A positive result of rehabbing a multi-family property is that you have an automatic “plan B.” Once you are done you can decide whether to flip it for an immediate profit or hold it for rental income. There are a number of considerations and calculations you must examine when making that decision.
There are calculations such as cap rate, cash on cash return, rent as a percentage of purchase price, rent percentage of purchase price plus rehab cost and the ratio of operating expenses to operating income. Debt service coverage ratio becomes particularly important if you are thinking of conventional financing through a lender or refinancing after some experience with renting the property. Be aware that any multi-family less than 5 units would not be viewed as commercial property by a conventional lender. That generally means that you will have to show the lender that you are capable of handling the debt by disclosing your personal income and source of funds. In a commercial transaction you can usually get the lender to consider the income producing property as a stand-alone business without you having to worry about what your personal income is.
Let’s look at some of these numbers. Cap rate (capitalization rate) is calculated by dividing the annual net operating income by the purchase price of a property (or possibly market value). So, if a property net operating income is $20,000 (which does not include any mortgage or debt used to finance the purchase of the building) and the building is selling for $200,000 then the cap rate is 10% or 10. $20,000 divided by $200,000. For smaller rentals I personally do not pay attention to cap rate. If there are 6 or 7 units in the building I will ponder it, but if it may not be a deal killer. In areas like Manhattan or Fairfield County, CT you will find very low cap rates 2, 3 or 4 may not be uncommon. Buyers of these properties are often looking more toward appreciation then what their return in current income is going to be. Cap rates in less affluent areas will normally be in the double-digit ranges for good deals. But again, it is not the only thing to consider. Generally it is felt that the higher the cap rate the better the deal you are probably getting.
I think cash on cash return should be a consideration in a multi-family buy and hold situation. After all, if you only get a 3 or 4 percent return on your money then there are probably better secure investments for you. I calculate the cash on cash by taking the actual cash flow on the property and dividing that by the actual cash you use to purchase the property. So, if the net operating income on a cash basis is $20,000 in the first year and you then deduct your loan payments, let’s say $10,000 for the year, you have $10,000 of cash flow. If you had to come up with $40,000 cash to get the building, then your cash on cash return is $10,000 divided by the $40,000 you needed to get the building, or 25%. That looks like a pretty good use of your cash.
I consider rent as the percentage of the purchase price and the purchase price plus rehab to be a “must compute” type of calculation for analysis and holding rental property. At a minimum, I am looking for the monthly rent to be equal to or exceed 1 percent of the cost of the property. At one percent I am not crazy about the deal, but if the current rents are too low and I think they can be raised or increased by getting new tenants I would consider the building. If you can get a 1.5 to two percent rate I think you are doing very well. So, let’s look at the calculation. Again, we will say the cost of the building is $200,000. Let’s say we get $3,000 in rent each month. The rent as a percentage of the price of the building is $3,000 divided by $200,000 or 1.5%. This, for me, is acceptable.
I do not like to see operating expenses being more than fifty percent of the operating income. I include it that calculation a reasonable estimate for vacancy loss as well as a reserve amount. This calculation with the rent loss estimate and reserve amount included in expenses is probably too conservative for many multi-family investors, but that is a personal preference and I am always willing to consider the pros and cons of this calculation given current market considerations and longer term projections.
The last calculation I will mention is the debt service coverage ratio. As I mentioned before, if you are looking for conventional refinancing or a bank loan this is an important calculation to a lender along with the cash flow. Most lenders that I have talked to are looking for a 1.2 or 1.25 ratio. Some may go with a lower ratio, but plan on a 1.2 or1.25 minimum requirement. The debt service coverage ratio is the net operating income amount divided by the loan payment amount. So, if we have $20,000 of net operating income, (which must consider vacancy loss, which should automatically be accounted for when using actual numbers), and our annual loan payments total $15,000 the ratio is $20,000 divided by $15,000 or 1.33, which is acceptable. Presented on a monthly basis, the monthly net operating income is $1,667 divided by $1,250 which is 1.33. This would be considered an allowable ratio. So, if the lender was confined to a 1.2 ratio or better, and wanted to see what the maximum monthly allowable loan payment is, the lender would take the $1667 monthly net operating income and divide that by 1.2 to say the maximum allowable loan payment allowed would be $1389 per month. In this example the monthly loan payment of $1,250 is perfectly acceptable.
Using a spreadsheet when considering multi-family properties before you make a deal allows you to properly estimate your annual income and expenses and then calculating these rates, ratios and numbers. This will help you make a more informed and intelligent decision when considering your alternatives before purchasing a multi-family property that needs work.
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