4 Plex
Investor · H, NE · Member since 2015 · 54 posts · 17 votes
Hi, All. I've been looking for a multifamily property, and finally came across one that seems to work. All 4 units are rented for a total income of $2,235($26,820/year), with overall expenses of $7,630. So Net Income is right at $19,000 without accounting for interest. I plan to cut back on expenses as I will begin to mow and clean the hallways myself. I'm wondering what kind of return one looks for on mutli family. This property has a rough cap rate of 8.75, which is decent.
With some minor improvements, and eliminating expenese, I don't see why I can't get the cap rate above 9 or maybe even to 10. Any suggestions or input would be great! Thanks!
Ethan
This is awesome. Even better would be if @Brandon Turner and @Joshua D. were to invite @Account Closed and @Account Closed on to a podcast to hash this out. Better yet - let's settle this once and for all. Give them some gloves and headgear and setup the camera!
"The Cap Rate (Capitalization Rate) is a unit of measure primarily used in commercial real estate and multifamily properties with 5+ units. The Cap Rate is used to compare the return on investment between multiple different properties. If you are analyzing a residential property with fewer than five units, leave this field blank."
Correct, there is no reliable third party source for cap rates on SFR's and low unit multis.
BUT, The IMPORTANT thing to know is that there is NO reason to try to utilize cap rates for these properties. Residential properties are not encumbered by long term leases like commercial properties are. That is the ONLY reason to utilize cap rates for commercial properties. You are buying the NOI. Two identical buildings can have vastly different rents because of the timing of their leases. So if one building has $100,000 NOI and the exact same building has NOI of $200,000 (All expenses are identical) then you would have to use a market cap rate to value the NOI.. Now if all commercial properties had rents adjusted to market every year like residential then you could use the WAY MORE accurate method of valuation of direct sales comparison.
@Bob Bowling @Ethan Bruland @Jacob Sampson @Michael Biggs
I think this may have been the reason for confusion too, and Ethan, this directly applies to your case in that you don't have to worry about this official cap rate since you're dealing with a 4plex. Hope this helped some.Correct, there is no reliable third party source for cap rates on SFR's and low unit multis.
I really don't want to get involved in this hot mess of an argument, but it looks like I've been dragged in so I'll clarify my position. I'll start by saying I'm far from the smartest person on this forum. :)
I agree with @Account Closed and @Jacob Sampson on this one, but can see where @Account Closed is coming from. Before everyone kills me, let me explain.
Capitalization Rate = NOI/Value (or Purchase Price), everyone on here agrees on that. So @Ethan Bruland is correct when he reasons that increasing NOI will increase the Capitalization Rate for this property. It is the calculation of Capitalization Rate for that particular property, independent of the prevailing capitalization rates in the area. There is definitely a distinction between the two, as @Account Closed and @Jacob Sampson pointed out. I agree with the information in their posts.
However, I'll try to find a middle ground and give @Account Closed the benefit of the doubt. He seems to be coming from a practical place. It seems to me he thinks that the only metric that is worthwhile - once you already own the building, that is - is the prevailing capitalization rate in the community rather than on the individual property. There is some merit to that. Having the "Cap Rate" of a building you own go up doesn't mean that much to me, it's the Value that makes the difference. One can "work backwards" to get a reasonable value for a property by using the prevailing Capitalization Rate for an area. (However, as noted above, there is definitely a distinction between the Capitalization Rate of a property and the prevailing Capitalization Rate for a geographical region.)
Correct me if I'm wrong, but I feel like that may be what @Account Closed was trying to express? If not, you're on your own. :)
At any rate, I look at it like this:
If Capitalization Rate = Net Operating Income/ Value, it follows that:
Value = Net Operating Income/ Capitalization Rate
@Ethan Bruland, if you know that investors in your area will generally deploy capital (invest money) at a 7% Capitalization Rate, for example, you're $19,000.00 NOI would make the theoretical Value $271,428.57. If you increase the NOI to $20,000.00, you would increase the theoretical Value to $285,714.29. Etc. I would tend to think about it in those terms rather than increasing the Capitalization Rate of a building that I own. It makes more sense to me to think of it in terms of overall Value of the property. I hope that makes sense.
You can look through similar recently-sold properties and calculate the prevailing Capitalization Rates in your area to get an idea for what to plug in as your anticipated Capitalization Rate for the purposes of the formula above. Investors in your area may also know off the top of their heads what the general rates are, but I would err toward calculating myself. It will also help you to assess whether or not the building you are thinking of buying is valued appropriately. What you are looking for is essentially an average of the Cap Rates, trying to eliminate any obvious outliers. Good luck!
David, this is what you stated in another thread, "
because of the generally low cap rates, as small increases in rent have an exponential effect on value" That is what I was agreeing with. I'm a little confused about what exactly you are disagreeing with me.
Now I agree you can divide a NOI by any number you want. But of what use is it? Hell, I can divide the length of my , well you know what, by my height but again what does that number mean and of what use is it? What if I divided my current NOI by my 1978 purchase price?
