I wanted to start investing in multi-unit properties(5+), and before I jump in, I need to understand the basic math behind this type of investment.
I want to try with classic strategy of buying a value-add property, where I can increase the rent and decrease the expenses after acquisition. Basically, the goal is to do BRRR and pull as much cash out as possible after refinance.
Can you please look at the math example that I put together and critique it? Is it directionally accurate?
The biggest unknown for me right now is how the bank evaluates the property value after the increase of NOI. Do they use the same Cap Rate and that's how the value increases?
I know I missed the closing cost and the cost of potential rehab or expense related to efficiency improvement. So, anything that you can add from a real life example is highly appreciated.
FYI - my example is hypothetical, but I would love to hear from you if those numbers are even close to realistic in B-C type neighborhoods.
Thank you!
@Anna L. Talk to brokers, other investors and analyze enough deals that you start to get a feel for what the cap rate in your area is. I'm very inexperienced (couple of months) with all of this as well and I can say that I have a lot more comfort in understanding market cap rates (in my area, Chicago and suburbs) after actively analyzing deals, getting feedback from brokers and talking to other investors. Two things to keep in mind:
1. There is a big difference in market cap rate depending on the building quality type, age, size, location and sub-location. So in the city of Chicago for a 40 unit well rented apartment in a nice area the cap rate might be 4%. While in a far reaching suburb, a 10 unit older building might be more like a 10% cap. Keep in mind, cap rate is ultimately just a guideline and the exact cap rate (and therefore price) on the building is negotiable.
2. Exit cap rate (what you are going to be able to sell the building for) is incredibly important to keep in mind. We may be at the top of the market right now (or not) but when you start modeling returns when you buy an apartment building the exit numbers are just as important as the acquisition numbers. For example, if you overpay for a building today (say you buy a building for a 7% cap price when it should have been a 8% cap) and the demand for multi-family goes down...or even stays the same, you are going to have a tough time getting the returns you modeled if the cap rate is 9% when you want to sell. Long story short, of course "buy right" but also be conservative about the exit. When I model an investment I like to assume that my exit cap rate is going to be approximately 1% lower than my buy cap rate. If the returns still look solid with the higher cap rate at exit, then I start digging deeper.
Directionally accurate, yes. One very big factor in evaluating MU is the assumed cap rate. If you model an investment with the same cap rate 5 years later, you are not being conservative enough and you might have no equity in your building, when you include selling or refinance costs. The rule of thumb I use is to add .5 to 1.5 to the exit cap rate, depending on building, location, starting cap rate and length of hold time.
You might not be looking for this feedback as it is only a hypothetical example, but your expenses are too low. Model in 50% (including capex and pm) and you will get numbers that are more realistic, so use a $50K NOI. This is more conservative.
Just looked quickly at your example again. Technically, property management goes above the NOI line and capex goes below. For the sake of modeling out whether or not an investment makes sense, I use 5% for capex reserves that is an expense that goes above the NOI line. My model, which is Michael Blank's spreadsheet, looks like this. Keep in mind that this is a summary page and there are other sheets feeding data into some of the cells.
The basic math is simple. Getting the projections (the pro-forma) right, meaning the numbers, can be a little more complicated. Your 'rehab' model of "buying a value-add property, where I can increase the rent and decrease the expenses after acquisition" is what a lot of us on BP do. So lots of information on posts elsewhere on BP.
First real quick... @Scott Skinger is correct about the numbers. 20% is way off and the boilerplate 50% Rule OF Thumb is a better neutral swag. Lots of information on 50% expenses elsewhere on BP (for you to look up). I'll add that the simple answer is review since your property will have all those line item expenses. Have something in all of those line items for anything you present (pro-forma or otherwise) to the bank.
Regarding your bank question... The short answer is 'it depends'. You asked "The biggest unknown for me right now is how the bank evaluates the property value after the increase of NOI." Your question implies you have unknowns about a stabilized property, a property that already has improved NOI, and that you don't have unknowns about the bank evaluation for property acquisition. I find that quite interesting.
