Are you afraid to take the plunge into owning small apartments because you believe that multifamily properties require knowledge of complex math formulas? Put your fears to rest! All that is required is simple math. If you have a basic understanding of Net Operating Income and Cap Rates, then you are armed with all of the math that you need to work with multifamily properties.
The first formula that you need to be aware of and understand is the Net Operating Income. The NOI is nothing more than your revenue minus your expenses. Net operating income is on an annual basis. Expenses include everything for running that property but it does not include the mortgage payment, which is otherwise known as your debt service.
Your expenses for a multifamily property would include property management, taxes, property insurance, maintenance and repairs, and utilities. Revenue for the property would include rents and any other income producing vehicles you may have on the property such as vending machines or late fees.
Here is an example of how to determine your NOI:
Let us say there is a ten-unit apartment building and the rent is $500 per apartment. The building is 90% occupied and the expenses are $27,000 per year. Your revenue will be the following:
10 units x $500 x 90% occupancy x 12 months = $54,000 per year
So now that you have determined the revenue, you need to deduct the expense to reach what your NOI is.
$54,000 – $27,000 = $27,000 per year.
This figure does not include the mortgage payments.
Cap Rate is an abbreviation for the capitalization rate. This is the return on investment on a percentage basis if you paid all cash. The formula for Cap Rate is NOI divided by the purchase price. The Cap Rate is the equalizer and will tell you how good a property performs.
From the example above, we know that we have an NOI of $27,000. The seller says that he will take $220,000 for the property. So, if you divide the NOI by the purchase price, you will come up with a Cap Rate of 12.2%
The golden rule in assessing multifamily properties is to look for properties that have a 10% or higher Cap Rate (for most markets). So, based on that rule, you know that apartment deal is a good one.
You do want to take into consideration the amount of repairs needed to be done to a property when looking at the Cap Rate. Many times, when you are looking at distressed properties, the occupancy is down and the Cap Rate may be less than 10% but you realize that with a little elbow grease you would be able to raise occupancy and the Cap Rate above 10%. You can use this to your advantage when negotiating with the seller.
So, there you have it, two simple formulas can put you in the driver’s seat of putting together a great multifamily deal. The NOI and Cap Rate are at the heart of assessing whether a small apartment deal is worth pursuing.