Evaluate Multifamily Investment Opportunities (Like a Pro!)

Ok. You're interested in investing in multifamily. But...where to start?!?

Investing in multifamily involves casting a vision into the potential future of the asset in question. When making projections on income and expenses of a rental property you are, you are basically making a series of educated (hopefully!) assumptions.

After analyzing hundreds of properties over the years, and as a long time owner and manager, I have the benefit of experience on my side. These experiences, for better or for worse, have improved the accuracy of my projections. This has helped reduce the risk of overlooking real life expenses that often crop up and project realistic income figures.

What if you want to invest but lack a similar level of experience? How do you limit your exposure to risk, know what questions to ask and empower yourself to make informed decisions? Educate yourself. Read books on the subject. Visit investor focused websites like www.BiggerPockets.com. Join local or virtual investors meetups. Let’s cover some common considerations below.

A pro forma, or projection of the income and expenses of a property, is just that, a projection. This will either be provided by the listing broker, owner, deal sponsor, or you could create one yourself. Guess what? We will all be wrong 100% of the time on some component of the pro forma. The key becomes limiting the magnitude of inaccuracy and having the courage to take action in spite of it.

The information a listing broker provides is often not inclusive of all the expenses a typical property would incur while the projected income figures are often overinflated. Interesting, right? But it makes sense. The broker is looking out for the seller’s best interest alone in most cases. It is the investor’s job to adjust the assumptions based on their expectations of reality.

“Industry averages” are commonly used for expense figures especially if the actual in-place figures are higher than normal or simply not made available from the seller. If you can’t get your hands on actual historical financials, you’ll have to empower yourself to project out what you believe to be reasonable pro forma figures.

On the income side, you have two main kinds of income:

1. Rental Income: simply the rents received from tenants

2. Other Income: this represents a variety of income sources, such as: laundry income, pet fees, utility reimbursements etc

You can generally take the in-place rental figures at face value, as you won’t have a chance to validate against the leases until you’re under contract on the property. Your projection of where rents can go can be based on online research at nearby comparable properties. Look at the location of the comps, photos, amenities, pet fees, condition etc to gauge if any adjustments should be made before assuming what a comparable rent could be for the subject property of interest. Apartments.com, Rentometer.com, Facebook marketplace and Zillow.com are some of many good sources of information.

One of the most accurate ways for projecting future rents is to visit the comparable properties themselves, or pay someone else to secretly shop for you. Getting a feel for the variables noted above firsthand helps increase confidence in how that may translate for rents on the property you’re pursuing. Then, take a weighted average of the various adjusted comparable rents, with the greatest weight given to the most similar properties.

Other income often includes sources that should not be factored into your pro-forma. For instance, security deposits that were retained and late fees are extremely variable, and with proper management, may vary greatly from in-place figures with a potentially less scrupulous manager. Other income sources can be based on industry averages which can be determined through your comparable rent survey or speaking with a property manager or experienced investor.

Vacancy is often overlooked. Don’t make that mistake. Even if a property has been 100% rented for 5 straight years, still assume at least a 5% vacancy factor, more if you need to vacate units to rehab upon taking ownership.

Operating expense projections can be ripe with errors and omissions, intentional or otherwise. This includes any fixed expenses, such as real estate taxes and insurance, along with variable expenses, such as utilities and management fees.

Listing brokers or sellers may understate expenses to make the Net Operating Income (NOI) look better, in hopes to maximize the value. Again, it is our responsibility to adjust the expenses to match our version of reality.

As a rough rule of thumb, expenses on small multifamily I have owned h.ave averaged an expense ratio between 35%-55% of gross income. The expense ratio is total expenses/total gross income, net of any assumed vacancy

The expense ratio depends on many factors.

Are utilities paid by the Landlord? The expense ratio will be higher than if the tenants pay.

Are rents well under market when taking over ownership? If so, your expense ratio will start higher and come down as income increases. Older vintage buildings typically carry higher maintenance costs.

Property management fees vary from 5-10%, typically highest for smaller properties. Real estate taxes might be reassessed for larger properties post-purchase, which could have a significant adverse impact on NOI. Most school districts have the jurisdiction to spot appeal properties they believe to be under assessed when certain thresholds are met.

Other expenses that often go overlooked or are underestimated include: leasing commissions, property manager markups on maintenance, municipal rental license related fees and required repairs, contract service fees such as landscaping/snow removal, janitorial and pest control, among others.

Maintenance costs, including the cost to turnover a vacant unit between residents, will typically be higher for older buildings. This is an area that can quickly spiral out of control if keen oversight is not issued, especially when a third party manager is coordinating the repairs. It is your responsibility as the owner to set thresholds in place for repair costs so that you have the ability to approve non-emergency expenses prior to approval being granted.

Water leaks are in a class all their own. A leaky toilet can lead to hundreds or thousands of dollars in wasted money. Many water suppliers no longer allow leak adjustments, so you may be out the full amount. Reduce this risk by constantly educating your residents to notify you of any water leaks, no matter how small. Reward them for any notifications. Install lower flow water fixtures. Carefully monitor the water bill each month for discrepancies. If the cost is up 20% from a previous month, schedule a walkthrough of the entire building to seek any unreported leaks.

Does the building you’re considering need repairs? It’s imperative that enough funds are being raised for capital improvements and set aside in an escrow account. Running out of cash in the midst of repairs or when facing unexpected replacement needs is not an ideal scenario to be in. Carefully evaluate the projected repairs and make sure enough capital is being set aside upfront.

At settlement, closing costs on financed deals average 4-5% of the purchase price. In addition, lenders may occasionally require reserves of their own, or hold back the release of funds for repairs until they are complete. Reserves may also be required for taxes and insurance. On the back end, closing costs average 4-7%, depending on broker fees and transfer tax rates. Also, verify whether any prepayment type penalties exist with the lender(s).

Regarding financing, when you come across any offerings that include an assumption for a cash-out refinance, or a conversion from an upfront floating rate loan to a fixed rate loan, scrutinize those assumptions carefully. Interest rates have a propensity for unexpected change so make sure the projected interest rate at refi is a good bit higher than the going rate today.

Cap rates are an oft misunderstood concept. In general, cap rates reflect the market’s expectation of risk-adjusted returns. Areas that are in greatest demand have lower cap rates, as the typical investor is willing to accept a lower return for that location. Cap rate is important as it is a determining factor in the valuation of a building 5 units or larger. The NOI/cap rate = value. The lower the cap rate, the higher the value, and vice versa.

Exit cap rate is the assumption of the future cap rate upon the sale of the building. Ensure a conservative assumption is being used, meaning, it should be higher than the in-place cap rate today. As a rule of thumb, exit caps should be 10 to 20 basis points (.10-.20%) higher each year until outsale. So if a building is projected to be held for 5 years, the exit cap in most cases should be 0.80-1.00% higher than the in-place cap rate. This therefore assumes the market will soften between now and then, a much more conservative assumption than assuming the market will strengthen. This is one area deal sponsors can make a deal look much better on paper.

For 1-4 unit properties, cap rate is less relevant, as the main basis of valuation is on recent nearby comparable property sales.

While this is not an all inclusive list, I hope it provides some thinking points the next time you’re considering an investment either actively or passively in rental properties. Remember, this is intended to empower you, not paralyze you. Furthermore, it’s often suggested you know, like and trust the sponsor of whatever deal you are considering. Trust your instinct and don’t be afraid to say yes in spite of fear and no if too many red flags exist.

To be made aware of investment offerings from Timber Run Capital, contact us here and we look forward to connecting with you.