From your example numbers of an $800K property, your numbers match very closely with an 18 unit apartment my company owns. I would call you what I am... a 'tweener'. Too small to be big, to big to be small. In tweener land, we seek financing from a commercial bank and not via Fannie Mae Multifamily Small Loan programs.
So... from what you have given me... information wise from your post, and to answer your question of how the bank will analyze your property... the answer is: they won't. At least not as their first priority. They will analyze you. I'm not trying to be flippant or funny, I'm just telling you how they treated me in a similar circumstance. I am assuming that you have the resources to acquire, rehab, and stabilize a property first. If I am wrong about that, then correct me and ignore much of what I posted above;)
@Scott Skinger, thank you for the info and breaking everything down!
Few questions:
1. Estimated Closing Cost in your example is roughly 2%. Is this realistic? What are the typical closing costs associated with buying 10+ unit building? What is the broker commission? If my husband has RE license, can he and his broker get a %? Or typically, only seller's broker get's a %?
2. Debt to Replacement Reserve - why did you include this into NOI calculation? Isn't that part of CAPEX once expense actually happens, and CAPEX shouldn't be included into NOI?
3. Interest of 4.75% and Amortization (30 years) - how realistic to get these terms for someone, who is just starting out? What should I prepare myself to? 5% and 20 year?
4. Have you ever re-fi after you increased NOI? How does appraisal works in that case? What are the typical conditions of the re-fi loan?
5. I noticed that your loan included Principal and Interest in that example. Why would some people want interest only loans? When they need cash to remodel and then re-fi?
I know it's a lot, so I really appreciate any info you can provide!
Thank you!
@Anna L. Sometimes people forget about the costs for bringing in tenants. If the property is not fully leased, it will usually cost you the first month rent to the PM company to get a tenant in. Also, sometimes you offer a discount to the tenant to move in (let's say 1st month free). Most of the time, people don't account for those costs. But they do affect the bottom line.
First off you are showing the NOI and cap rate, then you add in more expenses. The NOI is after ALL expenses, besides debt service. With that said, your expenses for a C type neighborhood seem really low, but I do not know the building that you are looking at. Generally speaking you would be around 50-60% of the gross income for your expenses, but that is a blanket rule, not a fact. The only way to really understand your numbers would be to see how you came up with your expenses and gross income. Lastly, you show no vacancy factor.
@Henri Meli, thanks! That's a good one to add.
@Scott Skinger, thank you for the info and breaking everything down!
Few questions:
1. Estimated Closing Cost in your example is roughly 2%. Is this realistic? What are the typical closing costs associated with buying 10+ unit building? What is the broker commission? If my husband has RE license, can he and his broker get a %? Or typically, only seller's broker get's a %?
2. Debt to Replacement Reserve - why did you include this into NOI calculation? Isn't that part of CAPEX once expense actually happens, and CAPEX shouldn't be included into NOI?
3. Interest of 4.75% and Amortization (30 years) - how realistic to get these terms for someone, who is just starting out? What should I prepare myself to? 5% and 20 year?
4. Have you ever re-fi after you increased NOI? How does appraisal works in that case? What are the typical conditions of the re-fi loan?
5. I noticed that your loan included Principal and Interest in that example. Why would some people want interest only loans? When they need cash to remodel and then re-fi?
I know it's a lot, so I really appreciate any info you can provide!
Thank you!
I assume that OP is buying out right (cash) then stabilizing and refinancing at some later date. To answer in this scenario:
#5. Interest only conserves your cash. Generally cash goes to improvements vs. operational expenses. Commercial lenders will not do IO loans.
#4. Appraisals work the same regardless of the financing since the appraisal is done by an independent party.
#3. 30 year terms are not realistic for commercial loans. Most have a 5 or 7 year call, most have a 20 or 25 year amortization.
