When investing in commercial real estate, there are a number of different options for investors in terms of type of property. Residential properties are popular because people always need a place to live, no matter where the real estate market is at any given time.
In this article, we’ll look specifically at how to evaluate multifamily properties, what makes a good real estate investment in general, and give you tips from our expert real estate investors.
How to Evaluate Multifamily Properties: An Overview
A multifamily commercial property is any property with five or more residential units and is usually a more profitable investment than a single-family rental. Before deciding on which multifamily property is right for your investment needs and goals, there are a number of steps to take and ample research to conduct. Before getting started, it’s important to know what you’re able to afford, how much debt you can take on in relation to your equity, and how much of a profit you’re looking to realistically make.
1. Conduct Market Research
The very first step when investing in a multifamily property is to conduct market research. It’s important to have an idea of how the housing market is doing at any given time so that you know what you’re getting into.
“Get to know the market,” said David Phelps, Founder & CEO of the investment advising group Freedom Founders and author of Own Your Freedom: Sustainable Wealth for a Volatile World. “That means collaborating with other experts or influencers in the market.”
Phelps recommended attending real estate investors meetups or joining investor groups, or even looking at online forums to learn more about the real estate market in any given area and what’s needed to invest in a multi family investment property.
Consider talking to a local appraiser to get a better understanding of the market. They know what makes a property worthwhile and what detracts from an investment property from performing commercial appraisals.
2. Choose Your Neighborhood
The next step when investing in a multifamily home is to figure out location. To do so, an investor first has to know what their goals are and how a certain neighborhood can help them to achieve those goals. Some factors to consider when researching neighborhoods are:
- School districts
- Nearby attractions
- Public transportation
- Public parking
- Public amenities
- Nearby businesses
- Conditions and prices of other homes in the area
- Neighborhood landscaping and appearance
- Housing market in the area
- Inclusionary zoning laws
- Future building projects in the neighborhood
Each of those factors will affect the price and value of your real estate investment over time. While you can always make changes to the property itself, you can’t make changes to the location. Therefore, it’s important to have a thorough understanding of the neighborhood before investing in a multifamily property.
Phelps also advised investors to look at different types of neighborhoods to determine what they want to accomplish.
“What’s the density already there? What kind of tenants are you going to attract in different neighborhoods?” Phelps asked. “You’ve got to decide, which tier market am I going after?”
“You’ve got to really think in terms of, who’s my tenant base going to be, what are their needs, and what level of affordability are they looking for?” continued Phelps. “If I know my market, I know which area of affordability this particular tenant class is going to be able to command.”
Phelps suggested looking at the security of an area as well. In areas with high crime, you may need to build a gate, for instance.
3. Secure Financing
Securing financing is an essential step to purchasing a multifamily property. When looking at real estate, you want to make sure you can actually afford to make a purchase. Often, investors might find their dream property only to realize they can’t afford it. Therefore, it’s important to know how much you can spend before you set your hopes on any one property.
Usually, you’ll need a typical long-term bank loan in order to finance your investment, but you might also check out private equity and other unconventional lenders. You’ll want to research loan rates, terms, conditions, and loan-to-value (LTV) to figure out what you can afford. Banks can also offer a “pre-approval letter” before you find a property to ensure that you will secure the loan when the time comes.
4. Evaluate Potential Repairs
Is the multifamily property you’re interested in ready to go, or will you need to conduct significant repairs before renting out the space? This is an important question to consider before putting money into a property.
How much will those repairs and renovations cost, and how long will they take? Is the overall investment worth the money, time and work involved? To answer that last question, it’s a good idea to calculate your potential income from the property as well as imputed equity and make an assessment based on how much you’ll be putting in, and how much you’ll be earning down the line.
5. Calculate Long-term Expenses
When determining whether or not to purchase a multifamily property, you also want to calculate your future expenses. Property taxes make up a large chunk of those expenses and vary depending on the neighborhood.
Phelps also advised accounting for foundational expenses, mechanical expenses, plumbing expenses and more.
“I’m talking about HVAC heating and air conditioning, dishwashers, appliances, structural aspects,” said Phelps. “And a good inspector could give you the livelihood of these.”
If your estimated long-term expenses outweigh the profits, then it’s probably best to keep looking for other properties.
6. Calculate the Net Operating Income (NOI)
NOI assesses the initial value of a property and determines the property’s ability to generate income. To calculate the net operating income for a multifamily property, you need to subtract property expenses from the total revenue, or income, that the property generates in one year.
Operating expenses include costs of maintaining and running the property, management fees, utilities, insurance, property taxes and repairs. Total revenue includes everything that brings in money, such as rent, parking fees, vending machines, etc.
The formula for NOI is:
Total income — Total operating expenses = NOI
If the NOI is too low or doesn’t exist, then it’s time to look at other options because in the end, Phelps said, “we’re not doing this for free.”
7. Calculate Cash Flow
Before putting money into a property, it’s essential to know your cash flow. To understand cash flow, said Phelps, you need to know your interest payments to lenders, your gross rent, or rents of all the units, costs of operation, maintenance, utilities, insurance and property taxes.
Total cash flow can be calculated by subtracting your mortgage payments and reserves for future capital expenses (CapEx) from the NOI.
Cash Flow = NOI — (Mortgage payment + reserves for CapEx)
The amount you reserve for CapEx is the amount you plan to save for large expenses. For instance, if your roof is expected to last 10 more years, you need to calculate the cost of a new roof, as well as the amount you need to save per year in order to afford a new roof.
Once you’ve calculated your cash flow, you should talk to a financial planner to figure out what qualifies as enough cash flow for your investment.
8. Calculate Capitalization Rates
The capitalization rate, or cap rate, on a property is calculated by dividing the property’s estimated net operating income by the current market value. You can estimate the market value by using the property’s listing price. Essentially, the cap rate evaluates the expected rate of return on a property.
Cap Rate = Net operating income / Current market value
This formula allows investors to understand a property’s potential profits. High cap rates are an indication of low listing prices, and the higher the cap rate, the more profitable the property.
However, multifamily properties with high cap rates are either found in less desirable neighborhoods or need significant renovation. So there are multiple factors to take into account when looking at cap rate, and a good cap rate does not necessarily mean a good investment.
“If it’s an older property, there’s nothing wrong with that,” said Phelps, “but you’re going to have a larger capital expenditure.”
9. Due Diligence
Always complete a property’s due diligence when doing your research on a multifamily investment. Check for risks, violations, potential lawsuits, unpaid penalties and more. Make sure you have copies of bank statements, rent history, unit inspections and any other documentation that will verify numbers and facts about the property.
It’s also important to inspect the building and see the property yourself. Check for any structural damage that could lead to problems down the line. You should consult professionals like brokers, lawyers and tax experts for advice before making a decision.
10. Negotiate a Purchase Price
Once you’ve completed all of the above steps and have decided to purchase a multifamily property, it’s now time to negotiate a purchase price based on the current NOI and the cap rate. To calculate a fat purchase price, the below formula is a good guide:
Purchase price = NOI / Cap rate
So, if your NOI is $50,000, and your cap rate is 10%, your purchase price should be no more than $500,000.
Once you’ve calculated your purchase price, you can make your offer. Don’t let the asking price deter you if your purchase price calculation is lower, and don’t overpay for a property that isn’t worth the price. From there, you can start your negotiations with the seller.
Make Sure to Do Your Research Before Investing
A multifamily property can be a great investment, ensuring a steady income for years to come. However, it’s important to be diligent with your research to make sure you’re choosing the right property for you. The above steps are a sure way to make sure you’ve covered all your bases.