Multifamily analysis is a different beast than investing in single family homes. The analysis is easier in some ways, but more difficult in others. In this post I’m going to cover how I run a quick multifamily investment analysis. I mostly focus on 5+ door properties or portfolios.
The Difference in Multifamily Analysis
When you invest in single family homes you’re probably not going to get detailed financials from the previous homeowner. It is possible, but often the previous owner just lived there. Even if it was a rental unit, the financial records may not be quite up to par. Multifamily is different. Here you are evaluating the cash flows of a business along with the potential for the property.
Loans are also more complicated. It is quite easy to head to bankrate.com to get the latest mortgage rates. You can even do a conventional loan on multifamily with up to 4 doors. With 5+ doors or with multiple properties under one loan you will be looking for a commercial loan. You can check out a website like commloan.com for a ballpark.
In some ways, there tends to be a lot more information to help you evaluate the potential profitability of a deal. However, there is more legwork and know-how required to get into the larger multifamily game.
Multifamily Loans
For homes with less than four doors (duplexes or quadplexes), you can actually get a conventional loan. You can even get an FHA loan if you live in one of the units yourself. You’ll be dealing with a commercial loan for larger properties or portfolios of single or multifamily homes.
When you’re putting several properties under one loan, it’s called a “blanket loan.” There are not government programs covering these types of loans, so you’ll likely be dealing directly with a bank. Make sure to shop around. Building a relationship and being known as a trustworthy investor can make a difference here.
For larger multifamily homes it is possible to get an FHA loan, but you’ll probably be looking at a commercial loan. If you can get an FHA guarantee it comes with better long term rates and some strings attached. Look up HUD 207/223(f) for more information.
Compared to single family: expect the rates to be higher, the term to be shorter, and the process to be a lot more like evaluating a business than the value of a single home.
Starting Your Multifamily Analysis
Here we’re not going to dive deep into due diligence (though don’t forget to do it later). Instead, we will take a look at a quicker evaluation of the numbers. The first thing you need to do is to get some numbers to work with! Typically once you find a deal (try Loopnet) you will need to reach out to the selling agent for financials.
Take a quick look at the financials to see if anything looks off. They will also typically provide what is called a “pro forma.” This is an estimate of what they think the property can achieve in the future. It is almost always higher than the historical financials would indicate thanks to increasing rent or the theoretical gains from investing a bit more capital to spruce the place up. I mostly ignore the pro forma in order to build my own.
You will initially see cap rates comparing all of the properties you’re looking through. For a primer on cap rates and basic analysis, check out this post. You’re going to find lower cap rates on Class A nice buildings and probably higher as you get into Class C. Remember, risk and return are related! Once you find a few properties you like, it’s time to start digging into the numbers.
Adjusting the Financials to Find Your Cap Rate
The seller may provide you with a nice looking pro-forma cap rate, but rarely do they meet reality. It’s your job to identify a realistic cap rate and apply costs from your financing choices to calculate your cash on cash return. We’re going to assume for now that the financials they gave you are correct. As part of your due diligence later you will need to verify these numbers.
On the financials, you will see some pretty basic main categories that break down into revenue and expenses. What I do for my quick analysis is take the most recent 12 months financials and ask the question “What if I were managing it and had bought it for the list price?”
Here are some adjustments that you will need to make.
Get Rid of Anything Weird
If there are some unusual one-time revenues or expenses, you will want to kick them out to normalize the expectation moving forward. This could be major renovations, legal settlements, insurance claims, etc.
You will also want to eliminate any non cash items that they may be putting on the books. For example, if they’re showing you depreciation and tax savings to boost your after tax returns, that’s nice but will be different for you. Take it out for now and if desired evaluate this in a later step.
Eliminate Financing Costs, Then Put Them Back
You’re going to have your own loan costs. The loan payments for the previous owner are not relevant to the multifamily analysis that you need to put together. I like to remove any financing payments from the financials and add them back off the income statement as it will help you easily update your financing assumptions. It will also help keep the calculation for Cap Rate and CoC separate.
Management Fees
Did they pay a management fee to a property manager? Will you? As an investor with a full time job doing “not real estate,” I absolutely will. Remember, we’re talking multifamily so there are going to be, well, multiple doors for you to take care of.
If the seller uses a property manager and you intend to keep them in place, it is probably reasonable to leave the numbers as is. Make sure to add some management fees into your assumptions if you’re going to use a manager and the seller doesn’t. If the seller’s management fee doesn’t make any sense or is well below market, just delete it and estimate your own. Depending on the property, anywhere from 4-10% of rent is probably reasonable.
Taxes
For whatever reason, this seems to be one that just isn’t ever correctly captured in sellers’ pro forma financial estimates. It’s a bit silly since the tax rate for an investment property is easy to calculate in most cases. There probably aren’t going to be any tax exemptions relative to what the previous owner was getting when you’re talking about a multifamily investment property.
I often see the pro forma just include some sort of percentage increase from the previous year’s taxes. This is just lazy. Your tax assessment will be adjusted based on your sale price, and for now the asking price is a pretty easy plug for the future tax assessment. Don’t worry about the sale date, just apply your expected tax burden to the historical financials to see what it would have looked like at your expected tax cost.
Calculating tax estimates can be a bit more difficult if it’s a portfolio of properties rather than one building, but with a simple Excel or Google Spreadsheet, you can tackle it pretty quickly. Find the current tax assessment for each property and their tax rate. Sum up the assessed values to get a total. For each property, compute a percentage of that property’s assessed value relative to the sum of assessed values. Now multiply that percentage by the asking price (or your estimated price) to get an after-purchase estimated assessment. You can multiply that estimated assessment by each property’s tax rate and sum it up to find your new tax burden.
Wrapping Up Your Preliminary Multifamily Analysis
Now that you’ve made most of the necessary adjustments to your financials, you should have a solid rough estimate of the historical cap rate using your assumptions. How does it look compared to the current cap rate? If it went up and there were no weird expenses on the previous financials, go back and double check your numbers. The cap rate really should go down due especially to the adjustment in taxes.
You can now also play with different financing structures to evaluate your cash on cash return. If these all look reasonable it may be time to take it to the next steps and start your due diligence.
I hope this post has helped you get started down the path of analyzing your next deal!
