What are multifamily properties and why should I invest in them?
Multifamily properties are any property that has more than one housing unit. Examples of multifamily properties include apartment buildings, duplexes, townhouses, and condo buildings.
There are many benefits when investing in multifamily real estate. First, multifamily real estate provides the opportunity to earn more cash flow than if you were to invest in a single-family home. For example, collecting rent from 30 tenants in an apartment building would provide more cash flow than collecting rent from one tenant in a single-family home. Additionally, there are many tax advantages to investing in multifamily real estate. Lastly, investing in multifamily properties provides you the opportunity to scale your business at a faster rate.
Calculating the cap rate
What is the Cap Rate and why is it important?
The capitalization rate is a popular measure to assess a real estate investment property’s return potential. The cap rate assumes the property is purchased using cash, and therefore shows a property’s intrinsic rate of return.
Simply put, the cap rate measures a property’s ability to produce income. The higher the cap rate, the better the return on investment.
How to calculate the cap rate?
The cap rate is a ratio of income compared to the purchase price, or value, of a property. The cap rate can be calculated using the following formula:
Cap Rate = Net Operating Income (NOI) / Total Purchase Price
Calculating the NOI
The NOI tells an investor how much money they can expect to make from a rental property at a high level. It’s also a metric used in many other equations when analyzing a potential rental property deal.
The NOI can be calculated by using the following formula:
Net Operating Income (NOI) = Total Income - Total Operating Expenses
To find the total income, you should consider two factors:
- Total annual rental income
- Total additional fees
To calculate the total annual rental income, multiply the monthly rent price by 12. If you’re unsure of what the rent price of the property is, a good starting place to get market rent data is Rentometer. Rentometer is the best way to get rental comp data in the U.S.
You also want to include in your total income any additional fees that you collect throughout the year. Some examples are pet fees, coin-operated laundry machines, parking, etc.
Now, it’s time to calculate your operating expenses. Any costs that are directly associated with the operation of your rental property are considered an operating expense. It’s important to note that operating expenses do not include your mortgage payment. Below is a general breakdown of what operating expenses to include in your NOI calculation:
- Vacancy (5-10% of rent)
- Taxes (City and county)
- Insurance (Talk to an insurance broker)
- Maintenance (3-5%)
- Management fees (Ask local property management companies for going rates)
- Utilities (Call utility companies for rates)
- Repairs (3-5%)
- Professional fees
Calculating the Cap Rate
Once you’ve determined the NOI, you can now calculate the cap rate of the property. Take the NOI and divide it by the all-in total Purchase Price of the property to determine the cap rate. Let’s walk through an example together.
Example of Calculating the Cap Rate during Rental Property Analysis
Jeff is looking to add another multifamily unit to his rental property portfolio. He’s currently narrowed his selection down to two properties, both are duplexes. Jeff also has a goal in place to purchase a property that has at least an 8% cap rate.
The two properties he’s considering are very similar, each is a duplex with 2 beds and 1 bath. They are, however, in different parts of town, and therefore their projected rents and purchase prices differ.
Property #1:
NOI
To determine the market rent in the area, Jeff uses Rentometer to get an idea of what the property could rent for. After running a neighborhood search for 2-bedroom, 1-bathroom properties, he finds that the average rent for 1 unit of the duplex would be $1,074. Based on market rent, Jeff is able to collect $2,148 in rent each month (since there are 2 units in the duplex, he multiplied $1,074 by 2). The annual gross rent for this property would be $25,776 ($2,148 x 12 months).
Jeff estimates that total operating expenses for the year will amount to $15,000. Therefore, his NOI is $10,776.
NOI ($10,776) = Total Income ($25,776) - Total Operating Expenses ($15,000)
Cap Rate
The purchase price for this property is $130,000. Therefore, the Cap Rate for Property #1 would be as follows:
Cap Rate = NOI ($10,776) / Purchase Price ($130,000) = 8.29%
Let’s evaluate Property #2 and see how the cap rates compare.
Property #2:
NOI
Jeff heads back to the Rentometer website to get an idea of what the second property could rent for. He finds that the average rent for 1 unit of the second duplex would be $1,273. Based on market rent, Jeff is able to collect $2,546 in rent each month (since there are 2 units in the duplex, he multiplied $1,273 by 2). The annual gross rent for this property would be $30,552 ($2,546 x 12 months).
Jeff estimates that total operating expenses for the year will amount to $18,000. Therefore, his NOI is $12,552.
NOI ($12,552) = Total Income ($30,552) - Total Operating Expenses ($18,000)
Cap Rate
The purchase price for this property is $270,000. Therefore, the Cap Rate for Property #2 would be as follows:
Cap Rate = NOI ($12,552) / Purchase Price ($270,000) = 4.65%
The Final Decision
Jeff makes his decision and decides to move forward with investing in Property #1 because it met his cap rate goal of 8%.
Conclusion
The Cap Rate is an important measurement to use when analyzing properties to invest in. It determines whether a property could produce net income and whether it represents an adequate investment based on your required investment criteria.
This article was written by the Rentometer Content Team. The Rentometer Blog features fresh takes and insights on rental housing topics, services, and technology.