Understanding how to evaluate apartment buildings will save you a lot of time and potentially expensive effort! By evaluating the numbers correctly, you can determine which buildings have good cash flow and which buildings have poor cash flow QUICKLY! Understanding this process will allow you to confidently recognize poor-performing buildings and build confidence when making competitive offers on buildings that meet your criteria.
If you want to purchase an apartment building in this competitive market where multiple offers have become the norm, you must understand four values:
1. What the building is worth to you
2. What the market value is
3. What the financing value is
4. The expected Loan to Value Ratio
All these values are accumulated from one proforma and it is the input of correct data that allows you to determine a purchase value for any given building in all market conditions. Some of the key indicators a proforma will establish are the capitalization rate, loan-to-value ratio, gross rent multiplier, expense-income ratio, cash on cash return, income after debt service, debt service coverage ratio, price per unit, rent income to suite square footage, and other square foot comparisons.
Canadian Mortgage Insurance allows for very flexible and attractive financing solutions for these properties with as little as 15% down payment required; however, this doesn’t mean you will achieve this ratio so having a good understanding of what is achievable building by building will help tremendously.
It is essential to understand the Net Operating Income and apply a cap rate to a net operating income that is correct. The underlying fundamental of applying a cap rate to a net operating income is that it is presumed to be correct and will cause a variation in value every time if not.
Expense numbers must be verified during due diligence to satisfy financing so why not start with the correct numbers? You must keep in mind that for every $1,000.00 in net operating income, the value of a building is affected by $14,000.00 at a 7% cap rate and, if the cap rate is even lower the value is higher. A 3.5% cap rate changes the value by $28,000.
The formula is simple $1,000.00 / .07 = $14,285.71. So, if your net operating income is incorrect by $2,500.00 the representation of value based on a 7% cap rate is incorrect by $33,333.33. This represents a high percentage of value for a smaller building.
If a building’s net operating income has been incorrectly determined and the incorrect net operating income number is higher by $2,500.00 you have just overpaid based on this error by $33,333.33. Vice versa applies, if the net operating income is underestimated by $2,500.00 you have found $33,333,33 in potential value. Yin Yang. As above so below.
Another mistake I see regularly is not including all the expense numbers or not understanding what industry standard numbers must be included in the expenses to determine a net operating income and satisfy financing!
CMHC and lending institutions will apply their standard figures for vacancy, management, superintendent, maintenance, and other expenses unless you present a compelling case. Even if you’ve provided actual figures for these expenses, lenders may revert to their own industry-standard numbers. Adjusting these figures can significantly impact the loan-to-value ratio from the lender’s perspective and potentially yours as well. Consequently, it could alter the final down payment amount required from you as an investor. Being aware of this in advance is advantageous and aids in the decision-making process. Analyzing the numbers based on the financial institution’s methodology is just one approach among many for evaluation.
Any major improvements made in the past year should not be classified as operating expenses when calculating the net operating income. It’s essential to distinguish between capital expenditures and ongoing maintenance. Capital improvements add value to the property and should be considered separately. Including these improvements in the cash flow projections of a proforma would underestimate the building’s value, as capital improvements enhance its worth.
If you intend to handle property management and superintendent responsibilities yourself, that’s fine, but it’s crucial to understand the lending process. Different buildings and institutions may require either actual figures representing these expenses or industry-standard numbers if the actual figures are deemed unrepresentative of the industry average. This can alter various calculations, and a different net operating income will affect the outcome with lenders. Upon receiving your letter of commitment, you might find that the Loan-to-Value ratio and the expected down payment differ from what you anticipated. This discrepancy is significant for all buyers, particularly small investors.
If you are expecting to make a down payment of $250,000.00 and you are informed by the lenders (usually 30 days into the conditional period) that you now need $300,000.00 or $350,000.00 for a down payment there is a very high probability that your deal is going to fall apart and you have just wasted 30 days of critical time and you may have spent thousands of dollars out of pocket on environmental reports, other inspection reports and financing fees, some of which are non-refundable.
