Multifamily CAP exercise.

15 Replies

Hello everybody,

The following is all theory and I am putting it out there for the community to correct my process not exactly the numbers.

I am doing my homework and trying to analyze 5 deals a day. Working on getting up to speed on multifamily. So obviously this involves CAP rates and unfortunately not a lot of deals that can be found on public search engines.

I did manage to track down a property in my old town of Phoenix AZ and figured it would be good to try and see what a good offer on it would be.

NOI = ~$45k (pro forma)

CAP = 4.11% (C class property)

Asking = $1,100,000

10-Unit.

I managed to see a few places to increase NOI, get it up to ~$55k.

Now I want to make an offer on this property but I do not know if the CAP rate is accurate.

I google and call brokers and it seems like class C properties are going for 5.5% cap in reality!

So in order to make a actual offer I would make an offer of NOI=$45k with a 5.5% cap rate. Therefore the counter offer is ~$818K.

I understand that in reality I would probably be closer to CAP rate of 6.2% and instead of using PRO FORMA rates I would use actual rates, and I would look at actual NOI. But besides that does my theory hold up on to how to evaluate and make a counter offer on a property?

@Michael Randle

I recommend looking more into apartment syndication. There are a number of very experienced apartment syndicators right here on BP, some of whom offer study materials that cover the whole syndication process. What you described in your post is part of a bigger process which takes into account other variables such as - how long is your hold time? - what's your financing strategy? - what is your exit strategy? - what are your assumptions on exit? - what is your desired CoC? what is your desired IRR?

You may  be looking at investing in multifamily on your own (i.e. as opposed to syndication) in which case some of the above variables are less relevant but I recommend evaluating investment in multifamily as if you were going to syndicate it, hence the recommendation to look into apartment syndication.

Cheers... Immanuel

@Michael Randle For whatever it’s worth, I think you’re looking at the wrong area. If you want to practice analyzing deals I wouldn’t start at the cap-rate. The “issues” are always in how you come up with an accurate NOI estimate, estimating rehab and holding costs, etc. I’d posit that any decent commercial multifamily broker can tell you the cap-rate of a Class C small apartment building in Phoenix. Granted, I can’t see Class C being a 4% cap in Phoenix but that’s the simplest variable to solve for.

If the average cap rate in the area is 5.5%, and you’re comfortable purchasing at that cap rate, then you’d want your purchase price to be around $818k. That means your initial offer would likely be lower than that and you’d negotiate up.

If you are comfortable with purchasing at 4.5% cap (below the average), it means you’ll be “overpaying” for the property initially. But if you’re comfortable doing that and getting it to perform better to hit the 5.5% market average, then that’s a viable option.

It’s really not as complex as some here make it out to be. Cap rates are simply a good comparative tool for comparing commercial/multi family properties in the same area, given that you know what the average for the area is.

More important is making sure that NOI is being calculated correctly, because if it’s not, then you won’t get an accurate cap rate. The formula is (Gross Revenue x Occupancy Rate) - ALL expenses = NOI. I find that many people, including MOST real estate agents, either don’t take into account occupancy/vacancy rates, or leave out some expenses (taxes, insurance, management, utilities, repairs, etc) and the NOI figure is therefore wrong.

@Michael Randle Regardless of what you decide to buy, make sure the property will cash flow from day 1. In other words, don't use pro-forma to make the decisions. Also, don't bet on appreciation. Instead look for value add opportunities and always, I mean always have multiple exit strategies ready when you're buying a property!

Best!

There may be site specific or submarket specific factors that justify paying this price and cap rate is not the end-all, be-all justification to price an asset, but in general a cap rate in the 4s for a c class multifamily property is ultra aggressive.

Thank you everyone for the good advise. Like I said this was just an exercise in understanding cap rates using a real world example and NOT a property I was going to bid on or do anything more then just look into the numbers publicly available.

Special call out to @Andrew Johnson for the great reminder to do due diligence.

@Daniel Akerman for confirming my math.

