Multifamily Basics

Unlike single family homes which are valued by “comping” similar sold properties in the surrounding area, multifamily and commercial properties are valued by the INCOME they produce. This is a very simple concept, but can often seem overly complicated and confusing to outsiders not familiar with the income approach. Here’s our quick tutorial:

Income is referred to in the industry as NET OPERATING INCOME or NOI for short.

NOI = Rents - Expenses

The next component is a sometimes confusing concept called CAPITALIZATION RATE or Cap Rate for short. Cap rate is effectively the ROI you can expect for an investment based on the value and income it produces. The math is not so important for now, but in practical terms think of Cap Rate as the risk profile of a certain asset class in a particular area. For example, a luxury multifamily property in an upscale neighborhood may command a 5% cap rate meaning at an at- market property will make 5% ROI. Similarly a less desirable asset such as a multifamily in a run-down, part of town may be trading at a 10% cap. Investors in these properties are generally more risk averse and want to be rewarded for taking on more risk, hence they demand a better return on their investment.

The equation for value is as follows

Property Value = NOI / Cap Rate

Why this is sometimes confusing is because a LOWER Cap Rate actually indicates a MORE desirable property and vice versa.

Okay now we’ve gone through the theory and math. Let’s look at why this method of valuating properties can be so powerful in growing wealth quickly. Let’s take an example:

You purchase a 12-unit multifamily property for $1,000,000. Each unit brings in $1,000 per month.

Gross income from rent is $144,000.

Total Expenses for the year including maintenance, property management, vacancies, property taxes, etc. is $60,000

Therefore NOI is $84,000

Since you have purchased the property at $1,000,000 – and using the cap rate formula, we get a cap rate of 8.4% (84,000/1,000,000).

Now the leases are coming up for renewal, you decide to raise rents a modest $50 per month, so that each unit is paying $1,050 per month. Your expenses have not changed with the rental increase so now your NOI is $91,200, an increase of $7,200 per year. A nice little bump.

But where the real magic of income valuation is when you value the property. An NOI of $91,200 at the same cap rate of 8.4% yields a valuation of $1,085,714. Just by increasing the rents by a modest $50/month has increased the value of the building by $85,000!

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Glossary

Net Operating Income – A key measure in the building’s value, NOI is a project’s annual income minus expenses

Capitalization Rate – A factor applied to a property’s NOI to give the property value. Lower cap rate indicates a more expensive (and likely nicer) property.

Commercial Property – Generally any property who’s sole purpose is to generate profit. This includes multifamily (5+ units), office, hotels and industrial spaces

Letter of Intent – Due to the complex nature of commercial contracts, Letter’s of Intent or LOI’s are typically used to lay out general terms of an agreement prior to signing a contract.

NNN Lease – Often pronounced as “Triple Net Lease”, this terminology is used in commercial office investments where the tenant pays for property taxes, common area maintenance and insurance for the building.

TI – Tenant Improvement. In commercial office space a “TI Allowance” is often given to a tenant to build out their suite to suit their needs. This is usually distributed as a $/SF number

Hard Earnest Money – Earnest Money becoming “hard” is a slang term describing the EM being non-refundable. This is typically after a due diligence period is complete before closing.

Common Area Maintenance – Often referred to as CAM, is an office term describing expenses related to upkeep of common areas such as hallways, bathrooms and other shared areas.

Debt Service Coverage Ratio – Mostly used by lenders, DSCR divides the monthly cashflow by the mortgage payment and is a good measure of risk and profitability of a deal.

Capital Expenditures – Often shortened to “CapEx”, are any larger expenses that add value and stay with the building (not maintenance items) such as a new roof, HVAC system or lobby renovation.

Class A Building – Class A buildings are typically in central downtown locations, modern with a stable, high end tenant base. They are typically purchased by institutional investors looking for a safe, yet modest return

Class B Building – Nicer building but typically outside of the most desirable locations and has a mid-range tenant base. They are typically purchased by syndicates and high net worth individuals with moderate returns.

Class C Building – Usually in less desirable areas, typically a lot older buildings with smaller and fluctuating tenant bases. They are often more suitable for smaller investors who are willing to take the risk for higher returns.