There are three important factors every real estate investor should know when buying Multi-Family Properties. The three variables are (1) purchase price, (2) net operating income (NOI) and (3) capitalization rate.
Multi-Family Key Buying Terms
The NOI is the difference between the income and operating expenses. The capitalization rate is considered a reasonable return on investment (on the basis of both the investor's alternative investment possibilities and the risk of the investment). It is used to determine and value real property through the capitalization process. We, of course, all know what the purchase price is. Having an understanding of how important these formulas are key to buying successful commercial real estate investments.
Multi-Family Investment Scenarios
Example #1 – Let’s say the type of property that you want to buy typically is trading at a cap rate of 7.5% in the market that you are working in. If the seller is asking $10,000,000 for the property, the Net Operating Income should be $750,000. How did we do? Check the broker’s property package and see what the property is generating for net operating income. Is the NOI lower than that? That means that the purchase price is too high. Renegotiate.
Example #2 – In this example, let’s suppose the cap rate is a nice even number like 10%. What happens when you increase the revenue by $1.00 or decrease the expenses by $1.00? In either case, your net operating income will increase by $1.00. Now plug that $1.00 and the 10% cap rate in to the above formula. What happens to the value of the property? It increased by $10.
Think about the power of that formula as it applies to your family. Increase the revenue of the property by any amount and that money goes into your pocket to live your life. Divide that increase in revenue by the cap rate and that is the amount of money that goes to your kids or grandkids or your favorite charity after you die. Pretty powerful formula, isn’t it?
Not only is this an important formula when you are looking to buy a property, but it is an important formula when you are running the property as well. When I sit down to formulate a budget for the year, I always know what the cap rate is at that particular time and look to see how I do with my net operating income calculations. Once I have these two numbers, I have an idea of what my property is worth. How does this new value compare to what I purchased the property for? Is the value increasing, decreasing, or staying the same. If the value is not meeting my investment objectives, can I trim on the expenses or increase the income and thereby increase the NOI which, as we saw above, increases the purchase price or value of the property.
That’s the beauty of multi-family. It should be an unemotional analysis of numbers. Who cares if the units are beautiful and the pool is “sparkling”? If the numbers don’t work, DON’T BUY IT! MOVE ON!