When assessing the value of a building, it’s crucial to understand its condition and identify any capital items needing repair or replacement. Even if the condition won’t impact value due to special circumstances, it’s vital to identify these items upfront. Your offering price should account for these items and rule out any possibility of price reduction during the due diligence period. Additionally, if you’re utilizing CMHC financing, CMHC will inspect the building, and necessary repairs may result in a holdback of funds until proof of completion is provided. This necessitates additional funds for repairs and cash to meet financing terms and conditions.
Understanding how financial institutions evaluate the income and expenses of income-producing investments is crucial, as it sets the stage for effective decision-making. Property valuation requires skepticism toward supplied numbers, often estimated, outdated, or inaccurate. Delving deeper than proforma statements, analyzing figures on a per-suite basis unveils operational efficiency. Comparing buildings becomes easier, identifying outliers with unusually high or low expenses. Additionally, an industry average for energy consumption per unit exists, based on factors like suite size and occupancy, aiding in benchmarking properties
When you start analyzing enough buildings you will be able to recognize the buildings running efficiently or inefficiently. But don’t shy away from inefficient buildings too quickly as they may represent your best opportunity for creating net worth quickly.
When evaluating a building, accurate numbers ensure straightforward valuation calculations. The cap rate, determined collectively by Sellers and Buyers, reflects perceived value in transactions and can fluctuate over time. Over the years, there has been a consistent downward trend in cap rates, surpassing even seasoned investors’ expectations. This rate is instrumental in determining value when applied to the Net Operating Income. However, it represents an actual return on investment only when purchasing a building outright with cash.
The concept of price per door serves as a fundamental metric in assessing the potential cash flow of a building. It’s a straightforward calculation that provides a rapid insight into the building’s financial viability. Let’s illustrate this with an example: Suppose you’re examining a market where, all factors being equal, buildings typically generate satisfactory cash flow when the price per door is $180,000 or less. In such a scenario, a building priced at $225,000 per door would face considerable challenges in cash flow generation. Therefore, understanding the average price per door in the specific market you’re analyzing becomes imperative. This knowledge allows you to gauge the financial feasibility of a potential investment accurately.
Let’s delve into the suite mix, which refers to the variety of apartment types and the proportion of each in the building: bachelor, one-bedroom, two-bedroom, and three-bedroom units. If there are more two-bedroom units than one-bedroom ones, the property might generate higher rent or revenue per apartment. Additionally, in different markets, certain types of units might be in higher demand due to demographic differences, making them easier to rent out Speaking with enough Sellers/Owners of buildings in any market and asking them which units are the quickest to rent is an easy and sure way of getting a handle on the suite mix that is most desirable for any given Micro Market.
Next, it’s essential to carefully consider which numbers will be included in our analysis and not solely rely on what the seller or their representative reports. This means conducting thorough due diligence to gather accurate and comprehensive data and comparing this data to CMHCs average for our number-crunching process. We should verify information such as income, expenses, occupancy rates, and any other relevant financial and operational metrics. By doing so, we can ensure that our evaluation is based on reliable and objective data, enabling us to make informed decisions about the property. The obvious ones are gross revenue minus a vacancy & bad debt giving you the effective revenue, current taxes, gas, electricity, water & sewer, insurance, superintendent, management, and maintenance.
For the taxes and utilities, you must have the current and accurate numbers representing the past twelve months (not last year) when you apply for financing. The lending institutions and CMHC want to see a snapshot of these expenses for the past twelve months current up to the month of the agreement of purchase and sale date and beyond if there is a long closing period. You may see a proforma from time to time without any numbers for superintendent, management, and maintenance. These are standard numbers the lending institutions use when analyzing a building for a loan to value and must be represented in your proforma when applying for financing.
