‘Commercial’ multi-family real estate is 5+ units on a single property.
‘Residential’ multi-family is 2-4 units on a single property.
Estimating the value of small multifamily properties is a relatively straightforward process, with a number of established methods including Gross Rent Multiplier. The purpose of this article is to explore methods of evaluating larger multi-family deals.
Before delving into detail, it’s important to be aware of the numbers used in calculations. If the numbers aren’t correct, metrics and calculations will be misleading. For example, expenses reported by a seller may not be complete and could make the deal look better. Expenses may also be different (higher or lower) depending on how you will manage the property.
There are two popular metrics for evaluating commercial deals:
- Capitalization Rate (Cap Rate)
- Cash-On-Cash Return (CCR)
The Cap Rate is generally used when putting a property for sale. Simply put, it is the return on investment based on income, operating expenses and sales price. It’s a way for potential buyers to quickly estimate if a property might fit their goals – higher Cap Rate, higher Net Operating Income (NOI). It also gives insight if the property is priced too high, or too low relative to other buildings in the area (if too low, it could indicate the property needs some work; too high, the price might need to come down).
Two quick and easy steps to calculate a Cap Rate:
- Calculate Net Operating Income (NOI): Gross Annual Income – Annual Operating Expenses
- NOI / Sales Price * 100 = Cap Rate
- NOI: Annual Income $100,000 – Annual Operating Expenses $45,000 = $55,000
- $55,000 / Sales Price $375,000 = 14.7% Cap Rate
Note operating expenses can include some or all of:
- Property Management Fees
- Property Tax
- Marketing / Advertising
- Employee Expenses
- Vacancy & Collection Losses
That list gets shorter or longer, depending on your situation. Note when you evaluate a potential purchase, make sure to factor in all the expenses you expect, and not what someone else reported. For example, you might higher a property manager or landscaper, whereas someone else will do the work themselves. Maintenance costs could also be higher in the future than previously reported on a building. Rents could be increased, but expenses may increase too.
It’s worth noting the Cap Rate does not factor in debt payments; a Cap Rate establishes profitability of a building without considering debt structure. One person’s acquisition will look different from someone else’s, so the Cap Rate establishes a way to evaluate the building, without considering debt structure. Different markets will have generally accepted cap rates.
A stable property in a large established market like NYC might have a very low cap rate (just a few percent). Investors in these properties look more at long-term appreciation, or perhaps other enhancements to extract more value from a property.
A stable property in a smaller market may have a rate around 8-10%, indicating higher profitably due to higher risk.
A property that needs some work done to it should be offered at cap rates higher than the going rate for turn-key properties in the area. Additional capital will be required to improve the property, and the investor should be rewarded for the increased risk.
So, the Cap Rate evaluates the property. Now, the Cash-On-Cash Return can help you evaluate your particular deal.
Cash-On-Cash Return (CCR)
The way you acquire a property will be unique from another potential buyer. There are many methods, including:
- Cash Purchase
- Standard Debt
- Hard-money Financing
- Vendor Take-Back (VTB) / Seller Financing
- Joint Ventures
- Much more…
You want to know your return on investment, based on the cash you invested into a deal. Start with the amount of cash you put into the deal. If you’re getting standard debt, this will be 25-35% of the purchase price, plus other costs.
Some potential costs to consider when adding up Cash Invested:
- Down payment
- Legal Fees
- Bank Fees
- Land Transfer Taxes
Two quick and easy steps to calculate CCR:
- Calculate Net Operating Income (NOI), INCLUDING DEBT PAYMENT: Gross Annual Income – Annual Operating Expenses – Annual Debt Payments
- (#1 Above) / Cash Invested * 100 = CCR
- Annual Income $100,000 – Annual Operating Expenses $45,000 – Annual Debt Payments $24,000 = $31,000
- $31,000 / Cash Invested $120,000 = 25.8% CCR
If you’re paying all cash, the CCR will equal the Cap Rate. By leveraging debt financing, the CCR should be higher. In our examples, the 14.7% Cap Rate is likely for a building in a risky area, or for a problem property. By leveraging debt financing, the CCR is much higher at 25.8%
Tying It All Together
Each investor will have unique goals and acquisition methods. Cash purchasers can look just at the Cap Rate, and find how profitable a property may be. It’s important to do your own calculations with your own numbers. Your costs may be different from someone else’s, and the rent you charge may be different too, based on your plans for the property and comparable rents in the area.
Cap Rates reflect the profitability of a property, without considering debt payments.
Cash-On-Cash Return (CCR) reflects the profitability of a property, including your debt payments.
Value-add investors will look at CCR to maximize their growth. Investors in later stages of their careers may look for more stable turn-key properties without regard to either of these metrics. Each investor will have unique goals to evaluate a property based on their goals at the time.
Your targets will be different from mine. Personally, I look for Cap Rates of 12%, with CCR at least 25%+.
Questions? Feel free to get in touch.