MULTIFAMILY REAL ESTATE INVESTING DUE DILIGENCE – KEY TERMS YOU NEED TO KNOW
Before you begin with multifamily investing or any type of financial venture, it’s highly advisable to take the time to learn the key terms so you can conduct due diligence. The depth of your knowledge about your investments, be they passive or active investments, not only have a hand in your financial success – but also gives you greater peace of mind that you’ve made a good decision.
Every person who invests in real estate must do their own due diligence. This means a thorough audit of every aspect of the investment that is available to you. That’s why we believe a good working knowledge of the multifamily investing key terms is of great benefit to you.
So, let’s start with multifamily building classifications and go from there.
Table of Contents
Multifamily Building Classifications
Net Operating Income (NOI)
Debt Service Coverage Ratio (DSCR)
Loan to Value Ratio (LTV)
Capitalization Rate (Cap Rate)
Cash on Cash (CoC)
MULTIFAMILY BUILDING CLASSIFICATIONS
First, the property value of an investment property determines the class under which it falls. Next, there are four main categories for investment properties which are Class A, B, C, or D. With that being said, let’s go into a little more detail about these four building classifications.
- Class A Multifamily:
- Usually built within the last 10 years or are substantially renovated.
- Charges premium rental prices.
- Attractive landscapes, rental offices, clubhouses, and other amenities.
- Highest quality construction, materials, workmanship, and maintenance.
- Offers high-end interior and exterior amenities.
- Class B Multifamily:
- Built within the last 10-20 years.
- Charges lower rent range than Class A.
- Good quality construction with a low amount of maintenance issues.
- Amenities are more dated and there are fewer offerings than with the higher-end properties.
- Class C Multifamily:
- Built within the last 20-30 years.
- Charges lower rent range than Class B.
- Aging with more maintenance issues.
- Amenities are outdated with fewer offerings than Class B.
- Class D Multifamily:
- Built over 30 years ago, in poor condition, and in less-than-favorable locations.
- Charges lower rent range than Class C.
- Remaining systems and amenities (if any) have a short life.
NET OPERATING INCOME (NOI)
When sellers of multi-family real estate present you with the net operating income (NOI) for the property you want to review for investment, it helps if you know what goes into that number. Moreover, of all the key terms, this is one of the most important because it’s the basis for other investment formulas.
Because the two formulas work together, I am listing the gross operating income (GOI) definition with the net operating income.
GROSS OPERATING INCOME
To determine the net operating income, you must first determine the gross operating income.
• GOI FORMULA
Gross potential income – Vacancy and credit loss = Operating income
• GROSS POTENTIAL INCOME
Gross potential income is the total of the number of units X annual rent per unit. This is what the return will be from a fully occupied multifamily property with all rents collected.
• VACANCY AND CREDIT LOSS
This is a result of lost income because renters leave the property or when they don’t pay their rent. This total may be based on either comparable property vacancies or current lease expirations.
NET OPERATING INCOME
Net operating income is the remaining cash flow after you subtract operating expenses from the operating income of a property.
• OPERATING INCOME
This refers to the income the property produces from monthly rents, laundry facility income, and parking and other fees.
• OPERATING EXPENSES
The operating expenses that properties incur are administrative and management fees, payroll, utilities, insurance, taxes, and miscellaneous others.
• NOI FORMULA
Operating Income – Operating Expenses = Net Operating Income
• NOI EXAMPLE
A property has a gross operating income of $52,000 and the operating expenses are $37,000; its NOI is $15,000.
$52,000 – $37,000 = $15,000
DEBT SERVICE COVERAGE RATIO (DSCR)
For an investment property, the net operating income and the annual loan payments determine the debt service coverage ratio (DSCR).
As you know, the net operating income is the remaining cash flow after all income minus the expenses for operation. However, the operating expenses do not include the cost of annual loan payments also known as note payments.
• DSCR FORMULA
Net operating income / Annual loan payments = Debt service coverage ratio
This formula calculates the percentages or ratios that prove or disprove the properties ability for positive cash flow. Along with the loan to value ratio (LTV), the DSC determines the maximum a lender will offer for the property investment.
Additionally, each lender sets its own requirements for a minimum DSCR that must be met before they will issue a loan.
• DSCR EXAMPLE
A minimum loan requirement for a lender is a DSCR of 1.25. The property’s NOI is $30,000 and the proposed annual payment is $25,000.
