Investing in commercial multi-family real estate is beneficial for so many reasons. Economies of scale managing multiple units on a single site, hedging risks by collecting income from other tenants when a vacancy occurs, and more. You’re spending time and money trying to find the perfect deal. But how do you know when you’ve found, or created, a good deal?
First, let’s start by defining commercial multi-family; in the US, that’s 5+ homes or apartments under a single roof or on a single piece of land. 2-4 units are multi-family, but not commercial multi-family, and that’s analyzed a bit differently. This article is about evaluating commercial multi-family.
You should have an understanding of your goals. If you’re getting started and handy or comfortable managing tradespeople, you’ll want a value-add opportunity (a property you acquire, do some work to it, and increase the value beyond what it cost you to do the work). If you’re more passive, you’ll want something turn-key.
Here are the metrics to look at:
- Gross Scheduled Rent: Total rent scheduled for collection. If you have 20 units, each renting or available to rent at $500 a month, that’s $10,000 in scheduled monthly rent ($120,000 per year)
- Net Operating Income (NOI): How much money the property makes before debt service. Let’s say the property has a rent roll of $10,000 per month ($120,000 per year). Expenses are taxes & insurance $5,000 per year, maintenance $12,000 per year, vacancy projected at $6,000 per year, property management $12,000 per year, and no utility costs. Take your $120,000, subtract all the expenses, and you have NOI: $85,000
- Annual Debt Service (ADS): Monthly mortgage payment(s) multiplied by 12. For example, if your first mortgage has a monthly payment of $4,000, and second mortgage is $1,000, the ADS is: ($4,000 + $1,000) x 12 = $60,000
- Capitalization Rate (Cap Rate): The relationship between a property’s value and NOI. Cap Rate is often used to estimate value. NOI / Sales Price = Cap Rate. For example if a property with NOI of $85,000 is listed for sale at $850,000, the Cap Rate is 10%: $85,000 / $850,000 = 10%. If you’re looking for value-add, 10% is a good target minimum cap rate in today’s market; the higher the cap rate, the more money the property makes. If it’s turn-key, expect a lower cap rate
- Cash Flow: How much cash you’ll make in a year, after all expenses. NOI – annual debt service = Cash Flow. Usually, this doesn’t account for income taxes.
- Cash-on-Cash Return: The ratio of annual cash flow to cash invested. If you invested $100,000 to close on a property, with no other out of pocket expenses, and the property had $30,000 of cash flow in a year, the Cash-on-Cash Return is $30,000 / $100,000 = 30%
- Debt Coverage Ratio: The ratio between the NOI and ADS. For example, $85,000 / $60,000 = 1.42; lenders generally look for a ratio at least 1.25, but it varies; the higher the number, the more comfortable you should be that you’ll be able to cover debt payments
- Appraised Value: The definition by Investopedia is: an evaluation of a property’s value based on a given point in time that is performed by a professional appraiser during the mortgage origination process. The appraiser is usually chosen by the lender, but the appraisal is paid for by the borrower. This is a key number when looking for financing since it’s used in the Loan-to-Value calculation (see below)
- Loan-to-Value Ratio (LTV): The ratio reflecting total debt financing to the appraised value of the property. For example, if you have a first mortgage balance of $600,000, a second mortgage of $100,000, and the appraised value is $1,000,000: ($600,000 + $100,000) / $1,000,000 = 70%. Generally, lenders will lend up to 75% LTV, but there is a wide variation depending on the lender, market, etc
- Vacancy Rate: The % of units that are vacant in a given period of time. In commercial multi-family, 5% is a standard number to use, but it will vary by market. For example, if you have a 20 unit building and last year there were three vacancies: one for two months, another for three months, and another for four months, that’s six months total vacancies out of 240 (50 units x 12 months = 240): (2 + 3 + 4) / 20 * 12 = 9 / 240 = 3.75%. That’s a low vacancy number, and you should explore an opportunity to increase the rent
Have any questions? Feel free to get in touch.