Analyzing a single-family investment property generally proves straightforward. Do rents cover expenses and debt service? Does it provide regular cash flow? These same questions certainly apply to multifamily investments. But, due to their A) scale and B) lack of uniformity, analyzing a multifamily investment requires an understanding of a number of additional metrics.
As such, we’ll use this article to outline the important metrics for a multifamily investor to know. Armed with this information, investors can make sound decisions on when to buy, sell, and hold a multifamily investment. Specifically, we’ll review these metrics within the following broad categories:
- Operating Performance
- Investment Return Analysis
- Financing
- Taxes
- Final Thoughts
Operating Performance
Net Operating Income (NOI)
Definition
Net operating income, or NOI, represents the income a property earns accounting solely for rental revenue and operating expenses. In other words, it’s what a property generates before including non-operating expenses like depreciation and mortgage interest. Basically, if you pay an expense towards your property’s daily operations, it factors into NOI.
Why It’s Important
NOI serves as the primary metric to determine the accounting-based income a property will generate (not cash flow, which we’ll discuss later). As such, when lenders and potential investors consider a multifamily investment, they want to see its current or projected bottom-line results – NOI.
Capitalization (“Cap”) Rate
Definition
NOI also feeds directly into capitalization – or cap – rate. Conceptually, cap rate represents the return an apartment building would provide on an all-cash deal. That is, if you didn’t use a loan, what return would you receive on a property? Mathematically, cap rate equals a property’s NOI divided by its value.
Why It’s Important
Apartment buildings lack the similarity that single-family homes share. How do you compare the results of a 50- unit versus 100-unit multifamily property? Cap rates provide a way to compare a variety of commercial properties, regardless of units. For example, the 100-unit apartment likely generates a larger NOI than the 50-unit, but does that make it a better investment? If the former offers a 5% cap rate compared to a 7% NOI with the latter, you see a comparability metric NOI on its own lacks.
Operating Expense Ratio (OER)
Definition
Operating expense ratio, or OER, provides investors a way to compare efficiency across different properties. More precisely, it measures how well a property controls expenses. To calculate OER, divide all of a property’s operating expenses by operating income. The lower the ratio, the more efficiently a property operates.
Why It’s Important
A lower OER means that a property has limited expenses relative to income. As you track this metric over time, it can provide insight on major issues. If OER continues to increase, it means that expenses have accelerated relative to income – a significant concern for investors. As a result, tracking OER allows landlords to assess when and where a capital improvement needs to occur. For example, if OER trends upwards over several years due to multiple roof leak repairs, a property likely requires a significant capital investment in the roof.
Occupancy Rate
Definition
As the name suggests, occupancy rate represents the number of units with tenants relative to total available units. Mathematically, you solve for occupancy by dividing the total number of units with tenants by the total available units. In other words, if a 100-unit building has 95 tenants, it has a 95% occupancy rate.
Why It’s Important
During the due diligence period before buying a multifamily property, you should always request at least the past three years of occupancy rates. It provides you key trends in how many vacant units you’ll likely face in a property. Unfortunately, property owners must pay most of their operating expenses (e.g. property taxes, insurance, property management, etc.) and debt service, regardless of occupancy. Consequently, if you can’t fill a property, you’ll struggle to drive solid returns on investment.
Rent Per Square Foot
Definition
This metric provides another effective way to compare otherwise dissimilar properties. As the name illustrates, rent per square foot, or rent/sq.ft., equals the average rent in a property divided by the total livable square footage. For instance, say a property has 100,000 total square feet of rentable living space (NOTE: apartments typically do not differentiate between rentable square footage and usable square footage like offices and other commercial properties do). If the market rates for this class of apartment call for $1.50/sq.ft, the investors could reasonably project $150,000 in gross rent.
Why It’s Important
When you develop multifamily properties, understanding this metric lets you project rent rolls. If purchasing a property for a value-add investment, it lets you determine potential return on investment. For instance, assume that a $500,000 investment in a property will boost it from Class B to Class A. If the local market commands a $1.5/sq.ft. rate for Class B but $2.25/sq.ft. rate for Class A, investors can clearly assess whether the $500,000 update makes financial sense.
Investment Return Analysis
Cash-on-Cash Return
Definition
As the name suggests, cash-on-cash return represents the annual return an investor receives on contributed cash. For instance, say you purchase an apartment building for $1,000,000 with a $200,000 cash down payment (ignoring closing costs). If you net $10,000 in cash that first year, you receive a 5% cash-on-cash return ($10,000 cash flow / $200,000 in contributed cash).
Why It’s Important
Most investors see real estate as an alternative to more traditional investments like stocks and bonds. Those assets provide long track records of dividend and capital gains distributions, letting investors reasonably estimate the cash they’ll receive at different investment levels. If these same investors consider real estate as an alternative, they will require a similar level of clarity as to expected cash returns relative to contributed capital.
Internal Rate of Return (IRR)
Definition
Cash-on-cash return serves as an annual measure of performance. While internal rate of return, or IRR, also relates to cash, it reflects an investment’s entire life. Conceptually, IRR projects the interest an investor will earn on each dollar invested in a multifamily property. Mathematically, IRR equals the interest rate where the present value of future cash flows (projected annual cash flows plus ultimate sale of property) equal the initial cash investment. Put differently, IRR represents the long-term yield a property will generate.