@Immanuel Sibero for the syndication info and a little more on how that process goes.

@Alina Trigub for reminding cash flow is almost always king.

and @David Miller for confirming that 4.11% is probably way over priced for the asset.

If you're trying to analyze deals, go to loopnet and then get on broker mailing lists (CBRE, Marcus and Millichap, Colliers, ARA Newmark, Cushman Wakefield and the small guys/gals). Doing this will get you a few deals each month to look at. 

For this deal basing the purchase on a low cap rate using pro-forma is a formula for disaster. Find out what market cap is in Phoenix in a C class area (likely between 6-8 cap) and then find out what the true NOI is looking at the detailed profit and loss. Make sure you add in the right amounts for reserves, management, maintenance and repairs, etc.

Originally posted by @Immanuel Sibero :

@Michael Randle

I recommend looking more into apartment syndication. There are a number of very experienced apartment syndicators right here on BP, some of whom offer study materials that cover the whole syndication process. What you described in your post is part of a bigger process which takes into account other variables such as - how long is your hold time? - what's your financing strategy? - what is your exit strategy? - what are your assumptions on exit? - what is your desired CoC? what is your desired IRR?

You may  be looking at investing in multifamily on your own (i.e. as opposed to syndication) in which case some of the above variables are less relevant but I recommend evaluating investment in multifamily as if you were going to syndicate it, hence the recommendation to look into apartment syndication.

Cheers... Immanuel

Can you explain your thinking? The OP simply seemed curious to know if his formula for cap rate calculation, and the resulting valuation was correct. In your opinion, what is the importance -- with regards to calculating cap rate and resulting valuation, specifically -- in understanding hold time, financing strategy, exit strategy, Cash On Cash, IRR, or assumptions on exit ? None of those factors would have an impact on the cap rate, as the cap rate is dictated by the market, and none of those factors would have an impact on a valuation based on cap rate alone. They might be factors in the overall analysis of a property and the decision whether to buy an asset or not, but I'm having a hard time seeing how they enter into the picture in terms of simply calculating the cap rate and coming up with a property valuation based on that.

A CAP rate in a listing is about as useful as shoe size. Unless the person has all the up to date expenses and knows the formula-rarely the case-the number is meaningless. You should be able to plug in the correct numbers-including educated your guesses and arrive at a pretty good rate. What really counts is how you intend to develop the property and well it generates cash flow; how much money you are going to make is what's important. For easy on the spot calculations I use the 1% rule as a guide and the 1/2 percent rule and those work well for me.

@Michael Randle good work underwriting 5 deals a day. That's a great way to get educated. Keep it up. At some point farther down the road you'll realize a sub 5 cap on C is a rip off in any market AND you'll start to see patterns of expenses that are conveniently left out... a few being; payroll, extermination, turnover (different from M&R), reserves, etc.

Little deals are easy to "mess up" as a buyer. I know I messed a few up myself when starting out.

All the best man!

@Ivan Barratt , I have noticed that about the sub 5 cap rate. But more of the deals I am looking at are off loopnet (where deals go to die) in order to just get the idea down and to see what some agents leave off or add in (pro forma) in order to try and push the property.

Right now I am trying to get more of a feel for what market I want to jump into and find the tricks (red flags) I can expect to see when it is time to start making moves. Also trying to get on a few mailing lists from non-loopnet type sites so I can get a flow of info to work with.

@Bjorn Ahlblad I like the shoe size comment. And I agree, but when I send out an information sheet to the realtors I know cap rate is something they expect to see so they can hunt down properties. It is just odd that something so easily manipulated is the 'baseline' for finding deals.

I dont invest in Phoenix, but a 5.5 CAP is barely over your cost of debt. For a C-class property that seems low. This may make more sense if you are in the heart of the city and believe the land value will rise significantly over the years.

Not saying it cant be a good deal, but I would make sure you test the sensitivities to your parameters during your underwriting. In particular look at your exit cap rate. How far can it go before break even?