$30,000 (NOI) / $25,000 (Annual loan payments) = 1.2 DSCR
As you can see, the total of 1.2 does not meet this lender’s minimum requirements of 1.25. Therefore, the amount of the loan will have to be lower to meet the minimum requirement.
LOAN TO VALUE RATIO (LTV)
Loan to value ratio is determined by both the loan amount and the value of the investment property. In other words, it’s the percentage of the proposed loan amount divided by the proven value of the property.
• LTV FORMULA
Debt or loan amount / Property value = Loan to value
As with the DSCR, lenders have set requirements for an LTV ratio or percentage to issue a loan. Additionally, higher percentages are higher risks from the lender’s perspective.
• LTV EXAMPLE
A lender will issue a loan on a maximum LTV of 75%, and the appraised price of the property is $500,000.
75% X $500,000 = $375,000
Therefore, $375,000 is the maximum loan amount this lender will issue for this investment property.
CAPITALIZATION RATE (CAP RATE)
Loan to value ratio is determined by both the loan amount and the value of the investment property. In other words, it’s the percentage of the proposed loan amount divided by the proven value of the property.
• CASH ON CASH FORMULA
• CASH ON CASH EXAMPLE 1
A real estate investor wants to buy a $500,000 multifamily senior housing property, and the net operating income of this property is $55,000.
$55,000 / $550,000 = 10% Cap rate
As you see, the cap rate for this property will be 10%. That means the investor will receive a 10% interest rate return on his equity of $550,000. Incidentally, if you know a property’s Cap rate and NOI you can determine its purchase price.
Net operating income / Cap rate = purchase price
Using the same example as above:
$55,000 / .10 = $550,000
CASH ON CASH (COC)
Cash on cash refers to the ratio of pre-tax cash flow that the investor may expect from their cash equity in a real estate syndication investment property.
• CAP RATE FORMULA
Net operating income / purchase price = Cap rate
• CASH ON CASH EXAMPLE 1
An investor wants to buy a property for $550,000 and will put down 20% in cash which is $110,000, and the prospective property cash flow is $750 per month or $9,000 per year.
$9,000 / $110,000 = 8.2% Cash on cash
This means that the investor will receive a return of 8.2% for his $110,000 investment.
• CASH ON CASH EXAMPLE 2
An investor wants to buy a property for $550,000 and will pay the entire amount in cash, and the property cash flow is $3,250 per month or $39,000 per year.
$39,000 / $540,000 = 7.1% Cash on cash return
Therefore, in addition to a lower investment amount (example 1), the investor gets a higher return when he finances the loan rather than paying the total purchase price of the property in cash.
In simpler terms, the investor receives a better return on his investment when he pays 20% rather than the full amount in cash.
AVERAGE ANNUAL RATE OF RETURN
The Average Annual Rate of Return (AAR) takes into account the NOI, property appreciation, and principal pay down (mortgage loan reduction).
• AVERAGE ANNUAL RATE OF RETURN FORMULA
((NOI + property appreciation + principal pay down) / (# of Years)) / cash invested = AAR
An investor bought a property exactly 2 years ago for $50,000 down payment and took out a mortgage for the difference. In the first year the NOI was $15,000; the property appreciated by $3,000; and he paid down his loan by $2,000. In the second year the NOI improved to $16,500; the property appreciated by $4,000; and the paid down the loan by $2,500. What is the current AAR?
($10,000 + $11,500 + $3,000 + $4,000 + $2,000 + $2,500) / 2 = $16,500
$16,500 / $50,000 = 33% = AAR
INTERNAL RATE OF RETURN
Like the AAR the IRR is simply the percentage rate earned on each dollar invested for each period of time that it’s invested. It is used in lieu of the AAR when you refinance a property and no longer have the initial cash amount invested in the property.
The formula for calculating the IIR is too complicated for this article. However, there are many calculators and finance tools that will conduct the calculation for you. I prefer to use Microsoft Excel. For additional information on how to calculate the IIR using Excel, see exceldemy.com.
Thank You for Your Interest
These are the key terms you need to know before investing in multifamily real estate, including passively investing through a multifamily or apartment syndication or joint venture. However, it’s important to note that there are other due diligence variables to consider in order to fully assess the viability and potential of a multifamily investing. This can only be done through an evaluation process called commercial property underwriting. I know it’s a lot to take in, so please feel free to contact me if you have questions, want more information on underwriting, or have a property you would like underwritten. You can also post a question or comment below.
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