4 Plex Analysis - 3 Questions

14 Replies

I just finished episode 61 with Ben Leybovich about how to succeed in multifamily properties (I highly recommend this podcast as well as episode 60 as the two best I've listened to so far). I was interested in what he had to say about valuation 4-plex, tri-plex and duplex properties. According to Ben, NOI is not correlated with purchase price as much as larger investments such as apartments. Instead, value of property is more about comparable 4-plexes or duplexes within that market.

QUESTION 1:  Can anyone explain on why a 4-plex is valued  on Comps than larger properties?

I have been running numbers on a 4-plex for weeks using NOI, CAP Rate, and Total ROI. I have been trying to nail down what I am willing to offer based on all of these measures with a CAP rate target of 8%. I am an analytical person and want the numbers to be "right" before I purchase my first multi-family (I currently own a single family).

QUESTION 2:  Concerning the 50% rule, if I plan to self manage the 4-plex is 40% a reasonable number to use?  My own estimates are at 36% currently.  These numbers can really swing these metrics dramatically!!

I really value TOTAL ROI as a metric, which includes cash flow, equity, taxes, and appreciation. I'm assuming it doesn't get discussed as much because 1) it is very subjective in nature (such as appreciation), and 2) the calculation is more involved and dependent on financing. However, this calculation to me, is a big picture approach and could be more valuable than even CAP rate and cash on cash. I have been a landlord for a single family for going on 5 years and to ignore equity accrual and income tax benefits doesn't begin to tell the story.

QUESTION 3:   Any thoughts on TOTAL ROI as a measure?

1, 4-plex is usually considered residential properties which is treated the same as single families by many so comps are usually used for valuation. But it doesn't prevent you from using the Cap. So I would go with the Cap. If the comps show a 4-plex should worth much more than your analytics, probably it won't make you money, aka overvalued.

2, 50% is general and depends on the condition of the properties, tax rate, insurance rate, your management skills etc. Use it as a first look and then go into those categories and have a better estimate. Estimate future large expenses like replace root, HVAC, waterheater, etc and that should be part of expense too. Self-management does not mean 0 fees since you need time and money to manage too. And someday you may not be able to manage yourself, so it is wise to always put 10% in management. My experience is after all these considerations, it will lean towards 50%, if the condition is good, you can lower a little bit.

3, ROI is a good measure, the drawback is it does not take into account the time value of money, like 10% ROI this year is better than 12% ROI next year. Also you need to think about what should be counted as return. You should at least count equity increase and net cash flow. Other good measures are IRR and ROE. They are complementary, so better use many measures to see the complete picture.

@Lee G. :

1. Properties up to 4-plex can be financed with a sellable Fannie/Freddie residential note. With that being the case, lenders (and therefore appraisers) valuate these as any other owner-occupied residential structure.

That said, for our purposes as investors, we should definitely evaluate all of the metrics relative to investment returns. However, if your plan includes either a refi or a sale, understand that the value will be driven by the comps - no exceptions.

2. I can't think in terms of "Rules". I can't comment on 50% rule, because just like the 2% rule it is nonsense...Underwrite the NOI and get comfortable - done!

3. If you want a very true picture of the investment return, underwrite to IRR. IRR takes into account all of the in and out flows of capital, including refi and disposition. You can further discount the cash flows to NPV and base your IRR on that for an extremely true picture, but one that's extremely sophisticated and nobody does :)

Hope this helps.

I appreciate the feedback Ben and Zach!    After listening to some of the podcasts which some people have said the rule of thumb should be more like 60%, it makes me feel like I'm doing something wrong in my calculations. 

Ben Leybovich: I calculated IRR and came up with 15.63%. However, my calculations did not take into account income taxes. Being a CPA, I am able to estimate with some accuracy. What is your take on this?

IRR (without taxes) = 15.63%

CAP Rate = 7.07% (at 4-plex's MLS list price)

Cash on cash = 11.80%

Total ROI = 18.92%

1-2% Rule = 0.92% (although this is at list price with current rent which I anticipate could be higher in the near future.

After calculating the IRR, the Total ROI appears to be vastly inferior because it only factors the tax consequences of one year.

I would appreciation any thoughts on these metrics above! thanks so much!!!

@Lee G.

The number looks at the border of good/bad deal, so if it is the best you can get for your area, you may have some decent returns from it.

For income tax, you can calculate your Before Tax Cash Flow and then deduct the income tax so you can see what the After Tax Cash Flow like.

One question for IRR. It should vary based on the years you expect to hold the property, and it should go up and down over the years. with 7% Cap Rate I would expect IRR go up to close to 20% by year 5 - 10, which is the best time to sell or refinance.

The last comment, what price did you use for calculation. If it is the listing price, the real numbers you get may be better so you have better chance to get a good deal. 

@Zach Liu:

Unfortunately, there are limited properties and comps in my area for this type of property. 

As for IRR, I used a 30 year time horizon, and used pre-tax cash flow at current rents for the first 5 years then for the next 25 years, I used the increase rents that I think the property could get for years 5-10, then for years 11-30, increased cash flow by 1% per year and then sold the property with no tax consequences (1031) in year 30 for $250,000.

The list price is $220,000, however, due to this area I live in, I consider this a cash flow play, and don't want to overestimate appreciation.

I apologize for my ignorance, but can you elaborate on why the IRR should be close to 20% at year 5-10? I did a quick IRR on my excel spreadsheet and at year 10, my IRR was at 6.91%. Also, my debt is amortized at 30 years at 4% with 20% down payment.

Originally posted by @Lee G. :

Ben Leybovich: I calculated IRR and came up with 15.63%. However, my calculations did not take into account income taxes. Being a CPA, I am able to estimate with some accuracy. What is your take on this?

IRR (without taxes) = 15.63%

CAP Rate = 7.07% (at 4-plex's MLS list price)

Cash on cash = 11.80%

Total ROI = 18.92%

1-2% Rule = 0.92% (although this is at list price with current rent which I anticipate could be higher in the near future.

After calculating the IRR, the Total ROI appears to be vastly inferior because it only factors the tax consequences of one year.

I would appreciation any thoughts on these metrics above! thanks so much!!!

Lee - I am not sure I understand your calculations. What is the ROI number? The IRR, if you did it correctly, should take into account all before-tax inflows and outflows, including the refinance. It should also terminate at some point, which of course require liquidation, and will therefore cash out the appreciation. The IRR is literally the most complete figure, therefore I don't understand what 18.92% is...what is more "total" than IRR...? You could do MIRR for reference, but this isn't what you're going after here.

Cap Rate is not a metric of financial return, per-se. It is a coefficient representing behavior of the marketplace relative to deployment of capital as a function of NOI. We use it, but not in a way you are thinking here. Certainly, if you are trying to figure out rte of return, Cap rate will not get you very far. Same can be said for CCR.

In other words, unfortunately, these numbers don't tell me much at all. How do you arrive at the IRR? What's this ROI and what's in it that which is driving it higher than the IRR?

Thoughts?

I think you did it right. The thing is IRR is very time sensitive and it is hard to predict things for 30 years. I usually use about 3-4% annual inflation rate for calculations that's why I get different result.

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