with the market cap rate. Ideally, your deal cap rate is higher than the market cap rate. For example, if there are four transactions in the submarket of our example property that closed at a cap rate of 7.5%, then the market cap rate is 7.5%. Since our deal cap rate is 8.8%, it is higher than the market cap rate, which means we have a good deal.
Conclusion
With these three simple steps, you can confidently evaluate any multifamily investment in just five minutes. By gathering information, calculating the essential multifamily metrics, and establishing a decision framework you can determine whether a potential investment is a ‘good deal’ or a ‘bad deal’. Remember, thorough evaluation is crucial, and these 3 steps are your initial evaluation and serve as a starting point for your assessment.
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If you are looking to take multifamily investing to the next level and build a successful portfolio or want to receive guidance and mentorship, apply for our Protege Program. Get your mentor here: Commercial Property Advisors Protege Program
If you have any questions, post a comment below or text PETER to 833-942-4516.
When I was trying to learn this on my own, I found the difficulties I want to thank you. You made it simplistic and straightforward and with celebrity I feel like I should have been meeting you 20 years ago. I’m still not that old and still like to learn and would love to do a deal somedhyundai. But I feel like I know. You taught it in a way that said you don’t need money to actually get started. But my mind set right now. Says you have to have some down money to do this, none the less. I may still want to do a learning course thank you sincerely