What financial measures to use in buying multi unit property

I’m doing a presentation for one of my finance classes on the topic Buying a Multi Unit Resedential Property (1-4units). In my research I have found many financial metrics for screening potential properties such as NPV, IRR, Gross Rent Multiplier, Gross Income Multiplier, and Cap Rate (seems to apply only to Commercial Properties).

I would like to get feedback from actual investors on the following:

1. what method they use to screen properties and why they prefer that method over others.
   2)What is an obstacle in calculating your numbers- estimating annual expenses, vacancy rate?
2. What is an acceptable return given current market conditions, 5%, 8%?
3. What is your strategy- Buy and hold, fix and flip,

Thanks in advance for all your feedback.

1. I usually screen by making sure market rent will come out to be at least 2% of purchase price and rehab cost. Or you could look at it as Rent X 50 = most I can have in the property to make it worthwhile. I also make sure the rent will be at least double what the mortgage payment is. Most of my properties are on 10 yr loans. I don’t like stretching investment loans out too much.
2. Many expenses can be accurately estimated. You should be able to nail down costs for insurance and property taxes. On a multi, you can see if the owner will show you recent utility bills for any utilities you’ll be paying. Trash should also be a fixed cost. Water/electric/gas will vary. On many smaller multi’s, you can expect the water will only have one meter and you’ll have to pay that. Electric and gas may or may not be separately metered. I would not put myself in a position where I had to pay to heat or cool someone’s house/apartment.
   2b. Are you trying to figure a cash on cash return? I shoot for $100/mo positive cash flow per unit. Many of my deals have been no money down, so the cash on cash return would be infinite.
3. Buy and hold long term.
   Have one small multi-unit building and several SFHs in my portfolio.
   Check out the numerous posts on here about the 50% rule. You can search for it using the search button at the top of your screen. That will show you some good estimates for properties.

Thanks for the great info, for question 2b. it doesn’t make sense to shoot for $100 cash flow p/ mo p/ unit since cash flows on different properties will vary. Wouldn’t a better measure be a certain % return of the cash flow per unit per month?

RErookie,

We’ve owned and managed older apartments for years, and we’re currently looking to buy more.

justin0419 is describing very well how to value small units and houses. It’s very good conservative advice. We want to find the 2% deals he’s finding!!! :banghead

However, the larger the number of units the more important it is to gauge value by CAP rate (capitalization rate). That is, of course, we take the net operating income and divide it by the sale price, to get the CAP rate. This is effectively the cash-on-cash return if we paid all cash for the project.

A capitalization rate of 5% would mean that the property pushed off a 5% pre-tax profit, after all expenses, on an all cash deal. Simple, eh?

Another way some (smaller) unit investors gauge value is to use a Gross Rent Multiplier. This means of course, dividing the sale price by the annual gross scheduled rent (GSI). The lower the number, the better the deal (theoretically).

Comparing pro forma operating data with actual operating data will tell us how much upside or downside potential there is in the deal. This also applies to CAP rate analysis.

Then there’s the “replacement cost” method of valuation. We’ve never used that to establish a value on an existing, project regardless of whether it was under-performing, or not.

However, unless the project is being demolished, or we’re needing to determine land value, or the amount of insurance coverage we need, the “replacement cost” valuation method is useless to determine.

We think the best advice regarding valuation is first knowing the average market CAP and even the GRM for a given neighborhood. These averages are influenced, at least, by price point, size/number of units, neighborhood, building type/construction, and liability/distribution of utilities.

For example an 80-year old 20-unit walk-up style building with a flat roof, common utilities, and enclosed hallways is going to have a MUCH higher operating expense than a 50-year old, 20-unit building with off street parking, separate utilities, pitched roof, and open hallways/stairs.

The older building will by default require much more management and maintenance such as vacuuming interior hallways, annual repairs of a flat roofs, boilers …all with effectively uncontrollable consumption of common gas, electricity and water, etc.).

As a result most investors want a much higher return in order to run the risk of investing in this type of project.

