An accurate evaluation of a multifamily property is fundamental for the profitability and long-term success of an investment. Multifamily investments can be financially rewarding if done right but can also backfire if a lack of understanding leads to mistakes. However, many of the common mistakes are avoidable with the right knowledge.
So, what’s the first thing you check when you set your eyes on a property and know how many units and square footage it has? Here are 6 key elements to consider when evaluating a multifamily property.
1. Determine the Net Operating Income (NOI)
NOI is used to assess the initial value of the property and determine the building’s ability to generate income by looking at its current cash flow. Unlike an owner or investor’s credit history, this measure of profitability is considered less vulnerable to manipulation because it can only be increased by raising rents and fees, or by decreasing operating expenses.
The net operating income is obtained by subtracting property expenses from the total revenue the complex generates in one year. Total revenue includes everything from rent to money generated from laundry machines, parking fees, vending machines and other services. Costs of running and maintaining the building and its grounds, such as property management fees, utilities, insurance and property taxes as well as repairs fall into the operating expenses category.
2. Look at the Cap Rates
A property’s capitalization rate is one of the most important factors to consider when evaluating a multifamily investment. The cap rate is determined by dividing the property’s estimated net operating income by the current market value, which can be estimated using the listing price. The cap rate is expressed as a percentage, and its formula looks like this:
For example, if you expect your annual net operating income to be $80,000 on a building that costs $1,600,000, your cap rate would be 5% per year.
This metric is an industry standard for brokers and investors because it allows them to calculate the investment’s profitability. High cap rates mean lower listing prices, and the higher the cap rate, the more profitable the property—but there’s a catch.
Usually, multifamily properties with high cap rates can either be found in rougher neighborhoods or are in need of significant remodeling, whereas communities with lower cap rates tend to be located close to the city center or in upscale residential areas.
Buying a C-Class property with a higher cap rate in a good area and revamping the asset to B or even A-Class standards is likely to bring in a higher cashflow, while A-Class buildings with lower cap rates are more likely to appreciate in value over time.
Also, note that factors such as loan amount, property type, occupancy, age of the property, location, economic conditions and taxes play a significant role in determining the return on a multifamily property. A good cap rate does not always guarantee a good investment prospect.
3. Due Diligence
When investigating a property, you can never be too careful. Always check for skeletons in the closet before buying, because when a deal seems too good to be true, it usually is. Risks, violations, unpaid penalties and potential pending lawsuits can quickly turn a profit into a loss, especially if you lack either the skill or the motivation to resolve any complicated issues after buying the asset. It’s also wise to inspect the building from top to bottom carefully for any potential structure anomalies, leakage and roof problems.
Keep in mind that it’s impossible to know every little detail about a prospective property, no matter how much research you do. Only when you become the owner will you truly discover both the good and the bad aspects of your investment.
4. Location, Location, Location
After identifying a rental building that you’d like to buy, it’s time to analyze its location. Economic conditions and location play a significant role in determining the value of the rental asset, as well as your rate of return.
Make sure you know the market in which you’re buying. Do some research on your city of choice to understand its economy. Weigh in both the positive and negative, and asses if the city you’re buying in will ultimately increase your asset’s value over time and guarantee a strong cashflow. Furthermore, multifamily supply and demand also play a pivotal role on how you’re building will perform.
Next, analyze the submarket, whether in the form of a neighborhood or a zip code, to have a better understanding of local trends. Buying in an emerging submarket usually results in a winning investment, but without the proper knowledge of the area, it’s possible to buy something in a rougher neighborhood and even lose money on the investment.
5. Perform a Comparable Search
This straightforward step entails analyzing nearby rental buildings that are similar to yours in terms of the number of units, the square footage, and any other specifications, to see if their cap rate, value, rent and NOI are similar to your property of choice.
If the multifamily dwelling in which you want to invest is undervalued or has lower rents when compared to similar assets in the neighborhood, you might just be lucky and land yourself a great deal. Comparing properties can also let you know if the one you’re trying to buy is more expensive than those next door, saving you from a bad decision.
6. Go See the Property for Yourself!
If you’re seriously thinking of buying, go and check out the building for yourself. Examine everything from the grounds to apartments, common areas and so on. It also pays to do open visits of similar assets in order in order to compare rents, levels of upkeep, and other important factors.
Following these steps can help you develop a clearer understanding of a property’s worth, but make sure to also consult professional brokers, lawyers and tax experts if you decide on buying. As an investor, apart from understanding the marketplace, analyzing recent sales comps, and knowing how to identify and then properly evaluate a property, it’s imperative to know that the investment you’re making is wise and aligns with your financial goals.
Making Your Investment More Profitable
After buying a rental building, figuring out how to increase its value and cashflow is the first order of business. The main idea is to always try to increase rent as quickly as possible by adding extra amenities to your apartment complex, or just bringing rents up to market standards. If rents are higher, NOI is higher, which automatically increases the property’s value and cashflow. Maintaining occupancy at a high rate is also a priority to keep your pockets happy.
Depending on how much unused space your property has, you can always find ways to make that space usable. You also have the option to tear down the building and build something new from scratch, and depending on the air rights, you may even have the option to add a couple of extra floors.
How Can PropertyShark Help Me with the Research?
With our Comps feature, you can easily determine a property’s value by taking advantage of the numerous filters the tool offers. You can access Comparables from the PropertyShark home page when you are logged in and have an active subscription.
Once in Comps, you can simply type in any address and click search. Depending on the radius selected, a list of properties will appear, and you’ll be able to view the neighboring asset’s median price and compare it to the price of your property. For more accurate results, you can also tick ‘Normal’ at the ‘Transfer Type’ tab, to eliminate other types of transactions, including ones between relatives, which could impact the overall selected radius’ median home sale price.
For more information on how we can help you with the research, check out this webinar hosted by PropertyShark Founder Matthew Haines.