Multi-family Homes, Investments and 5th Grade Math
Have you ever dreamed of owning a multi-family house? Perhaps you want a charming old Victorian in the center of town, where you could live in one unit and rent out the other one or two? Or perhaps a larger building, of 10 or 20 units for example, to run as a commercial rental property?
Each type of investment can be a dream come true…if you do your homework and make sound decisions. A Realtor who is experienced with multi-family purchases as well as rentals can help you to identify comparable homes or buildings, estimate the potential rent income, and determine a fair purchase price. Your goal should be to maximize your monthly cash flow while finding a house that works for you.
There are two proven ways to estimate the fair value of a rental property: Gross Rent Multiplier or GRM and Capitalization Rate or Cap Rate. We will introduce the concepts of each here, and your Realtor can help you through the detailed analysis.
Gross Rent Multiplier
When a residential property has 4 or fewer units, buyers typically use a Gross Rent Multiplier (GRM) to identify properties, and then use a CAP rate to get to brass tacks.
GRM = purchase price divided by the monthly rent income
GRM represents the number of months’ rent it would take to pay for the house if you were paying cash up front…the lower the GRM, the better. This is an oversimplification, of course, but GRM can help you determine which house out of several comparables might make sense for you to purchase, or what the target price would be for a potential purchase.
Let’s look at four 3-family houses in the same town; it’s important to select comparable properties that have SOLD in the past 6 months, not current list prices. These 4 homes all have 3 units, and the potential buyer intends to live in one of the units. She wants to estimate a fair purchase price for House E.
A key element in the GRM calculation is your estimate of monthly rent income. Here again, it is important to use actual RENTED unit data, not current list prices. Note that Houses C and D have the same layout of rooms and baths, but in House C the owner lives in a 2 bedroom unit while in House D the owner chose to live in a 1 bedroom unit. This choice significantly affected the rental income and the GRM for these two houses.
Once you calculate GRM for your 4 comparables, you take an average of the 4. This average GRM is used to estimate a price or value for House E. In this Table, the average GRM is 153.25.
We multiply this times the estimated monthly rent of $3200 and arrive at fair purchase price of $490,400,which you and your Realtor can use to guide your negotiations with the seller.
*Note* that GRM does not reflect any operating expense, property taxes, or management costs; to include those elements in your analysis you would want to calculate a Capitalization Rate (Cap Rate), which is an expression of Return on Investment for rental properties.
Capitalization Rate, CAP Rate or Simply CAP
When the rental property has 5 or more units, it is considered a commercial property. As a potential investor, you should compare the return on investment or ROI with the return you could get by investing in something else, such as the stock market. In commercial real estate, the most commonly used calculation for ROI is called the Capitalization Rate or Cap Rate.
CAP Rate = Net Operating Income divided by the Property Asset Value
For example, if you buy a rental property for $1,000,000 and generate an annual Net Operating Income of $100,000, then your Cap Rate would be 10%.
To arrive at Net Operating Income, you will need data on recent or projected Gross Rent Income and vacancy rate (to estimate your Net Income), as well as Operating Expenses such as property taxes, insurance, utilities, maintenance, management fees, etc.
Note that mortgage principal and interest are not considered operating expenses; they are debt service, and they get subtracted from NOI to determine Net Cash Flow. Your Realtor can help you build up this data from similar properties, and also help you to estimate the rents you could charge by making cosmetic improvements to the rental units.
Net Operating Income = Net Income – Operating Expenses In essence, your NOI is the cash generated by the property, which you would use to pay your mortgage, fund capital improvements, and give yourself some Net Cash Flow! Remember…Net Cash Flow is the most important calculation!
Net Cash Flow = NOI – Debt Service – Capital Improvements
To estimate a fair purchase price for a rental building, you would first estimate the Net Operating Income the building could generate and divide that by your target Cap Rate. For example, if a building could generate NOI of $85,000/year and you are looking for a Cap Rate of 10%, then your target purchase price would be $850,000.
Purchase Price = NOI divided by Cap Rate
The most important guideline here is that you should rely on an experienced Realtor to help you through your analysis and negotiation process.
Article written by Jason Kinard