I am looking for some help/guidance from some experienced investors that are good at valuing a property. My fiancé and I just finished paying off her large med school school debt, and we put a suite in our house last summer that covers our mortgage cost. We are now in a position to start getting serious about investing, we have become much more interested in multifamily properties. I am sure our rationale is the same as everyone else's that gets into multifamily - more tenants to spread the expenses over, less risk overall in regards to vacancy.
What I am curious, and a bit confused over, is how to value these properties. I understand the Cap Rate calculation, but I view that as more of a quick and dirty metric just to determine if the property is worth researching further. Below is how I am valuing properties and would really appreciate if someone could chime in if I am off the mark.
NOI / Capital Employed (down payment) = Net Return
I then break out the Net Return into what would be cash and equity. I have found that these result are all over the map. I have found properties that have a net return anywhere between 7-12% and some that return 20-25%.
Does anyone know what is a reasonable net return? I know it varies with regional area, but just looking for a range that people have found with their experience? I base all properties on the required 20% down payment that the banks ask for.
Also as Immanuel mentioned, I've never seen the metric you're using. If you're looking at 5+ units, you want to compare across cap rates (NOI / purchase price) and opportunities to add value, increase rents, and decrease expenses.
There's a few books you may want to read to get a better sense of how to evaluate and manage multifamily properties, and then ask around on BP for more market / property specific questions.
Congratulations on paying off the large student loan. I'm sure it's a huge relief. Now that you're financially more flexible, I applaud you to turn your attention into investing.
First, I'm assuming you are referring to 5 or more unit properties, since income based valuation is largely irrelevant when it comes to 4 or less unit properties. Properties with 1 to 4 units are normally valued using recent sales of comparable properties. If you were to apply income based valuation on 1 to 4 unit properties, you would likely get the wild swing that you have observed.
Second, the formula of "Net Return" as you defined it (i.e never seen it used before) is essentially Cap Rate * 5 (i.e. using your assumption of 20% down). So why not just use Cap Rate?
Third, there are many metrics that we deal with in real estate - NOI, Cap Rate, CoC, ROI, IRR, Down Payment, etc. It helps to understand them by separating them according to their purposes. For example, NOI and Cap Rate are metrics that are property specific whereas CoC, ROI, IRR, Down Payment are metrics that are investor specific. To calculate "Net Return" as NOI/DP is IMO mixing apples and oranges. You can certainly use this metric across different properties, but Cap Rate already does that. Your Net Return is always going to be Cap Rate * 5.
Also as Immanuel mentioned, I've never seen the metric you're using. If you're looking at 5+ units, you want to compare across cap rates (NOI / purchase price) and opportunities to add value, increase rents, and decrease expenses.
There's a few books you may want to read to get a better sense of how to evaluate and manage multifamily properties, and then ask around on BP for more market / property specific questions.
Yes you are correct, the property that I am looking at right now is a 9-unit property. It has a cap rate of 6% based on what the seller's price is.
The reason I viewed the Net Return based on down payment is because its a metric I have used to value other companies in the past. My thought was that you would apply your NOI to the capital you actually used (capital employed), not the total price of the property. My thoughts are that anything above the down payment is paid by tenants, so why would you base your NOI on total purchase price? I guess I am trying to figure out what Net-worth gain we would get back based on the money we initially invested at the beginning. Am I just complicating the analysis by looking at it this way?
Also, in your experience what is a good Cap Rate for a multi-family property roughly this size? Is the 6% reasonable? Sellers price is 35% higher then the assessed value at moment.
I will learn about the other metrics you mentioned and see how I can apply them and which scenario they fit best.
Specialist · Houston, TX · Member since 2016 · 68 posts · 41 votes
8y
Hello Sheldon (and fiancé) ,
Great to hear that you and your fiancé are out of school debt.
Valuations on different types of assets can be tricky. In this case, I believe you are looking at a commercial multifamily property (5+ units). Properties with a lower unit count will be valuated by comparable assets in the marketplace. That said, it is still valid to find suitable return metrics residential properties as well.
