Updated: Mar 6, 2020
Many of our readers get hung-up when looking at the numbers on their first multifamily real estate deals. In this article, we will review some calculations and terms, then we will provide you with the tools and knowledge to critically assess a property's historic performance and develop your own projections necessary to arrive at an acceptable purchase price.
Determine value using the Income Approach
First, when we say "multifamily" we need to specify the difference between smaller multifamily properties of 2 to 4 units versus those with 5 units or more. This is because these properties are often valued differently by appraisers and lenders. For instance, a 2 to 4 unit property can be purchased with a residential loan or a commercial loan, but anything with 5 apartment units or more, usually requires a commercial loan.
Aside from the loan type, appraisers and lenders will put more weight on different valuation methods, depending on the size of the property. Small multifamily apartments of 2 to 4 units are often times valued more heavily based on sales comparisons versus the income approach. That means that regardless of what the property brings in for rents, the appraiser is more concerned about what similar properties are selling for. On the other hand, the income approach is more heavily weighted with properties of 5 or more apartment units. This method of valuation is based strictly off of the historic and expected financial performance of the property.
All commercial properties use the income approach as a primary determinant of value. To arrive at a value using this method we will divide the Net Operating Income by the Capitalization Rate.
Calculate Net Operating Income (NOI)
The Net Operating Income or NOI is calculated by subtracting the property's Operating Expenses from the Gross Revenue. Keep in mind that the Operating Expenses do NOT include any financing payments (ie. mortgage principle or interest). In the next section, we will discuss the types of revenue and expenses you can commonly expect to see in multifamily real estate and apartment building financials.
Gross Revenue includes all of the income the property generates from rent, laundry, parking, vending machines, application fees, and late fees.
Operating Expenses are all of the costs associated with the day-to-day operations of the property and excludes financing costs and principle payments on loans. Most properties will have operating expenses in these categories:
- Property Taxes
- Contract Services
- Trash Removal
- Water and Sewer
- Property Management
- Repairs and Maintenance
- General / Admin
It is important for owners to accurately track these expenses so they can monitor the property's performance and so you can deduct the expenses from income. For individuals and partnerships, the Internal Revenue Service (IRS) requires these expenses to be detailed in Form 1040 Schedule . It is prudent to request these tax forms when analyzing a property.
Calculate Cap Rate
The Capitalization Rate or Cap Rate is a factor determined by the market. Speak with brokers or gather a list of recent sales from your municipal or county assessors office to assess average cap rates for your market. To calculate Cap Rate, we divide the NOI by the property's Value or Sales Price.
Consider the class of property as well as location when comparing cap rates. For instance, new buildings with expensive amenities and high-end finishes like underground parking, pool, fitness center, granite counter-tops, luxury flooring, stainless appliances, etc, will be considered a Class A property. As the property ages and things begin to deteriorate and become outdated the property may drop to a Class B. Properties greater than 20 to 30 years old in need of lots of maintenance and updates can fall into Class C or even Class D.
Analyze the Deal
Now that we understand how value is determined, we can get down to analyzing the real numbers of our subject property. At this stage, we need to assess what information is available to us and decide just how much weight to give it. Many sellers offer very little information from the outset so it is the buyer's responsibility to request additional documentation.
Proformas and Offering Memorandums
Proformas and offering memorandums are sales documents, plain and simple. They can provide valuable information, but we are always careful about how much we rely on the information provided in these documents and work hard to verify their accuracy. Our motto here is to "trust, but verify".
Sometimes, the format of the proforma or offering memorandum can give you a sense of how accurate the information is and how serious the seller is. Fresh, professionally prepared documents convey that the seller is committed to the disposition of the asset but probably doesn't intend to give much in concessions. On the other-hand, if all that is available is a spreadsheet with some operating expenses, this could mean the seller is just testing the market.
We always request the actual past 12 months of financials and 3 years of tax records when analyzing a property and are very picky about the format of the documents we receive. To reduce the chance of receiving doctored information, we look for indications that the financials were exported directly from an accounting software.
The format of the data below is consistent with the format of freshly exported data that has not been manipulated or summarized:
Compare against market and rules of thumb
Once you have some basic operating financials on a property, you can immediately begin to look for anomalies by comparing the cap rate against the market and considering a few rules of thumb. The goal is to use these rules to build your own set of financial statements that will reflect the property's performance as if you owned it yourself.
Multifamily real estate and apartment buildings, the operating expenses should be near 50 percent of the gross income. If you calculate 40% or less, the financial information you have been given may not be accurate or the property may have significant deferred maintenance or unpaid bills. If you calculate 60% or more, the property may be ripe for new management to implement some cost saving measures.
Operating Expenses = Gross Income X 50%
Here is a table of expense rules that can help you get started. They are only meant to give you a general sense of what we are trying to accomplish here. These amounts can vary widely depending on the building and market. Ask some local owners in your market if they would be comfortable sharing their operating information.
Determine your offering price
We will determine an offering price based on our projected financials and any auxiliary information we have assembled during our initial analysis. The seller's asking price is now irrelevant. We will only offer what makes sense according to the projections we have arrived at. Before making any offer, the cap rate must be a good deal compared to the rest of market and the financials must match your long-term objectives.
A good start to making an offer is to compare your projections against the property's historic financials and/or the financials provided in the proforma. Use the originally advertised cap rate and your projected net operating income to make your offer. If the proforma stated the cap rate at 8 percent with $100,000 NOI and your projections estimate an $80,000 NOI, you can use that same cap rate of 8 percent to arrive at your offer price:
Asking price: $100,000 NOI / 8% cap = $1,250,000
Offer price: $80,000 NOI / 8% cap = $1,000,000
This method will get you in the ball park and on the radar of sellers and brokers, but many additional factors can be considered in order to ensure your offer matches your goals and is competitive with other offers.