Cap rates are born on the date of completed purchase. A cap rate will die on the date of a better cap rates birth.
Now you also stated above, "So @Ethan Bruland is correct when he reasons that increasing NOI will increase the Capitalization Rate for this property"
Let's do some math.
$100,000 NOI at 10% cap rate has value of $1,000,000.
$100,000 NOI at 11% cap rate has value of $909,090.
So how can it make sense for Ethan to increase his NOI, but since you said it would increase his cap rate, then he would DECREASE the value of the property?
Psst, my number is over 11%, not that it means anything.
I really don't want to get involved in this hot mess of an argument, but it looks like I've been dragged in so I'll clarify my position. I'll start by saying I'm far from the smartest person on this forum. :)
I agree with @Account Closed and @Jacob Sampson on this one, but can see where @Account Closed is coming from. Before everyone kills me, let me explain.
Capitalization Rate = NOI/Value (or Purchase Price), everyone on here agrees on that. So @Ethan Bruland is correct when he reasons that increasing NOI will increase the Capitalization Rate for this property. It is the calculation of Capitalization Rate for that particular property, independent of the prevailing capitalization rates in the area. There is definitely a distinction between the two, as @Account Closed and @Jacob Sampson pointed out. I agree with the information in their posts.
However, I'll try to find a middle ground and give @Account Closed the benefit of the doubt. He seems to be coming from a practical place. It seems to me he thinks that the only metric that is worthwhile - once you already own the building, that is - is the prevailing capitalization rate in the community rather than on the individual property. There is some merit to that. Having the "Cap Rate" of a building you own go up doesn't mean that much to me, it's the Value that makes the difference. One can "work backwards" to get a reasonable value for a property by using the prevailing Capitalization Rate for an area. (However, as noted above, there is definitely a distinction between the Capitalization Rate of a property and the prevailing Capitalization Rate for a geographical region.)
Correct me if I'm wrong, but I feel like that may be what @Account Closed was trying to express? If not, you're on your own. :)
At any rate, I look at it like this:
If Capitalization Rate = Net Operating Income/ Value, it follows that:
Value = Net Operating Income/ Capitalization Rate
@Ethan Bruland, if you know that investors in your area will generally deploy capital (invest money) at a 7% Capitalization Rate, for example, you're $19,000.00 NOI would make the theoretical Value $271,428.57. If you increase the NOI to $20,000.00, you would increase the theoretical Value to $285,714.29. Etc. I would tend to think about it in those terms rather than increasing the Capitalization Rate of a building that I own. It makes more sense to me to think of it in terms of overall Value of the property. I hope that makes sense.
You can look through similar recently-sold properties and calculate the prevailing Capitalization Rates in your area to get an idea for what to plug in as your anticipated Capitalization Rate for the purposes of the formula above. Investors in your area may also know off the top of their heads what the general rates are, but I would err toward calculating myself. It will also help you to assess whether or not the building you are thinking of buying is valued appropriately. What you are looking for is essentially an average of the Cap Rates, trying to eliminate any obvious outliers. Good luck!
David, this is what you stated in another thread, "
because of the generally low cap rates, as small increases in rent have an exponential effect on value" That is what I was agreeing with. I'm a little confused about what exactly you are disagreeing with me.
Now I agree you can divide a NOI by any number you want. But of what use is it? Hell, I can divide the length of my , well you know what, by my height but again what does that number mean and of what use is it? What if I divided my current NOI by my 1978 purchase price?
Cap rates are born on the date of completed purchase. A cap rate will die on the date of a better cap rates birth.
Now you also stated above, "So @Ethan Bruland is correct when he reasons that increasing NOI will increase the Capitalization Rate for this property"
Let's do some math.
$100,000 NOI at 10% cap rate has value of $1,000,000.
$100,000 NOI at 11% cap rate has value of $909,090.
So how can it make sense for Ethan to increase his NOI, but since you said it would increase his cap rate, then he would DECREASE the value of the property?
Psst, my number is over 11%, not that it means anything.
I do not think what we are saying is inconsistent. It depends on which variable you choose to solve for in the equation.
1. Capitalization Rate = NOI/ Value (or Purchase Price)
In Ethan's example, he is solving for Capitalization Rate based upon his purchase price. His Capitalization Rate is higher because the purchase price does not change. He is not looking at the theoretical Value of the property for resale, but only at the Capitalization Rate. The Cap Rate is a metric of what percentage of his purchase price the property produces per year, without accounting for debt service. As NOI increases, the Capitalization Rate increases. It's one way among many for Ethan to know that he made a good investment. It does not affect the prevailing Capitalization Rate in the area, as that is tied to the time of purchase.
2. Value = NOI/ Capitalization Rate (estimated)
Now, if you are solving for the current Value of the property the equation is different. In that case, you use a Capitalization Rate you believe a buyer is willing to pay, judged by Capitalization Rates of similar, recently-sold properties in the area, at the time they were sold. When NOI increases, the Value of the property increases with it. That is a measure of the capital another investor in that area would be willing to deploy to get that same NOI.