I will be honest, I have never seen your version of Net Return used before, but to your note the metric itself is actually quite similar to the Cap Rate calculation. In your case, you mention down payment which to me implies that you are leveraging this property with a bank loan. If that is the case, I would recommend you consider what is called a "Cash-on-Cash Return" or COCR. The equation is as follows,
COCR = Net Income / Initial Investment
The net income here takes the NOI and subtracts the debt service payments from the loan. I also subtract any capital used for reserves. The COCR is not necessarily a valuation metric, but it does help gain an understanding of how the property performs from a cash-flow perspective.
Regarding pure valuation (aka, what price will someone pay for my asset), I believe Cap Rate is more than a back of hand calculation. It is subtle, but the true Cap Rate ultimately represents an aggregate return that investors expect to deploy capital in the marketplace. In other words, if investors bought a property all cash they would expect an X% return on their investment. The X% is the Cap Rate. The trick is discovering the actual Cap Rate in the area you plan to invest. One way to get a feel for this is to look at recent acquisitions that have occurred around your area and try to see the Cap Rate at purchase. Institutions like CBRE and IRR also offer reports of general cap rates in submarkets across the country.
Assuming I have convinced you of the value in Cap Rate, the magic of valuation (at least for a commercial asset) is in the NOI. Lets say that you are investing in an area that is at a 7% CAP (give or take). If you find a property and the owner shows you an operating statement of $100k, it is safe to assume that the property is worth ~$1.43M (NOI/CAP = Value).
Or is it safe to assume? In my experience, once you start examining operating statements you find that the expenses are conveniently low. It is possible that the owner is the best property manager of all time, but more likely they are trying to boost the value of the property. My recommendation to you is to get very good at understanding the dollar value of your marketplace's rents and common expenditures. If you get a very good feel for this information you can avoid some major mistakes and potentially find some great value add opportunities.
Returning to our example, if you vet the property and find that the expenses are actually $20k higher your NOI is actually $80k. Now you just avoided buying a property where you would have lost ~200k out of the gate or you have a way to go back to the owner and attempt to purchase the property at a fair price (~1.14M).
On the other hand, if you know your market very well and see an opportunity to increase rents with a small capital investment then you may be able to achieve a $120k NOI after purchase. In this case, you just raised the properties value to $1.71M and increased your cash flow. These are the investments you are looking for in the market place.
My personal preference is to look at metrics which take the opportunity cost of capital into account such as internal rate of return (IRR), net present value (NPV), or profitability index (PI). These are all very related but can be used to help gain an understanding of how time and market risk affect your judgement on an investment. I would not recommend worrying about these metrics until you have had time to research them enough that you feel comfortable applying them to your analysis. There is good literature online that you can look up to get a better feel for these metrics.
I apologize that was so long (I am a big nerd for this stuff). If I can help explain something more clearly let me know. Go get 'em.
... My thoughts are that anything above the down payment is paid by tenants, so why would you base your NOI on total purchase price?...
It is correct that tenants pay for the property beyond your DP (i.e. the 80% portion that is financed). But how do tenants pay for the property? They use NOI, don't they? If so, then you shouldn't take 100% of the NOI in calculating your Net Return because some portion of NOI goes to pay for the property (i.e. it doesn't go to you). So your Net Return should be Your portion of NOI / Down Payment. I should also add that you will find that as an owner "Your portion of NOI" is really what is left of NOI after all obligations are satisfied (i.e. "residual"). And incidentally, under this definition your Net Return is essentially Cash On Cash metric (i.e. CoC) which is also very commonly used by investors.
What is a good cap rate? There are many posts asking this question, you will find that the answers are almost always "it depends". Depends on the market, the local economy, the type of property that you're considering (i.e. A, B, C, D). I would say a good cap rate would be a cap rate that is higher than the prevailing market cap rate for the type of properties comparable to the one you're considering to purchase. In you example, if the property you're considering is 6 CAP, and if the recent sales of comparable properties in the area have been trading at 5 CAP, then I'd say 6 CAP is a good cap rate for the property you're considering to purchase. The point is, a good cap rate is relative.
Thanks for the book suggestions, I will order them right away and develop a more thorough knowledge on this - very appreciated!
