Multifamily property investing is the preferred investment strategy for those investors who want an additional source of monthly income along with slow but steady appreciation in the value of their portfolio.
- A multi-family property can multiply your income with only incremental added cost
- Multi-family are typically easier to finance, compound returns more quickly, and benefits from economies of scale
Multifamily Investor Returns
One of the first questions from potential investors interested in learning about commercial multifamily investment opportunities is: How do I make money on the deals? In short, there are 3 core areas that make up total investor returns: Cash on Cash Return, Appreciation and Principal Pay Down. In addition, the unique tax and estate planning benefits that commercial multifamily investing can provide is important to understand.
What is Cash on Cash Return?
The simplest way to describe cash on cash return (CoC return) is that it’s a return on investment metric. It is mainly used by real estate investors who are looking to buy investment properties to rent out. The cash on cash return calculation reveals the rate of return you should expect an income property to produce in relation to the amount of money you invest. So, in order to make it easier for you, here’s the cash on cash return formula:
Cash on Cash Return = (Annual Pre-tax Cash Flow / Total Cash Invested)
Note here that we said the cash invested. It means that it only includes any amount of money you paid from your pockets. It includes the down payment (if you financed the rental property with a mortgage), the closing costs, in addition to any other costs you paid for in cash like renovation costs, for example.
As for the annual cash flow the income property produces (except for taxes), it is typically referred to as the Net Operating Income. And, in case you don’t know how to calculate cash flow, you deduct the monthly rental expenses from the monthly rental income. To turn it into NOI, you multiply the number by 12 months. With a multi family investment, you need to multiply the cash flow by the number of units and then multiply the result by 12.
For example, let’s assume you receive a distribution of $20K and you invested $200K in the property, then your cash-on-cash return is 10%:
If you invested in a value-add deal, the cash-on-cash return may be lower the first year as the sponsors work to implement their business plan and get tenants in the units. In year 2 however, thing should begin to stabilize, meaning occupancy increased and rents have gone up to market value.
A good cash on cash return is different from one location to another. Moreover, it is also different for each real estate investor. In general, an average of 8-12% is considered a reasonable rate for CoC return.
For some investors, good is not what they’re looking for. Instead, if it’s not a high CoC rate, they won’t even bother looking at the investment property.
What is Appreciation?
Unlike residential real estate, which is based on the sales comparison approach model, commercial multifamily assets are valued based on the income they produce. All else being equal, if an asset’s net income increases over a given period of time, it is going to be worth more money. To provide a basic example let’s consider the following: An apartment complex brings in $500K in annual NOI (Net Operating Income) Year 1. 4 Years later this same property brings in $700K in annual NOI. If the cap rate for the submarket is 7.0, then the property has increased in value by nearly $3 million in just 3 years!
Year 1: $500,000/7%= $7,142,857
Year 4: $700,000/7%= $10,000,000
Appreciation from Year 1 to Year 4 = $2,857,142
What is a Principal Pay Down?
Most investors have personal experience owning a home at some point. A commercial multifamily loan is very similar to a home loan in that the monthly payment is broken down into 2 parts: principal and interest. As time goes on the portion of the monthly payment that is applied to the principal increases while the interest portion decreases. The big difference for the investor vs. the home owner, is that the renters in your apartment complex are making the monthly payments for you. Each principal dollar that is paid down increases your equity in the property.
You don’t have to be a real estate expert to know that over long enough periods of time both prices and rents go up (excluding markets where prices are artificially inflated by bubble conditions and rents are controlled). Even under the most conservative of appreciation assumptions (I.e. inflation rate), the investor that controls the highest asset value reaps the largest benefits on both the income and net worth front.
For more information or to begin investing in multifamily properties, contact the experts @ MarketSpace Capital.