Multi-Family Property Considerations
Multi-family properties are quite different than single family homes for a few reasons:
- Buyers are only investors; there is no opportunity to sell the property to a home owner at a premium over the rental return.
- The value of multi-family properties are calculated based primary on the rent and (secondarily) the location; the opposite of single family homes.
- Multi-family properts compete with apartments and condos and in the current Las Vegas market can be difficult to rent.
Since the unit you buy today will eventually be sold to another investor who will evaluate it based on the return, you need to buy it based on the return as well. Below are the formulas I would use to compare properties. Note that these formulas depend on accurate vacancy rates, existing lease terms and other issues such as deferred maintenance. Since these factors are specific to individual properties I will not include them in the following. It is critical that you do. Capitalization Rate = NOI/Cost.
For example, suppose you are considering a 4 unit complex and the rents are $600, $600, $600, and $700 and the asking price for the property is $190,000. Assuming 100% rental rate (a really bad assumption) you would calculate the Capitalization Rate of the building as follows:
Capitalization Rate = ($600x12+$600X12+$600x12+$700x12)/($190,000) or
Capitalization Rate = $30,000/$190,000 or 16%
Looks great! However, the above cap rate is fantasy (100% occupancy rate is not realistic in the current market). Trying to be realistic, assume 10 months of rent for all units and $5,000/year rehab/repair costs. Note, the following is how I calculate return; not everyone uses the same method but this has worked very well for me on multi-family properties.
- Cash Flow = Rents Received - Management Fees - Repairs - Debt Service - Taxes - Insurance
- Rents Received = $600x10+$600X10+$600x10+$700x10 or $25,000
- Management Fees = $25,000 x 7% or $1,750
- Repairs = $5,000
- Debt Service assuming 20% down, 7% interest (multi-family property interest rate is typically 2% higher than for single family investment properties) and a 30 year term. The debt service is $1,076/Mo or $12,912/Yr.
- Taxes = approximately 1% of purchase price so about $1,900/yr
- Insurance - about $700/yr
Pre-Tax Cash Flow = $25,000 - $1,750 - $5,000 - $12,912 - $1,900 - $700 or $2,738.
So, Cash/Cash = $2,738/(20% x $190,000) = 7.2%
On the surface, this multi-family property looks good but it all depends on deferred maintenance, ongoing maintenance and keeping the units rented. A few other things to consider:
- Association effectiveness - Most of the multi-family properties I've seen are in a community. For example, 50 x 4 unit buildings with ownership of the individual buildings divided among many investors. However, you need to check ownership records since there might be one investor who owns many units and effectively controls the association. If you need something done and this major owner does not agree, its not going to happen.
- Seller motivation - Investors tend to sell these properties only when they are not making a sufficient return. The reason they are not making sufficient return is usually due to differed maintenance, excessive vacancy rates, vandalism, excessive rehab costs, financing issues, etc. So, you need to have at least 15 days due diligence and really check the units out. 30 days would be better.
- If you close right after the first of the month, you will receive most of all the received rent. This is a nice little plus.
- Do your homework!!! - As part of the purchase offer, include a requirement that the seller provide their books for at least the last two years. Have the books looked at by a professional. Also require copies of leases for all tenants. Note: when you do look at the books, do so with a strong measure of disbelief.
- Crime - Check what is happening in the area. See if there is a crime website. Walk around and talk to residents, the post person and, if you can, the beat cop.
- Rental Fees - Every time you need to rent a unit, you will incur a $300 to $400 fee (plus rehab costs which I will ignore for the moment) from most property managers for advertising and/or commissions. If you have more than four charges a year, you greatly reduce your profit. For example, assuming $350/rental and the above example, your annual profit would decrease from $2,738/Yr to $2,738-(4x$350) or $1,400. Also, we did not include any rehab costs. There are a lot of "moving parts" with multi family properties and you need to go in with your eyes open.
Expect the unexpected! I purchased a 4-plex in Atlanta with all 4 units rented. Things looked good. After I closed, I learned that 2 of the tenants were threatening to leave due to the antics of one of the other tenants. It took months to get this guy out (this was in Georgia, not Nevada) and I had all sorts of problems with the other tenants until he was gone. The lesson here is to talk to all the tenants during the due diligence period so you know the actual situation.