Why It’s Important
Most investors have a designated hurdle rate – or retired return – that they must meet for a certain type of investment. With real estate, IRR provides an ideal metric for this required return. Investors can look at an apartment’s projected IRR and decide whether, for the associated risk, the return justifies the cash investment. For instance, if an investor has a hurdle rate of 12% for 10-year investments, a multifamily deal projecting a 10-year IRR of 15% would meet that threshold, whereas a 10% IRR would not.
Cash Flow
Definition
Investors calculate cash flow by subtracting all operating expenses and debt service from net rents (rents minus vacancy). In simple terms, it’s how much cash you put in your pocket every year. As such, cash flow ignores non-cash expenses like depreciation while accounting for cash outlays like mortgage principal that don’t actually qualify as expenses (but still require cash payments).
Why It’s Important
As stated, many investors – particularly limited investors – view stakes in multifamily properties like annuities. That is, they want to guarantee some level of cash payments on a monthly basis. As a result, if you want to organize a multifamily deal with limited investors, you’ll need to be able to reasonably project future cash flows. If an investor can guarantee X cash flows via a bond fund but cannot project greater cash flows from an apartment building, why would he or she choose the real estate option?
Financing
Loan-to-Value (LTV) Ratio
Definition
Loan-to-value ratio, or LTV, represents the amount of leverage investors can expect on a certain property. Put differently, LTV defines the size of mortgage a lender will provide on a property. When you want to purchase an apartment building with a loan, the lender will commission an appraisal. Say this appraisal determines value as $1,000,000. If this particular lender agrees to 80% LTV terms, that means it’ll issue a loan of $800,000 ($1,000,000 value x 80% LTV).
Why It’s Important
LTV means two major things for investors. First, it tells you how much capital you need to raise for a deal. Following the above numbers, investors would need to come up with $200,000 to make this deal happen ($1,000,000 value – $800,000 loan). Second, LTV factors directly into return on investment. The more cash you put into a deal, the lower your ROI. For example, assume the above apartment generates $25,000 in cash flow in its first year of operations. That represents a 12.5% cash-on-cash return with a $200,000 down payment. But, let’s boost LTV to 90%, which corresponds with a $100,000 investment. Now, that $25,000 in cash flow (ignoring changes in debt service based on loan principal) leads to a 25% cash-on-cash return.
Bottom line, the greater the allowable LTV, the more you leverage, and the greater your potential ROI. However, you also amplify potential risks with increased leverage.
Equity
Definition
On the other side of the debt coin investors deal with equity. In simple terms, equity represents your ownership in a property. Mathematically, equity equals a property’s fair market value minus the outstanding mortgage. Investors with a property worth $1,000,000 and a $600,000 mortgage have $400,000 in equity in that property ($1,000,000 fair market value – $600,000 mortgage).
Why It’s Important
Equity tells you how much you can expect to cash out when exiting a deal. Using the above numbers, investors could potentially gross (ignoring capital gains taxes and transaction costs) $400,000 if they sell the property. Of the $1,000,000 purchase price, $600,000 would pay off the outstanding mortgage, while $400,000 would go to the owners. As such, the amount of equity in a property significantly drives hold/sell decisions for investors.
Debt Service Coverage Ratio (DSCR)
Definition
Debt service coverage ratio, or DSCR, equals a property’s NOI divided by total debt service (mortgage principal and interest). For example, assume a property has a $100,000 NOI in a given year. If the associated annual debt service totals $75,000, it would have a 1.33 DSCR ($100,000 NOI / $75,000 debt service).
Why It’s Important
DSCR plays a critical role in commercial lending. Most lenders impose debt covenants when they provide loans for multifamily properties, that is, metrics borrowers must meet. While not an absolute, many lenders require minimum DSCRs of 1.25. As a result, when you provide a pro forma (projected operating income statement) to lenders, they’ll use that bottom-line NOI to determine your maximum loan amount. The lower the NOI, the lower the allowable loan, as DSCR remains constant.
Additionally, most lenders mandate submission of annual financial statements. If your property falls below the DSCR outlined in the loan agreement, lenders can call the loan. While not guaranteed, the possibility of this happening makes DSCR a critical metric for investors to track.
Taxes
Cost Basis / Annual Depreciation
Definition
In real estate, cost basis equals a property’s purchase price plus the costs necessary to put it into service. For example, if you purchase a property for $750,000 and put $250,000 in rehab costs into it before leasing, it would have a $1,000,000 cost basis. Of note, your cost basis ignores debt. As such, it doesn’t matter whether you finance or pay cash for that $1,000,000 investment – your cost basis remains the same.
From your cost basis, you can determine your annual depreciation expense. While financial accounting depreciation varies, depreciation for tax purposes (which matters for real estate investors) proves fairly simple. For residential properties, you divide your cost basis by 27.5 to determine your annual depreciation expense. Using the above numbers, investors could depreciate $36,364 per year ($1,000,000 cost basis / 27.5). In other words, you can reduce your taxable income by $36,364 every year – without reducing the associated cash flow.
Why It’s Important
When new investors consider real estate, they often do so due to the associated tax benefits. These tax benefits largely revolve around depreciation. This cashless expense lets investors reduce their taxable income without affecting pre-tax cash flow. In other words, depreciation allows most apartment buildings to operate at a taxable loss while providing positive cash flow.
Final Thoughts
The above doesn’t serve as an exhaustive list for analyzing multifamily apartments. But, as an investor, if you understand these core concepts, you have the background to assess a deal’s merits. With this knowledge, investors can make sound decisions on when to buy, sell, and hold multifamily investments.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available multifamily apartment investment opportunities – and their associated metrics.