An analysis of a single-family home as an investment is usually quite simple. Can you pay your bills and your debt service with the rent you collect? Do you get consistent payments from it? Indeed, it should raise the same concerns about investments in several dwellings. However, a multifamily investment demands knowledge of several indicators due to its size and lack of homogeneity.
Therefore, this post’s purpose is to summarize the key parameters that any multifamily investor should be aware of. With this data, investors can make informed judgments about whether or not to acquire, sell, or hold multifamily properties. We’ll be looking at these measurements in the following main classes:
- Operating Performance
- Return on Investment Analysis
- Financing
- Taxes
- Conclusion
Operating Performance
- Net Operating Income (NOI)
Definition
NOI, or net operating income, is the profit made by a property after deducting all operational costs and rent. It’s the amount of money a property brings in before costs like maintenance and mortgage interest are subtracted. The net operating income of a property takes into account all the operating costs incurred regularly.
Why This Is So Vital
Net operating income (NOI) rather than cash flow (which we’ll get to in a minute) is used as the primary statistic to estimate the income property will generate for accounting purposes. As a result, net operating income (NOI) is a metric looked at closely by lenders and potential investors when considering a multifamily investment.
- Capitalization (“Cap”) Rate
Definition
NOI also feeds directly into the capitalization – or cap – rate. Conceptually, the cap rate represents the return an apartment building would provide on an all-cash deal. What return would you receive on a property if you didn’t use a loan? Mathematically, the cap rate equals a property’s NOI divided by its value.
Why This Is So Vital
There isn’t the sense of community you get in a single-family house that you do in an apartment complex. I need to know how to evaluate the performance of a multifamily property with 50 units versus 100 units. Capitalization rates (or simply “cap rates”) allow for the unit-size-blind comparison of commercial properties. Does an apartment building with 100 units have a higher NOI than one with 50 units automatically make it the superior investment choice? Using the NOI as a comparison statistic, you can see that the former gives less value if the cap rate is only 5%, compared to the latter’s 7% NOI.
- Operating Expense Ratio (OER)
Definition
Investors can compare the performance of different properties by looking at their OERs. Exactingness indicates how well a property manages its costs. OER is determined by dividing the total operating expenses by the total operating income of a property. Generally, the smaller the ratio, the more efficiently a building function.
Why This Is So Vital
If the operating expense ratio of a property is low, then it is a good investment. Over time, keeping an eye on this measure can shed light on pressing problems. A rising OER is a warning indicator that spending has outpaced revenue for investors. Landlords can determine if and when a capital improvement is necessary by keeping tabs on OER. For instance, if OER increases steadily over the years owing to repeated roof leak repairs, it’s a good indicator that the roof needs a sizable capital expenditure.
- Occupancy Rate
Definition
As the name implies, the occupancy rate is the ratio of occupied to vacant dwellings. To calculate the occupancy rate, divide the number of occupied dwellings by the total number of available dwellings. When 95 of a building’s 100 units are occupied, the occupancy rate is 95%.
Why This Is So Vital
Always ask for at least the previous three years’ worth of occupancy rates before purchasing a multifamily building during the due diligence stage. It shows you the general tendencies of how many empty apartments are in a building. The majority of a building’s operational costs (such as taxes, insurance, management, and so on) and debt servicing are incurred whether or not the building is occupied. Therefore, it isn’t easy to generate high returns on investment if a home is not fully occupied.
- Rent Per Square Foot
Definition
This metric provides another useful technique to compare qualities that are otherwise different. The average rent in a building is divided by the total number of usable square feet to arrive at the rent per square foot, or rent/sq.ft. Let’s pretend for a moment that a property offers 100,000 square feet of total rentable space (NOTE: apartments typically do not differentiate between rentable square footage and usable square footage like offices and other commercial properties do). Investors could expect $150,000 in gross rent if the market rate for these types of apartments is $1.50 per square foot.
Why This Is So Vital
If you’re in the business of building apartment complexes, knowing this measure will help you estimate future rents. It helps you estimate your return on investment (ROI) if you plan to buy a property to improve it financially. For the sake of argument, let’s say that it can upgrade a property from Class B to Class A with an investment of $500,000. If the going rate in the area is $1.5 per square foot for Class B but $2.25 per square foot for Class A, then it is easy for investors to see if spending $500,000 on the upgrade is worthwhile.
Return on Investment Analysis
- Cash-on-Cash Return
Definition
Cash-on-cash return is an investor’s yearly rate of return on cash contributions. Consider the following: you put down $200,000 on a $1,000,000 apartment building (ignoring closing costs). In the first year, if you bring in a net of $10,000, your return on investment is 5% ($10,000 cash flow / $200,000 invested funds).
Why This Is So Vital
Most financiers consider property an alternate investment vehicle to stocks and bonds. Long histories of dividend and capital gains distributions from such assets allow investors to accurately predict the amount of money they will get at various investment levels. If these same investors are thinking about investing in real estate, they will need to know what kind of financial returns they may anticipate for their money.
- Internal Rate of Return (IRR)
Definition
Performance is evaluated each year based on the cash-on-cash return. Even while the internal rate of return (IRR) is a measure of financial performance, it takes into account the full duration of an investment rather than just its cash outflows. IRR is a theoretical method for estimating the rate of return on a multifamily investment. For a given cash outlay, the Internal Rate of Return (IRR) is the interest rate at which the present value of future cash flows (projected yearly cash flows plus final sale of property) equals the outlay of capital. To rephrase, IRR is a measure of the expected return over the life of an investment.
