Maybe you’ve got a few single-family rentals under your belt and you’re looking to step up your game. Or, you want to get started in real estate investing by buying a duplex, triplex, or other multiplexes to live in while you rent the other units.
Let’s say you’ve found a few apartment buildings that seem to fit your budget, but how do you evaluate them? How do you know if they’re performing, sub-performing, or worst of all, non-performing?
Fortunately, you don’t have to go into it blindly. There’s plenty of data and calculations you can use to evaluate an apartment building.
This article assumes you already have an idea of how to get commercial financing. You just want to be sure you’re making a wise investment. Without further ado, here are 3 steps you can take to evaluate multifamily buildings.
1. Market Comps
Just like residential real estate, commercial real estate relies on comparative market analysis (CMA), also known simply as comps. Market comps are used by real estate agents and brokers to determine the current market value of a property based on what similar properties in the area are selling for.
If you truly trust your agent, they should be able to provide you with comps. However, it’s always wise to cross-check information and do your own digging.
Make sure that the properties used for comps have comparable:
- Price per square foot
- Property size
- Number of units
- Age of property
- Timeframe of sale
Now that you have a sense of the market, it’s time to dig into the numbers on the apartment building that’s caught your eye. At the end of the day, real estate is more about numbers than property.
Net Operating Income (NOI)
Net operating income is a term you’ll see frequently in the world of rental properties. That’s because it’s used to determine the initial value of a property and its income potential.
NOI is the total revenue minus property expenses. The formula for NOI is:
Total Income - Total Operating Expenses = NOI
You can typically ask the current owner for last year’s total revenue for your calculation. Hopefully, you’ll find ways to lower expenses and increase revenue, but let’s not count our chickens before they hatch.
To calculate your cash flow, you need to have a sense of your interest payments to lenders, gross rent (the total rent of all the units), operating expenses, and a ballpark estimate of maintenance, utilities, insurance and property taxes.
Here’s the formula for cash flow:
NOI - (Mortgage Payment + Capital Expenditures) = Cash Flow
If your potential new apartment building is cash flowing, you’re off to a good start.
Another term you’ll hear often is capitalization rate, or cap rate. The cap rate of a multifamily property is the expected rate of return on a property.
The formula for cap rate is:
NOI / Current Market Value = Cap Rate
Remember that cap rate doesn’t take into account long-term or unexpected expenses, so always keep a little extra tucked away for a rainy day.
Financing Terms and Conditions
Finally, you’ll want to shop around for a lender with the best financing terms and conditions. Make sure your lender is offering competitive interest rates, term lengths, and loan-to-value ratios (LTV) so you can lock in great rates and avoid high fees for refinancing down the line.
3. Due Diligence
Once you’ve found an apartment building that passes all the numbers tests, it’s time to drill down into the physical condition of the building.
Always be sure to hire your own inspector and appraiser. In fact, you may not even want to use your agent or broker’s recommendations. Finding independent inspectors and appraisers could save you thousands down the line.
A commercial real estate appraisal will give you a better understanding of the true market value of the property. A commercial inspector will examine the roof, HVAC system, plumbing, foundation, and all other facets of a building that make it functional and safe.
After all, market comps and municipal appraisals often don’t take into account a roof that’s on its last leg or a furnace that’s about to give out. Costly repairs like these could end up putting your investment underwater before you’ve gotten a chance to lease up your multifamily building.
Time to Negotiate Your Purchase Price
If you’ve made it this far, congratulations! You’re well on your way to purchasing your first apartment building. Most multifamily property buyers divide the property’s net operating income by its cap rate to get a rough idea of a fair purchase price. Be sure they give you leeway if the inspection found significant damage, too.
Purchasing a multifamily building is nothing short of exciting. All your hard work crunching numbers and performing due diligence will pay off the day you sign the bottom line.