Jacob,
Thanks for your detailed explanation, it does appear I was basically using the COCR. Your example clearly explains how to view a property and some variables that come into play and what to watch for. I did notice their expenses were lower then I estimated, also no line item for insurance. They are trying to tell me they don't carry insurance to save on costs..... concerning to say the least. Wonder what else they are trying to save costs on, although they did just replace roof.
I will get more acquainted on the area and the cap rates in the past few years. I do see the value and usefulness on the Cap Rate now after Immanuel, James, and Your explanations.
Is it out of line to call a real estate agent and ask them to provide cap rates in their areas? That seems like the kind of information they could provide quite easily, also would like to build a relationship with a realtor in that area. The property we are researching is about an hour away from our town in Northern BC, Canada.
Thanks again for all the advice, really appreciate your time. I'm sure I will come back with more questions but will burry my head into some more research and books for now.
Yes you are completely correct here, I don't think I was very clear with my question to begin with. What I was considering NOI was after all expenses paid (or what expenses they have provided me so far) including the mortgage payments. So this was the amount that drops to the bottom line before taxes, which you mentioned in your earlier reply; along with Jacob, that this is actually the COCR calculation. Lots to learn, just like any industry, terminology is a big learning curve!
Investor · Chicago, IL · Member since 2009 · 1k+ posts · 1k+ votes
8y
Here is some advice: 1. Your rate of returns are skewed because you don't add in your time value. Certain high yield properties, like I own, take way more time than more expensive, well located low yielding properties. Seems like you have another job, so focus on buying quality real estate and hold it long term. The returns will come. 2. Cap rates are the best way to evaluate properties, over your cash-on-cash leveraged returns. Please note that most cap rates that brokers give to you, omit pertinent costs. For example, using a leasing agent. 3. The first metric that I use when evaluating apartment units in my market is "price per unit," assuming normal sized units. It is just a smell test.
I'd probably shop for a loan that would lock your interest rate for as long as possible. Most of us believe that interest rates are creeping up. Most of my local banks lock the rate for only 5 years. I use commercial / investment loans.
Specialist · Houston, TX · Member since 2016 · 68 posts · 41 votes
8y
Goodluck Sheldon, keep at it and I am sure you will find something great.
I don't think it is a problem asking a real estate broker for the cap rate in an area, just be aware that they may not truly know the answer (in other words, do your own research as well). Also keep in mind that they are incentivized to sell the property at the highest price achievable for their client.
We just took possession of our first duplex today. I would like to thank everyone here for the advice that was given.
Here are some details, please, if you have time, give advice if we missed something or overlooked.
1. 3-bedroom unit upstairs (1100 Sq.ft) has large deck, complete with two gazebos for shade and lounging. Laundry, dishwasher, and typical appliances.
2. 1-bedroom unit downstairs (1100 Sq. ft) Newly renovated by previous owners through insurance work. (city water main broke and flooded basement) insurance work was approx. $25,000. Insurance replaced all floors, full bathroom, trim, drywall (4ft high), and paint throughout full unit. Has a natural gas fireplace, own washer/dryer, all appliances in kitchen except dishwasher.
3. Purchase Price: $260,000
4. put 20% down, plus requires approx. $10-12,000 in upgrades (need to install kitchen downstairs, plus the associated electrical/plumbing to do this)
5. Should be able to get $1200 for the upstairs, and $1000 for downstairs. Which gives us just over a 10% Cap Rate. Should provide approx.. 12-14% cash-on-cash, with about 7% equity build, giving us close to a net 20% annual return.
5. Each unit had a separate storage unit outside , plus one parking spot in driveway each.
What we like about the property:
1. very close proximity to Hospital (Federal and Provincial Gov't have committed to invest $125 Million into the hospital starting next year, with the intent that this hospital will be the central medical hub for the Cariboo Region - which is a region in British Columbia, Canada) This is big news, as this town has a population of about 25,000.
2. 3-bedroom units have the lowest vacancy rate in the town at approx. 1.5%.
3. Family orientated neighbour hood, with families on both sides of the property
4. Simple build - it is a 2 piece modular house with a concrete foundation, roof only 5 years old.
That is about it for now, open to questions and criticism please.