How to Evaluate Multifamily Real Estate Return Potential
In a perfect world, math homework would stop once you’ve got your diploma in hand. Unfortunately, your 6th-grade teacher was right when she said, “you’ll be doing math for the rest of your life so you might as well pay attention.” Investing in multifamily real estate is no exception.
In fact, it’s the rule.
Being able to calculate your return on investment when jumping into income property could be the difference between financial ruin and financial freedom, and knowing these few key calculations will go a long way in saving you from a bad situation.
Net Operating Income (NOI)
Net Operating Income is all revenue from a property, minus it’s operating expenses. Simple enough, right? Money coming in minus money going out. In equation form:
Net Operating Income = Real Estate Revenue (RR) – Operating Expenses (OE)
For example, if every unit in a 30-unit building is occupied and the monthly rent for each unit is $2,000, your revenue for a month (30 units x $2,000) is $60,000. Since you’re a very generous landlord, let’s say you cover some utilities for your tenants in addition to paying a property manager to handle any issues that arise. Once we also account for repairs and improvements, let’s say the operating expenses come to $10,000 a month. So…
RR ($60,000) – OE ($10,000) = NOI ($50,000)
$50,000 a month in your pocket. Sounds like a great deal so far. But we’re not done.
Cap Rate
Your Capitalization Rate, or cap rate, is typically represented as a percentage and indicates the rate of return you can expect on your multifamily real estate property. The bad news is we have another equation to deal with. The good news is we already figured out part of it above.
Capitalization Rate = NOI / Current Market Value
There are some other versions of this formula, but using current market value tends to yield the most realistic results. Going back to our previous example, let’s say even though your slick negotiating skills were deployed to perfection and you were able to nab this 30-unit complex for an even $1 million, current market conditions place its value at $1.2 million.
NOI ($50,000) / Current Market Value ($1,200,000) = Cap Rate (0.04167 or about 4%)
Now you have a hard number to work with. It’s entirely possible you could invest that $1 million and do better than a 4% rate of return elsewhere, sure, but you could also adjust your tenant’s rent in order to increase your cap rate. The devil is most certainly in the details.
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Debt-Service Coverage Ratio (DSCR)
DSCR is all about cash flow. If you are trying to attract investors or looking to become one yourself by joining an individual or organization, this formula will show whether that individual or organization will have enough income to pay its debts.
DSCR = NOI / Total Debt Service
And yes, there’s NOI again! Now we just need to figure out yet another acronym. TDS, or Total Debt Service, can be figured by simply knowing the mortgage payment on our 30-unit complex and any other debt outstanding. For our example, let’s say our principle and interest comes out to a mere $5,000 on the complex, but a series of bad decisions made before knowing these helpful calculations ran us into a hole to the tune of $46,250 a month. That brings our TDS to $51,250.
NOI ($50,000) / TDS ($51,250) = DSCR (.976 or 97.6%)
A DSCR score of 97.6% means the NOI will only cover 97.6% of the debt incurred, hence, someone will have to dig that 2.4% out of pocket to keep things even. It’s a fair bet you’ll have trouble attracting investors.
Risk-Adjusted Return
Risk-Adjusted Return will help figure your ROI while taking into account the risk associated with your investment. There are several different formulas you can use and each one is slightly more mind-boggling than the last. And since we don’t have enough acronyms, Internal Rate of Return (IRR) estimates the profitability of an investment. If you can figure it out on your own, you should consider freezing your grey matter in the name of science.
Homework is Key
The success of a multifamily real estate investment is dependent on far more than just the purchase price. Having these calculations will help you fine-tune your expectations and put you in a much better position than those folks who aren’t doing their homework.