Why This Is So Vital
Every investment has its unique “barrier to entry,” or required rate of return, that most investors must achieve. The internal rate of return (IRR) for real estate investments is a great way to measure this necessary profit. The estimated internal rate of return (IRR) on an apartment can help investors determine whether or not the investment’s risk is worth the potential reward. If an investor requires a minimum internal rate of return (IRR) of 12% on 10-year investments, a multifamily contract with a projected 10-year IRR of 15% would be acceptable, but a deal with a 10-year IRR of 10% would not.
- Cash Flow
Definition
Cash flow is the amount left over after deducting operating costs and debt payments from net rents (rents minus vacancy). A person’s annual take-home pay is, in a nutshell, the amount of money they earn. Therefore, cash flow does not take into account expenses that do not involve a cash outlay, such as depreciation, but does include payments that involve a cash outlay, such as mortgage principal (but still require cash payments).
Why This Is So Vital
As previously indicated, many investors, especially restricted investors, treat their holdings in multifamily homes as anniversaries. They hope to ensure a minimum amount of regular cash payments. You must reliably predict future cash flows if you wish to negotiate a multifamily deal with restricted investors. Why would prudent investors put their money into an apartment building if a bond fund guarantees X in cash flows each year and they can’t reasonably expect more?
Financing
- Loan-to-Value (LTV) Ratio
Definition
The loan-to-value ratio (LTV) measures the degree of leverage a buyer can expect to have when purchasing a home. Said, LTV establishes how much of a mortgage can be obtained from a given lending institution for a given piece of property. Lenders typically require an assessment when financing the acquisition of a multifamily complex. Let’s say $1,000,000 is the value determined by this appraisal. This lender will provide a loan of $800,000 if the loan-to-value (LTV) terms are 80% of the $1,000,000 appraised value.
Why This Is So Vital
For investors, LTV indicates two crucial factors. The first thing it does is calculate how much money you’ll need to close a deal. According to our calculations above, the project would require $200,000 in funding from investors ($1,000,000 value minus $800,000 loan). Second, Return on Investment (ROI) is directly related to LTV. The greater the initial investment, the less the return on investment. For the argument, let’s say the flat, as mentioned earlier, brings in $25,000 in its first year of operation—a $200,000 initial investment yields a cash-on-cash return of 12.5%. Let’s increase LTV to 90% instead, which would mean investing $100,000. Now, a 25% cash-on-cash return has been achieved on the $25,000 cash flow (without considering any changes in debt payment due to variations in loan principal).
Ultimately, the LTV cap affects how much leverage can be used, affecting the return on investment (ROI). On the other hand, using more leverage increases the likelihood of adverse events.
- Equity
Definition
Equity is the other half of the coin that investors deal with, opposite debt. In its most basic definition, equity is the amount of ownership stake you have in a piece of real estate. Simply put, equity is the difference between the current market value of a property and any mortgages or liens on it. If the fair market value of an investment property is $1,000,000 and the mortgage is $600,000. The investor would have $400,000 in equity in the property ($1,000,000 value minus $600,000.
Why This Is So Vital
The value of your equity indicates how much you anticipate receiving upon sale. Based on these assumptions, investors might make $400,000 after selling the home (before accounting for capital gains taxes and closing fees). The existing mortgage would be paid off by $600,000 of the $1,000,000 purchase price, leaving the owners with $400,000. Therefore, the equity of a property is a major factor for investors when deciding whether to hold or sell.
- Debt Service Coverage Ratio or DSCR
Definition
The DSCR of a property is calculated by dividing its net operating income by its total debt service (mortgage principal and interest). Take, as an illustration, the hypothetical case of a property’s NOI in a given year being $100,000. One can calculate the debt service coverage ratio (DSCR) as 1.33 ($100,000 NOI / $75,000 debt service).
Why This Is So Vital
DSCR is very important in business loans. Loans for apartment buildings typically come with debt covenants or requirements that the borrower must follow. A DSCR of 1.25 is typically required by lenders, though this is not a hard and fast rule. Lenders will look at your pro forma (a predicted income statement) and use your net operating income (NOI) as the bottom line when deciding how much money to provide you. As DSCR is held constant, the lower the NOI, the smaller the loan that can make.
Also, annual financial statements are typically required by lenders. Lenders can terminate your loan if the DSCR on your property drops below the threshold outlined in your loan agreement. DSCR is a crucial indicator for investors to monitor because of the possibility that this will occur.
Taxes
- Cost Basis / Annual Depreciation
Definition
A property’s cost basis in real estate is its acquisition price plus the costs of bringing it into use. For instance, a property with a $1,000,000 cost base was purchased for $750,000 and then rehabilitated at $250,000. Take notice that debt is not factored into your cost basis calculations. Therefore, your cost basis for that $1,000,000 investment is the same whether you finance it or pay cash.
You can calculate your annual depreciation cost from your cost basis. While depreciation is treated differently in different financial accounting systems, calculating depreciation for tax reasons (which is important for real estate investors) is straightforward. The yearly depreciation cost is calculated by dividing the cost basis by 27.5 for a single-family home. Based on the calculations above, annual depreciation for investors maybe $36,364 ($1,000,000 cost basis 27.5 years). You can lower your taxable income by $36,364 a year without affecting your cash flow.
Why This Is So Vital
Considering real estate as an investment generally attracts first-time capitalists because of the favorable tax treatment it receives. Depreciation is the primary factor in these tax breaks. This cashless expense can lower an investor’s taxable income without impacting cash flow before taxes. Most apartment complexes can generate positive cash flow despite operating at a taxable loss thanks to depreciation.
Final Thoughts
The preceding isn’t all there is to consider while assessing apartment complexes. However, as an investor, you may evaluate the potential of a business with more confidence if you have a firm grasp of these ideas. This information equips investors to make informed judgments about buying, selling and holding multifamily properties.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.