The two calculations serve different purposes in different circumstances for different people. It sounds like you think Capitalization Rate is arbitrary. It is. It's just a random metric to be able to compare multiple, different properties on an apples-to-apples basis. It is one tool of many and it is not the end-all-be-all.
@Max T. I am a total geek. On a podcast I would start talking about Arbitrage Pricing Theory vs Capital Asset Pricing Model. Anyone that attempted to listen would be asleep in the first five minutes. The smart people would turn it off and start looking for good deals.
I do not think what we are saying is inconsistent. It depends on which variable you choose to solve for in the equation.
1. Capitalization Rate = NOI/ Value (or Purchase Price)
The Cap Rate is a metric of what percentage of his purchase price the property produces per year, without accounting for debt service. As NOI increases, the Capitalization Rate increases. It's one way among many for Ethan to know that he made a good investment. It does not affect the prevailing Capitalization Rate in the area, as that is tied to the time of purchase.
Thanks for posting David. Here are my thoughts. Cap rate is not defined as this years NOI divided by sales price at a different time. A cap rate is only looking at limited financials for a limited period. It does not take into account capex or account for depreciation.
Exactly how would Ethan determine that his investment is good? What if the market cap rate increased since his purchase?
2. Value = NOI/ Capitalization Rate (estimated)
Now, if you are solving for the current Value of the property the equation is different. In that case, you use a Capitalization Rate you believe a buyer is willing to pay, judged by Capitalization Rates of similar, recently-sold properties in the area, at the time they were sold. When NOI increases, the Value of the property increases with it. That is a measure of the capital another investor in that area would be willing to deploy to get that same NOI.
The two calculations serve different purposes in different circumstances for different people. It sounds like you think Capitalization Rate is arbitrary. It is. It's just a random metric to be able to compare multiple, different properties on an apples-to-apples basis. It is one tool of many and it is not the end-all-be-all.
David, I do not see how you can make a valid comparison using cap rates. If I am in a 10% cap rate market then all properties are performing the same. I could use a cap rate to determine how much each seller is asking over market but why would I waste my time doing that?
@Ethan Bruland @Account Closed @David Tipton Thanks for participating in this discussion.
Ethan, understanding this will make you a better investor. The main problem I have with all the incorrect use of cap rates is that too many people use them on the forum to entice novices to buy their properties by making them think a 12% cap rate makes a property profitable. If you can show me that the market is buying NOI at 8% and you are willing to sell to me at 12% then let's talk. But if the actual market cap rate is 15% then your 12% is me overpaying to you. You are trying to scam me because you think I don't know how to use cap rates. Shame! LOL
Hi Ethan, some big wheels on this site have a 1% rule... rent should be no less than 1% of purchase 2% lot better... you passed.... same source thinks you should plan on 50% of rents for everything other than principal and interest. if you finance 30 years 5%with 0 down you pass this also. As @Mark F. said interest rates are real low now.. don't worry to lock them in for a long time. you might also keep reading here lots of info. It keeps coming up that you should try to be creative in adding value to any property by making it "more wanted"... find a way to get the seller down a little more or tell them to put $10000 in some kind of escrow account and if the place is in such wonderful shape and nothing major breaks in the next 3 years he gets it back if all the AC's go out then you get to use his money....remember his property is only worth what someone will pay.... continue to laugh
Am I the only one who read all of this, learned a lot, but got to the end and thought "Hey, wait - @Ethan Bruland is talking about buying a quad.....why is he worried about Cap Rates?"
Doesn't traditional wisdom say he should be more concerned about comps than cap rates?
Another thing to keep in mind: any savvy investor down the road will look at your expense numbers and immediately notice a lack of expenditure on landscaping, cleaning or anything else you decide to do yourself to reduce expenses. Think of it more as paying yourself for while you're doing it, but not necessary adding sweat equity, because they will assign their own number to that service when it comes time to value the property.
Lastly, if the intent here is more of a "house-hack" than investment, you should be as much concerned about buying a place you want to live as one that is a good investment. Especially with a wife and kids to think about, make sure it's both a nice apartment, and in a place you want to live. Even if you buy a duplex (that's a good deal) and wind up paying out a couple of bucks every month, you're still living essentially for free, having someone else pay down a mortgage you hold, getting depreciation, etc., etc.
But all that aside, I wish I was smart enough to consider this when I was at that point in my life.
Great thread and good information here.
I do not think anyone has mentioned the fact that Cap Rates work much better with triple net commercial leases.
Triple Net Leases basically shift the Taxes, Insurance, and most Cap Ex to the tenant.
That completely changes the analysis process,
Also in large commercial multiunit transactions, buyers will consider Alpha and Beta risks for tenants and the properties. Which in short means, if a company is going to but 50 properties with NNN leases to one company, they will do a detailed analysis of the management of the tenant compared to other companies in the same business. They will also consider the entire industry as a whole.
But who cares...
The main thing to remember is projections are projections. Having an extremely detailed analysis with crap numbers going in will just give pages and pages of crap out.