By Pavlo (Paul) Prokop
Here are some terms that are being used in the multifamily investing business. As a passive investor becoming familiar with these terms will help you ask better questions. These terms will be in the investment offerings, so here we go:
Numbers to be used in all examples:
Purchase Price: $ 2 Million
Closing Costs: $ 200,000
Gross Income: $ 200,000
Operating Expenses: $ 80,000
Market Cap Rate = 6 %
Monthly Mortgage Payment = $ 8500
NOI (Net Operating Income)
NOI (Net Operating Income) = Gross income or revenue for the property minus all operational expenses (OPEX) or costs.
Gross income includes all the rents, pet fees, laundry, storage, or any other additional income received. Operational expenses are property taxes, insurance, management, repairs and maintenance, advertising, etc. Operational expenses exclude mortgage debt service, depreciation, capital expenditures (commonly referred to as CAPEX) and income taxes. Typically when NOI is increased so is the value of the asset.
Example: If the property generates $ 200,000 revenue and $ 80,000 in operating expenses, what is the NOI?
Answer: $ 200,000 – $ 80,000 = $ 120,000 NOI
Capitalization (Cap Rate)
Cap Rate is a ratio of NOI to Property Value (market value).
Cap Rate is a measurement of market sentiment. If cap rate for comparable properties is known, it can be used to estimate the property value. Factors include type of property, how old, and risk. Cap rate is a market driven number.
If cap rate is lower, say 4 to 5% the risk and/or return is typically lower but purchase price may be higher than a comparable multifamily building at a cap rate of 8 to 9%. As growth markets increase in appreciation and rent price (increased NOI), the cap rate decreases. The inverse is also correct, as prices decrease, the cap rates increase. This is known as cap rate compression. According to Brian Burke, the cap rate is most useful for estimating the sale price of the property.
Example: Market cap rate is 5% in your purchasing area and the property is listed at $ 2 MM, how much income should the property produce to support the asking price? What is the expected NOI of the property?
Answer: $ 2,000,000 x .06 = $ 120,000 for expected NOI
Example: A building with $120,000 NOI has an asking price of $ 2MM, what is the offering cap rate?
Answer: $120,000/2,000,000 = 6 % Cap Rate
Apartment Value = NOI/ Cap Rate
This is why every dollar raise in rent is crucial for a value add asset, because it affects the bottom line of the asset in apartment value. See examples below.
Example 1: Market Cap Rate is 5 % in this area and the NOI is $120,000, what is the current market value of the asset?
Answer: $120,000/.05 = $ 2,400,000 value of asset
Example 2: Raise rents $ 50 per unit in a 50 unit building due to minor reposition in year 1.
Step 1: Year 1 = $ 50/mo. x 50 (units) x 12 (annual months) = $ 30,000
Step 2: New NOI Yr. 1 = $ 200,000 + $ 30,000 – $ 80,000 = $ 150,000
Value of Asset = $ 150,000/.05 = $ 3,000,000 value of asset
Answer#2: Value of Asset = $ 30,000/.05 = $ 600,000 raise in 1 year
The previous value of the asset was $ 2,400,000. Now the new value is $ 3,000,000 with $50 per month raised rents at the end of year one and a higher NOI. Pretty incredible!
Cash Flow = NOI (annual) minus 12 months of mortgage payments
Example: Calculate the cash flow for an NOI of $120,000 and $8,500 debt service per month.
Answer: NOI is $120,000 – (12 x $8500 debt service per month) =$ 120,000 – 102,000 = $ 18,000 Cash Flow
Cash flow is only one factor to consider when making an offer. Appreciation, mortgage debt pay down (amortization), tax benefits (depreciation) and exit plan are other major factors to consider in your projections. Your acquisition should cash flow on day one of purchase.
Cash on Cash Return (CoC)
CoC = Cash Flow / Initial Equity Investment or down payment including closing costs; or from an investor standpoint how fast your money is moving or growing (velocity) or return on equity. A CoC of 25% would return the initial capital invested in four years. As a rule of thumb, an 8 – 12 % CoC is considered a reasonable rate of return.
It is important to note that CoC equation does not factor in future cash flows, loan reduction principle, income taxes, or changes in property value. It does calculate the use of leverage when purchasing an asset using a mortgage loan to finance the property (i.e. 20% down).
Example: If a property has a purchase price of $ 2 MM, and the Bank has offered a 4% note rate with 25 year amortization at an 80% loan to value (LTV). Your closing costs total $50,000. The current NOI is $ 120,000 and the market cap rate is 6%. After monthly mortgage payments of $ 8500 per month or $ 102,000 annually, you have $ 18,000 left. What is your CoC return?
Step 1: Calculate the value of the property: $120,000 NOI / 0.06 cap rate = $2 MM
Step 2: Calculate your down payment: $ 2,000,000 x 0.20 = $ 400,000
Step 3: Calculate CoC $ 18,000 / ($ 400,000 + $ 50,000) = 4%
This CoC return in our example is well below our guideline of 8 – 12%.
This article has been prepared for informational purposes only, and is not intended to provide, nor should it be relied upon for legal, tax, or accounting advice. You should consult your own legal, tax and accounting professionals.
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