Open up LinkedIn or a Google search and you can quickly find a multifamily real estate opportunity. Maybe you’ve heard of the tax benefits of investing in multifamily real estate or you’ve had friends who’ve doubled (or more) their money in a multifamily syndication. You thought to yourself: “I want in on that.” But then thought to yourself, “How do I know which one to choose?” In this article, we will shed some light for you with these 5 questions you must ask. Disclaimer: I am going to use some industry jargon that you’ll probably have to look up if you’re unfamiliar.Here are the five questions you need to ask when analyzing a multifamily investment:
- What is the going-in cap rate?
- What is the price per unit?
- What about debt?
- Loss to lease, or rental growth?
- What is the exit cap rate?
I’ll walk you through each of these in this article.
1.) What’s the Going in Cap Rate?
Knowing the going-in cap rate is essential because it tells you multiple things (as a reminder, cap rate is the net operating income divided by the purchase price):
- How healthy is the cash flow? If my cap rate is high (say 5 – 7%) I know I have solid cash flow.
- How good of a ‘buy’ is this deal? With higher cap rates, I’m probably getting the deal at a great price.
- How does this cap rate compare to other similar deals sold in the market?
One critical thing a cap rate tells you is whether the deal is being purchased with positive or negative leverage. If you know the cap rate you can compare it with the interest rate for the loan being used and you can see if the cap rate is higher or lower than that interest rate. If it’s higher, there’s positive leverage, and if it’s lower, there’s negative leverage. Why should you care? You want to know if the lender is making more or less yield than the investors in the deal. It’s a good barometer of risk for investors. If the property is throwing off more cash to the investors than to the lender, then the property has more tolerance for setbacks in performance and fewer chances of the syndicator defaulting on the loan.
2.) What’s the Price Per Unit?
The price per unit gives you an idea of whether or not the syndicator is overpaying or getting a great deal. How?You need to review the age of the property and similar properties being sold in that market. Obviously, a newer and more recently updated property will have a considerably higher price per unit than older assets. You also need to compare the subject property’s price per unit to the comparable properties sold in the market within the last 6-12 months. If the price per unit is lower, it’s probably a good deal, and if it’s higher, then it’s probably a bad deal.
3.) What About the Debt?
The debt (or the mortgage) being used can make or break the deal. Let’s face it, the debt makes up 50 – 80% of the capitalization of the deal. It’s seriously important. Syndicators who are using high leverage (75 – 85%) can yield high returns but it also comes with high risk. If there isn’t positive leverage (see above) and there’s a high loan to value, any drop in performance or any dips in value in the market can spell doomsday for the property. Why? If the property does not perform as expected (because the loan is so high and there isn’t positive leverage) the syndicator could miss mortgage payments and have to give the keys back to the lender (wiping out the equity). Or, if the loan to value is high (and there’s negative leverage) and values drop (due to interest rates rising) the syndicator won’t be able to refinance without bringing in more equity which will be dilutive to returns. Alternatively, in this scenario, the syndicator also won’t be able to sell without taking a serious haircut to the equity.It’s important to pay attention to debt to assess the stability of the property before you invest.
4.) Loss to Lease or Rental Growth?
Loss to lease is a comparison between the current average rent at the property versus the average rent in the subject market. If the current average rent is lower than the average market rent, there’s an opportunity to raise rents either through proper management or through strategic renovations (often both). Rental growth is the growth of the average rents in a market. There are plenty of syndicators who base their models for a deal on achieving rental growths of +5%. In many cases in the last decade, multifamily has seen this type of growth and then some. But to bank your investment thesis on a bright future is risky because it might not happen.What you want to see in a syndicator’s model is a modest rental growth of 2-3% and a significant reduction of loss to lease. In other words, the property is currently charging $1,500/month for a 1 bedroom and the property next door is charging $1,800/month. That’s $300/month of low-hanging fruit that the syndicator can grab and there’s no betting on significant rental growth.
5.) What’s the Exit Cap Rate?
This is the most powerful lever in the syndicator’s model. This is the cap rate that the syndicator is assuming for the future sale of the property. If the syndicator is assuming a significant reduction in the cap rate (i.e. they buy it for a 6 cap and sell it for a 4 cap) then the model is also overly optimistic. Granted, this concept is a bit nuanced and depends on timing. If the deal is being purchased in a high interest rate environment with positive leverage, then it’s okay to assume some compression in the exit cap if the deal is being underwritten for a +5-year hold period (i.e. buy it at a 6 cap and sell it at a 5.5 cap). This assumes that interest rates have peaked, they will eventually come down in the next 5 years and cap rates will follow (cap rates always follow interest rates). Make sure that the exit cap rate is either the same as the going-in cap rate or slightly lower.
Learn More About Multifamily Real Estate With Our Free Handbook
There are obviously many more details to consider when assessing a multifamily investment, but these are the 5 pillars. If you ask these 5 questions and get the right answers, you’ll more than likely stay out of trouble and make some great returns in your multifamily investment journey. Fill out the form below to download our free multifamily real estate handbook to show you the ins and outs of investing in multifamily real estate to build passive income and generational wealth.
.jpg)
