The 4 quadrants of multifamily real estate
Theres a lot of noise when it comes to investing in real estate. If you aren’t careful, that noise can cause you to focus on a lot of shiny objects.
As a multifamily real estate investor, there isn’t much shiny about it. That makes it much easier to understand when breaking down the fundamentals of multifamily real estate.
Just because multifamily real estate is simple to understand, doesn’t always make it easy. I don’t want that message pushed.
But the simplicity is broken down into 4 factors on a quadrant when analyzing a multifamily deal. Below I list them.
Now price is least important. In a way it can become irrelevant. But it would be irresponsible to not analyze the price.
The price is a factor because it gives you the price per door you are paying. You can use the price per door to compare comparable sales in the area.
Now price can be irrelevant at the same time. Thats because the price of a multifamily property is based on the income it produces. So depending on the income it produces, that will give you a strike price that you should pay for the asset.
NET OPERATING INCOME
This is the most important number when underwriting a property. The net operating income is the income a property produces before income taxes and debt service. Check out the formula.
NOI = gross income – operating expenses
The great thing about the NOI is you can control it. In great economic times, you can push rents up that will make the property more valuable.
In tough economic times you can lower rents and still be able to meet your debt service. A way that you figure these numbers is performing a stress test.
A stress test allows you to figure out how vacant you can be in order to still me your debt service. Or how low can you lower rents and still meet your debt service.
Some people believe that the lower the down payment, the better the deal. This is not true. One trap that people fall into is over-leveraging a piece of property.
Over leveraging is simply taking on more debt than what the property can sustain. Usually when you hear the phrase “all debt is bad debt”, it usually comes from people who’ve had a bad experience with over-leveraging their property with debt.
99% of the time, you can prevent an over leveraged situation by putting more money down on your down payment.
In multifamily, no money down is not always good. Sometimes, putting more money down is the smartest decision because it helps lower your exposure to risk.
CASH ON CASH
Cash on cash is what I like to call the royal number. This is the cash return to you out of the actual cash invested. The formula is below.
COC = NOI – debt service / equity invested
The only note I would mention about the cash on cash return is it doesn’t include taxes. For that it doesn’t give your ACTUAL return but it gives you a pretty accurate return number based on the figures.
You cash on cash return is fairly simple to calculate and in most cases its known as the back of the napkin formula do to its simplicity.
This is why people choose the cash on cash formula to calculate over the IRR because IRR takes a little bit more sophistication and understanding of an investment to perform.
Overall, you can get a pretty clear view of an investment if you have these 4 things down. Yes, of course there are more factors that goes into underwriting a property.
The most important thing is to not complicated.
Thats why I use this quadrant and choose these four to focus on before moving forward.
I ALWAYS want to know my price, the net operating income, my down payment to prevent over leveraging, and my cash on cash return.