#2. Commercial banks may or may not require reserve accounts. If you have experience with the lender, they are more willing to will work with you. For stabilized (fixed, rented, increase NOI for "good" numbers) property my lender doesn't worry about reserves.
#1. On cash purchase, CC are <1%, and seller generally pays commission. On Bank refi, expect about 2%.
@Scott Skinger, thank you for the info and breaking everything down!
Few questions:
1. Estimated Closing Cost in your example is roughly 2%. Is this realistic? What are the typical closing costs associated with buying 10+ unit building? What is the broker commission? If my husband has RE license, can he and his broker get a %? Or typically, only seller's broker get's a %?
2. Debt to Replacement Reserve - why did you include this into NOI calculation? Isn't that part of CAPEX once expense actually happens, and CAPEX shouldn't be included into NOI?
3. Interest of 4.75% and Amortization (30 years) - how realistic to get these terms for someone, who is just starting out? What should I prepare myself to? 5% and 20 year?
4. Have you ever re-fi after you increased NOI? How does appraisal works in that case? What are the typical conditions of the re-fi loan?
5. I noticed that your loan included Principal and Interest in that example. Why would some people want interest only loans? When they need cash to remodel and then re-fi?
I know it's a lot, so I really appreciate any info you can provide!
Thank you!
Sorry for the late reply...been real busy the last couple of days. In addition to @chris martin's comments, I will add:
1. My understanding is that your husband can represent you as your broker but commercial listing agents aren't usually real fond of this. The broker commission would be split but somebody needs to shed more light here.
2. You are correct on the calculation of NOI (no CAPEX), however, for my projections I include CAPEX reserves as an expense so I'm tracking real cash flow when I do my return calculations. For tax (return) purposes, CAPEX isn't an expense, so it can be adjusted within your accounting software. Also, when I'm dealing with a broker and cap rate comes into play, I will just adjust accordingly. For example, "mrs. broker, my offer is x, which is a 9.2% cap rate including capex reserves, with capex reserves removed, the cap rate is 10% which is the market rate for this area and property class".
3. For commercial loans over $1MM, these terms are available through Freddie Mac small loan program. 30 year am, 10 year term, 20% down, rates from 4.5% depending on other factors and possibly 3 years of interest only...and non-recourse. Loans from a community bank will look much different.
Thanks for your responses @Scott Skinger!
As far as the market cap rate for the area... How do you know what is the avg rate in the area, to determine whether you're getting a good deal? With residential, I just do comps in Trend MLS, but with commercial - I am a bit lost...
@Anna L. Talk to brokers, other investors and analyze enough deals that you start to get a feel for what the cap rate in your area is. I'm very inexperienced (couple of months) with all of this as well and I can say that I have a lot more comfort in understanding market cap rates (in my area, Chicago and suburbs) after actively analyzing deals, getting feedback from brokers and talking to other investors. Two things to keep in mind:
1. There is a big difference in market cap rate depending on the building quality type, age, size, location and sub-location. So in the city of Chicago for a 40 unit well rented apartment in a nice area the cap rate might be 4%. While in a far reaching suburb, a 10 unit older building might be more like a 10% cap. Keep in mind, cap rate is ultimately just a guideline and the exact cap rate (and therefore price) on the building is negotiable.
2. Exit cap rate (what you are going to be able to sell the building for) is incredibly important to keep in mind. We may be at the top of the market right now (or not) but when you start modeling returns when you buy an apartment building the exit numbers are just as important as the acquisition numbers. For example, if you overpay for a building today (say you buy a building for a 7% cap price when it should have been a 8% cap) and the demand for multi-family goes down...or even stays the same, you are going to have a tough time getting the returns you modeled if the cap rate is 9% when you want to sell. Long story short, of course "buy right" but also be conservative about the exit. When I model an investment I like to assume that my exit cap rate is going to be approximately 1% lower than my buy cap rate. If the returns still look solid with the higher cap rate at exit, then I start digging deeper.