Multi-Family apartments are on fire today. It seems like everyone in the business wants more. This is probably because multi family is one of the strongest and most consistent ways to produce passive income... that is income you can automate. However, it seems like everywhere I look, people are doing it wrong. The simple question is, what is it worth? What price should I buy it for? Here are some of the basic formulas and pieces of knowledge I've used to very successfully evaluate 100+ units I've purchased.
1. Understanding Multi-Family: The apartment rental game is substantially different than single family rentals, and house flipping. In fact, I would argue that it's quite a bit easier. While single family homes and house flipping are often very emotional and psychological purchases for people, apartments are generally purchased based on one primary factor. Income.
Some people will purchase apartments for appreciation... or in other words, equity. However, I have always invested on cashflow, not equity, for two glaring reasons.
- Equity will always follow cashflow, but cashflow does not always follow equity.
- Equity could be gone tomorrow, but even if you're upside down in your apartment complex, if it's still cash flowing, you don't need to sell. I do love forcing appreciation and reaping the rewards of increased equity, but I do this for different reasons. Before we finish today, I'll explain how we can force $40,000 in equity into a multi family building.
2. The Income Approach: There are several different methods used to value real estate. There is the Sales Comparison Approach (Looking for what other properties have sold for and comparing those sales to your property), the Replacement Cost Approach (Determines how much it would currently cost to replace/rebuild your property), and the Income Approach (Values your property based on the amount of net income it produces).
The people who buy multi family property are normally investors, and investors care about what? Money. They want a solid return on their investments, and they're willing to purchase property at any price point that gives them that targeted rate of return. If the property in question gives them a lower rate of return, then they know it's priced too high, and if it's giving them a higher return, then they know it's priced too low. This is why Multi-Family property is almost always valued using the Income Approach. Their sole purpose is to produce income for the owner.
3. Cap Rates and Net Operating Income: Are you still here? This is where it gets important. Write this formula down.
(Gross Monthly Rents x 12 months x 70%) / Market Cap Rate = Market Property Value
(Gross Monthly Rents x 12 months x 70%) / Return You Want to Make = Property Value to You
Alright, now let's explain what we just wrote down. A cap rate is a rate of return determined by all of the purchases everyone else in the area has made. Essentially, it is the average return on investment that everyone in the market has shown that they are willing to accept on their money. A cap rate (Capitalization Rate) makes two assumptions.
- Everyone is purchasing in cash. (This is because everyone's financing will be different, so purchasing in cash allows you to create a baseline.)
- This is the amount of time a buyer is willing to wait to recoup their money. (If you purchase a home for $120,000 and it nets $12,000 annually, it will be 10 years before the investors recoups all of their money. This essentially makes the cap rate 10%. They recoup 10% of their investment every year.)
Let's break this down. Here's a real property I looked at last month.
In my market, the cap-rate is 7.5%
Expenses are almost always 30% (Which is why we multiply by 70%. We're taking the expenses out to get our net income. This will include property management, repairs, capital expenditures, etc.)
Type of Property: Triplex
Monthly Income: $1,800/month
Asking Price: $240,000
Alright, let's plug this into our formula.
($1,800 x 12 = $21,600 x 70% = $15,120) / 7.5% = $201,600
As we can see above, the property is over-priced by roughly $38,400. Now you know what you can offer on it, and what it's worth. Here's the exception.
Let's say we're looking at the same property, but we know the rents are really low, and can easily be raised to $2,200/month.
Type of Property: Triplex
Monthly Income: $2,200/month
Asking Price: $240,000
($2,200 x 12 = $26,400 x 70% = $18,480) / 7.5% = $246,400
In this situation, it actually shows that at the new rents would justify the asking price, however, it's still too thin of a deal, and so I passed.
I hope that this formula will help you value some of the properties you're looking at! If you learned anything, sign up above! Leave a comment! Follow us! Facebook: ( https://www.facebook.com/DWinvestors19 )
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