Have you set your sights on investing in multifamily real estate property? If so, before you dive in, you need to review property choices carefully and calculate your expected returns. Here’s how to do that and avoid an unnecessary gamble.
What to Look For
For multifamily real estate property investments, it’s essential to follow the mantra “location, location, location.” That’s because to maximize your returns, you need to attract a stable of tenants to one location. So look for a property in a safe, well-maintained and popular locale.
Also, if this is your first venture into the world of multiunit residences, consider dipping your toe in the water first with a duplex or triplex.
How to Assess a Property’s Profit Potential
Once you’ve found a property that fits your criteria, your buying decision comes down to dollars and cents. To calculate the potential return, you need to gather data and run through some calculations. If you take the due diligence process step-by-step, it’s manageable and will guide you to a sound decision.
Step 1: Is the Purchase Price Reasonable?
First, assess the property’s value versus the asking price. You can do so by comparing property details with market comps — value estimates based on “comparable” multifamily units in the neighborhood. As much as possible, comps should have similar square footage, amenities and locations. While it’s unlikely that you’ll find an apples-to-apples comparison, if there are enough similar units nearby, you can make a realistic value assessment. The analysis of comps will give you a good feel for whether your potential investment is within negotiating range of a fair price.
Step 2: Gather the Financial Data
Next, collect data on the upfront costs, expected income and expenses.
How Much Will it Cost?
In addition to the purchase price, your cost should include any rehab that’s required upon purchase or in the not-too-distant future. To determine these capital improvement costs, hire a professional building or home inspector to uncover hidden flaws, such as a roof you might have to replace. Finally, add in closing costs, including the bank appraisal, loan application fee, real estate attorney’s fee, title, prorated taxes and insurance and more. Your realtor and bank should be able to help you with these details.
Use the following equations to summarize the total investment cost and cash requirements:
Cost = property price + rehab costs + closing costs
Cash requirements (investment) = down payment + rehab costs + closing costs
Also summarize your mortgage assumptions: number of years, interest rate and monthly payment.
How Much Income Will the Property Produce?
The true value of a rental property is the income it churns out month after month. While rent makes up the lion’s share of your revenue, don’t forget any other consistent income streams, such as parking, laundry fees and vending machine sales.
So where do you get these numbers?
The seller should provide a pro forma of anticipated income and expenses, which gives you some idea of what to expect, but you should not rely on them. That’s because they sometimes hug the high side of what is possible. For instance, the seller may use “market” rents, which could be unrealistic due to a nearby, noisy construction project. Also, the seller might inflate the occupancy rate, thus pumping up revenues. As renters move on, you should expect vacancies along with associated lost revenues.
Since the pro forma is likely the best-case scenario, ask to see historical data, including profit and loss statements and the rent roll, which details rental payments received. Review the rent roll to determine vacancy rates. Since these rates vary by geography, to find out what’s reasonable, search the Internet to find industry trade groups or local universities that track these numbers. If there are excessive turnover and vacancy rates at the property you’re researching, try to discover the reasons behind it. Are the issues surmountable or not?
Also, dig into any discrepancies between rents due and those collected. After all, renters are no good to you unless they pay up.
What Are Projected Expenses?
Let’s turn to the other side of the equation — expenses.
These include taxes, insurance, management (if you decide to hire a property manager), maintenance, marketing, landscaping and utilities. Instead of looking at the rosy pro forma data, ask for tax returns from previous years. Double check anything that might change in the future, such as tax assessments.
Step 3: Calculate Net Operating Income
Now you have the data you need to estimate your net operating income, which does not include expenses related to financing. The equation is:
Net Operating Income = Income (rent, parking, etc.) – Operating costs (taxes, insurance, management, maintenance, etc.)
Use net operating income to compare different real estate investment properties regardless of the financing options available.
Step 4: Estimate Cash Flow
To calculate your cash flows, subtract your mortgage payment as shown:
Cash flow = Net operating income – mortgage payment
The mortgage payment always includes principal and interest. Often taxes and mortgage insurance are added in, too.
Step 5: Reckon Your ROI
If cash flow is positive, you’re still in the game. Now you need to take your analysis to the next level —return on investment (ROI). The secret to multiplying your success in real estate investments is to leverage your money, generating the maximum return for the money that you invest. Here’s how to calculate it:
ROI = Cash Flow/ Investment Cost (down payment + closing costs + rehab costs)
As you can imagine, to increase your ROI, it’s better to have a low down payment even though it increases your monthly mortgages expenses.
What’s a reasonable ROI for real estate?
While the answer is subjective, it helps to compare it to the return on other financial investments. For example, money managers consider a reasonable return on a balanced portfolio of stocks and bonds to be around eight percent. Based on that, what do you feel is a satisfactory ROI target for real estate?
Step 6: Tally Up Your Total ROI
There’s one final twist — calculating your investment’s total financial impact. Because most rental property expenses are tax deductible, there are likely to be tax benefits. Also, you’ll build equity as your tenants help pay off your mortgage. Finally, your property may appreciate. However, since increases in value are hard to predict, you would be wise to be conservative and leave them out. The Total ROI equation is:
Total ROI = Total Return/ Investment Cost
In summary, to invest wisely in a multifamily rental property, start by selecting an in-demand location and finding a property of the size that fits your investment appetite. After that, your decision comes down to the numbers.
First, look at comps to make sure the asking price is reasonable. Next, gather the data. For a finger-in-the-wind net income estimate, use the pro forma numbers. If they look good, request actual numbers for more accurate projection. Then, contact a financial institution to determine your mortgage financing options. Once you have all the data, you can estimate cash flows, ROI and Total ROI, which includes tax benefits and building equity. If the estimated return meets your targets, you may have found the rock-solid investment property you seek.