I don’t need to go into an analysis on a newer building. The returns are usually less since there is more demand for them, because they are less of a management and maintenance burden (theoretically).

Meantime, the “best valuation method” we use is, “He who cares least, wins.”
:beer

How can I get a copy of your presentation?

Jay

Guys thanks for all the input.

Jay I can send you all the info after tomorrow when I’m done putting it together. I have the hardest part which is discussing various valuation methods and applying them to actual properties for sale. I am currently working on comparing 2 multi units (one is a 2 unit the other a 3 unit) using the Gross Rent Multiplier and cash on cash return as an initial screening tool. Next, I have calculated the Net Present Value of both property’s after tax cash flows for 5 years taking into account the net sales proceeds at the end of 5 years (estimate of 2% appreciation every year). Additionally I have calculated the Internal Rate of Return, Profitability Index, and Debt Coverage ratio for both properties.

Total number of financial measures I have found were 38, the ones above seemed like the best. Of course if the operating estimates are off, all these are useless!

What I have learned is that there is no one measure for analyzing the properties but rather multiple which help fill in the whole picture and also taking into account investment strategies.

One thing I have found on this forum that wasn’t in any textbook or any other books on investing in multi units is the 2% rule (estimating gross rents) and the 50% rule (estimating expenses). I live in southern California and the 2% rule doesn’t seem to work well with the properties analyzed. I had to use the GRM for the initial screening and 42% as an estimate for the operating expenses otherwise there was negative cash flow!!

Finding properties where the rent is 2% of the purchase price is really difficult on the coasts. It’s hard to invest for cash flow in those areas. It gets easier in the mid-west and south. That’s why you see so many people from California asking about where to invest.

Justin,

I also found that I needed to use at least 20% down for the calculations in order for the property to cash flow!!! Anyways, got an A+ and extra points for the analysis, thanks everyone for the input.

Great job. Congrats!

RERookie,

I would also like to see your paper/presentation. I know you are already finished, but I would like to clarify how the 2% rule and the 50% rules are used.

The 2% rule does not estimate rents. Instead, the 2% rule uses the current market rent for the property to establish the maximum amount the investor will pay to acquire and rehab the property.

The 50% rule does not really estimate expenses, though many will tell you to assume that half your monthly rent will go to overhead costs when you are doing a preliminary cash flow analysis. In actual practice, you determine whether 50% of your market rent will cover 100% of your overhead costs. If it does, then the property will probably generate a positive cash flow.

For my own acquisitions, I like using the Internal Rate of Return and the Debt Coverage Ratio. The DCR uses a cash flow analysis to determine whether the property’s cash flow will support the property. The IRR tells me whether the return on my investment compares favorably with the return I could get from other investment vehicles.

If the DCR does not meet or exceed my investment threshold, then the rents are too low, the property cost is too high, the cost of financing is too expensive, or some combination of all three. I assume 80% financing to avoid PMI. The IRR keeps me from making too large a down payment. A large down payment will improve cash flow and increase the DCR but will lower the IRR. If the DCR and the IRR are both within acceptable limits, then I can be confident the cash flow will be sufficient to support the property and that the return on my invested capital is better than I would get from some other investment with the same or lower risk.

Dave
The assumptions were based on it being an owner occupied property with 20% down. Apparently no lender finances a non owner occupied property with a conventional loan, according to the Professor you need at least 30% down and finance it with a commercial re loan??? I did not come across this info anywhere, maybe all the books and sites I read were outdated. If this is correct then putting 30% down will make most properties cash flow.

I am looking to buy a multi unit myself with a VA loan but all the properties I’ve looked at have negative cash flow. Even though I plan on living on one unit eventually I would move out and rent out the complex but the cash flow isn’t there even increasing the rents significantly (and decreasing the expenses but these are only estimates and won’t be guaranteed). So in essence the only cash flow I should expect is from appreciation and sale? This would make my return infinite with 0 down.
So should I compare the PV of all cash flows (assuming I put a % down to make it cf) against the PV of the future sale proceeds (with nothing down)?