We received a question several weeks ago from a reader by the name of Lori who asked “I’m more interested in multi family investing. Any suggestions on some great strategies?”
The answer Lori is yes! We’ll be doing a two part series just for you on how we evaluate and buy multi family properties. But first we have to define what multi family properties are.
Here is the definition from Wikipedia for Multi-family Residential (also known as Multi-dwelling unit or MDU) is a classification of housing where multiple separate housing units for residential (i.e. non-commercial) inhabitants are contained within one building. The most common form is an apartment building.
Now when investing in multi family apartment buildings there is a distinct difference in financing as regards to the number of units there are per building/parcel number.
4 Units or Less
If you’re purchasing 4–units or less, then a conventional loan can be obtained to finance the purchase. This is huge because under current conventional guidelines and investor can finance 4 units and under using traditional conventional financing. I’ll give you an example, we purchased and renovated a 4–plex in North Phoenix a month or so ago and we sold it to an investor out of New York who is in the process of refinancing the property into a conventional loan. The property was built in 1987 and each unit has 2 beds and 2 baths which are 950 sqft. Each unit will rent for ~$700-$750 a month. After expenses and debt service this property could generate over ~$14,798 a year in cash flow. The beauty is that the investor is getting a 6.5%, 30 year fixed loan and is going through the traditional conventional lending process which is a lot easier than obtaining a commercial loan. Oh, and he is also going to have $63,000 of Equity, based on the appraisal that was just completed!
Loan Qualifications for 4 units or Less:
1. 680 Credit Score
2. 25% Down Payment
3. Documented Income
5 Units Or Higher
Back in 2003–2005 it was seemingly easier to secure commercial financing for larger apartment complexes. Today it’s a whole different story, due to the credit crunch; commercial banks are becoming a lot stricter on who and what they lend on. A while back we secured a loan for a 329 unit apartment complex that we were considering purchasing for $13 million. The loan process was very painful, the amount of information they requested was amazing, including property financials, pro formas, resumes, net worth statements, complete lease audits for every unit, contractor estimate for repairs for each unit and so on. The due-diligence and the appraisal alone cost us over $10,000. I’m glad to say we didn’t purchase the property because we couldn’t agree on the amount of the seller credit that was going to be applied for deferred maintenance.
Loan Qualification for 5 Units or Higher:
1. 700+ Credit Score
2. 2+ Years Experience
3. 30%-40% Down Payment
4. Documented Income and Net Worth
5. Property Management
6. Debt Coverage Ratio 1.2 or Higher
Don’t let this scare you off from buying 5 units or higher, there are some smokin deals out there right now that make sense. We’ll get into some creative ways to avoid having to jump through the commercial financing hoops in part two of this series. Let’s move on to evaluating a multi family deal.
The best spreadsheet we’ve found was developed by Scott Scheele from Commercial Adamancy called the Opportunity Evaluator. This spreadsheet is great because it gives you correct input fields needed to determine if the deal is good or not. Below is an example of the 4–plex we mentioned above in North Phoenix. We’re going to cover each and every aspect of the spreadsheet so you can use it to your benefit.
1. Vacancy & Credit Loss: We use a 10% vacancy rate in our calculation; this number can fluctuate due to the market and area. I know of some markets that have vacancies as high at 18% and as low as 4%. Try to find out what the vacancy rate for your area is by asking a local apartment specialist. It’s better to be more conservative and estimate on the high side.
2. Operating Expense: Verify cells 7–28 the best you can, be sure you call the utilities companies and verify the annual amounts paid along with verifying the taxes and insurance. If you have extra items use cells 29–34.
3. DCR-BANK: This is the Debt Coverage Ratio; the bank will use this to determine if the property has sufficient cash flow to cover the debt service after the expenses are paid. Most backs like to see a 1.2 DCR or higher. If the number is below the 1.2 DCR than your paying too much for the property.
4. Property Info: This is where you put the property information; try to make it as accurate as possible.
5. Loan information: This is where you enter your loan amount and interest rate; this will calculate “interest only” not “princpal and interest.” If you are obtaining a princpal and interest loan make sure to adjust numbers accordingly.
6. Capitalization Rate: Capital Cost (asset price) = Cash flow / Capitalization Rate
For example, in valuing the projected sale price of an apartment building that produces an annual net cash flow of $23,248, if we set a projected capitalization rate at 10%, then the asset value (or price we would pay to own it) is $232,480. The Cap Rate may vary from area to area, so check with an apartment specialist and ask what the going Cap Rate is for the unit size in question.
7. Actual Cap Rate: This is the actual Cap Rate of the property at the $130,000 purchase price.
8. Cash Flow Before Taxes: This is the annual cash flow before you pay personal or company taxes. In the example this property could produce $1,232 a month in cash flow after expenses and debt service.
9. Gross Potential Rents: This is the gross amount the property could produce in cash flow before expenses and debt service.
So how do you know if you have a good deal or not? In cell 6 drop in the going cap rate for the units you are looking to acquire (you can get this number by asking an apartment specialist in your area) in cell W2 it will show the approximate value of the property. If your purchase price is lower than this number there’s a good chance you have a good deal on your hands.
Now remember this is spreadsheet used to do a quick and dirty analysis and is not to be used for a buying decision, if the property looks good I would hire an appraiser as part of your due diligence to give actual value of the property. In the example 4–plex above the appraised value came in at $255,000. We used this initial spreadsheet to determine if we potentially had a good deal and then we had a licensed appraiser give us an opinion of value prior to acquisition.
In part two of this series we’ll give you some techniques strategies to acquiring multi family properties. Make sure you subscribe to the RSS feed so you don’t miss a tip!
If you have any questions about this article please feel free to leave a comment below.
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