Insurance serves as a prime example of a number provided by sellers that may not always align with our analysis. Typically, insurance premiums increase over time during each renewal period, potentially resulting in significantly higher costs after several years. It’s common for buildings to pay thousands more in insurance than a new buyer could obtain by seeking quotes. Moreover, insurance isn’t assumable, necessitating a new policy at the time of closing. Therefore, it’s prudent to begin shopping for insurance early to secure the most favorable rates. Your goal is twofold, one is making sure the numbers for utilities and other expenses are accurate and you understand the effect of increased cost over time. Second, is finding areas where an industry number may represent the building better for achieving your highest loan-to-value amount.
Once you have and feel comfortable with all the numbers the formula is as simple as dividing the net operating income by the purchase price for determining a cap rate; however, when looking at the analyses you must take into consideration the price per door, cash on cash return, return on investment, GRM and debt service ratio.
While learning the ins and outs of analyzing a building it is important to have an experienced person to reflect your calculations off, as this will save you valuable time, shorten your learning curve and potentially prevent any pitfalls.
By using this exercise, you will be able to quickly ascertain if it is worthwhile asking for a proper set of income and expenses.
Net Operating Income: Effective Gross Income – Annual Expense
Cap Rate: Net Operating Income / Purchase Price
Cash on Cash Return: (Net Operating Income / Yearly Financing) / Down Payment
Expense vs Income Ratio: Expenses / Effective Gross Income
Income After Debt Service: Net Income – Annual Financing
Debt Service Coverage Ratio: Net Operating Income / Annual Mortgage Payment
Cost Per Door: Purchase Price / Number of Door
Profit Per Door: (Operating Income – Annual Debt Service) / Number of Doors
| Asking Price | $1,150,000 |
| # of Units | 13 |
| Cost Per Door | 88,461.53 |
| Financing 80% | 920,000 |
| Gross Income | 132,600 |
| GRM | 8.67 |
| Expenses 50% | 66,300 |
| CAP Rate | 5.7 |
| NOI | 66,300 |
| Financing | 6,440 @ 7% .007 Multiplier |
| Profit after Debt | 417 |
- This straightforward exercise requires just two figures: the purchase price and the gross revenue. Remarkably, by following this simple method, you’re likely to arrive at a more accurate valuation for the building than those represented with erroneous figures. With utilities costs escalating and the need to report expenses for financing purposes, most buildings tend to hover around a 50% income/expense ratio, give or take. Larger buildings with recent retrofits might even boast a lower ratio, around 25 or 35%. Regardless, this initial assessment offers a quick gauge to decide if further analysis is warranted. Understanding the asking price and correct gross revenue unveils crucial insights. These ratios serve as early warning signs during the evaluation process.
- In this scenario, four key indicators emerge: cost per door, gross rent multiplier (GRM), cap rate, and profit after debt. While the price per door seems straightforward, its implications are multifaceted and merit close examination. Buildings with prices per door above the local average may struggle with cash flow, while those below present opportunities for improvement.
- The Gross Rent Multiplier, easily calculated, complements the Cap Rate, especially when juxtaposed. Cap rates are based on NOI, or Net Operating Income, as a ratio against property value or price, compared to the gross scheduled income that is used in the GRM.
- Comparatively, the significance of the Cap Rate becomes more apparent when it’s contrasted with the Gross Rent Multiplier (GRM). When they are nearly equal, it indicates a balance or equilibrium between the expenses and income.
- Ultimately, real estate is a business, and setting realistic expectations for your business’s return is paramount.
Calculations:
Cost Per Door Asking/Number of Units
Annual Gross Revenue Supplied
GRM Asking Price/Annual Income
Expenses Rule of thumb 50% of rent
CAP NOI/Asking Price
NOI Annual Revenue/Asking Price
Financing Here is a tip if you don’t know what the multiplier is for financing use .007 (James Bond). 007 is the multiply for 7%.
Profit after Debt NOI – Financing