Creating a laser focus criteria for your multifamily investment - P4

As we continue our quest through creating a laser focus criteria for your multifamily investment (Part 1 here, Part 2 here, Part 3 here) let's recap the criteria items we have already covered:

• Area - Metro/City/Neighborhood/etc. (Covered in Part 2)
• Asset class - A/B/C/D (Covered in Part 2)
• Area class- A/B/C/D (Covered in Part 3)
• Size: in units (Covered in Part 3)
• Budget: in USD
• Expected cap rate: percentage
• Expected COCR (Cash On Cash Return): percentage
• Expected Annualized Returns: percentage
• Stabilized vs Value Add preference
• KP availability

On with the list...

Budget

As a derivative from all the other items we've reviewed budget is something one should always consider.  If you decided want a 200 units (size) class A asset (assent class) in an A class area (area class) then you better have lots of cash available for the down payment. 

What would a broker expect you to know about your budget:

• How much liquid cash do you (or your group) have on hand? This is cash you can prove is available immediately and will not require time to liquidate.
• How much additional budget will you need to inject into the business in the first few months? This is especially important if you have a "value add" opportunity on hand (we'll discuss that in more details later)
• Are you accounting for closing costs. Apartments buildings has closing costs too. Things like title insurance, surveys, environmental reports, lawyer fees, etc. will require a hefty sum of money before you even get to the closing table.

Expected Cap Rate

Now this one is much more interesting. Not that I wrote Expected Cap Rate and not just cap rate. 

Let's start with a quick definition of cap rate:

Cap Rate = [NOI] / [purchase price] (as a percent).

For example:

Purchase Price = $1,000,000

NOI = $100,000 annually

Cap Rate = $100,000 / $1,000,000 = 10%

* NOI is Net Operation Income. I'll dedicate an entire post to NOI in the future. For now let's define it  as the money left at the end of the year after all income and expenses are accounted for before taxes, capital expenses and debt service.  

With this formula in mind you look at properties and can compare them. What you will notice real fast is that properties present different cap rates based on multitude of factor. 

For example a class A asset will be traded at a lower cap rate because it represents a much lower risk of high ticket maintenance items in the near future. 

Different class areas will have different cap rates (a D class area will have to provide a much higher cap rate to offset the risk of the collection challenges).

When can you compare apples to apples? When you have two properties of similar size, similar condition and very close to each other and even then, there can be many things that would cause the cap rate to differ. 

At the end of the day, the cap rate represent the return on your money thus the Expected Cap Rate because no one but you can determine what you will be expecting as a return. 

Unfortunately, in a hot market like ours you will find investors that are willing to buy at a lower cap rate for various reasons and only you can determine if it's a cap rate you are willing to accept or not.