I’ve looked at several multi-family buildings over the past 12 months. Most of them are bad deals. I’m surprised by the number of poorly kept buildings. I’m more surprised by the greed I see in the marketplace: unnecessarily high prices on buildings that I would otherwise be interested in purchasing.
To make money, you have to be a disciplined investor. That’s why I’ve only made one offer and one purchase in the past 12 months. I want good deals.
The good multi-family buildings make good money – free cash flow – and that’s why they don’t come up for sale often. The current owner is making money.
I don’t know who to quote here, but someone said about real estate that the money is made in the purchase, not the sale. It has to be a good deal today. If it’s not a good deal today, it probably won’t be a good deal tomorrow. It’s the same strategy Warren Buffet takes: buy at a discount and hold.
Here’s the criteria I use to decide whether a multi-family property is a good deal:
- The property must produce free cash flow after everything is paid for. Everything includes all expenses (electricity, water, natural gas, landscaping/snow plowing, insurance, property taxes, maintenance, …) plus the mortgage.
- The property must be turn-key: no large upfront investments required (no new furnace needed, no new roof in the next 10 years, no significant cash outlays for improvements, …) and no significant historical vacancies. This relates to the first point: I want cash flow from day one.
- Location must be good: close to work and shopping. This helps minimize vacancies and turnover.
- Rents must be accessible to the mid-market: no luxury buildings. I want an influx of renters to choose from.
- The building should have mostly two-bedroom units: this allows for couples and roommates who benefit from cheap rent but like a nicer unit than they could otherwise afford on their own.
And that’s really it. Let’s get into a specific deal.
Here’s a deal I like. The building is an all-brick 6-plex, build in 1992. At 3,500 square feet it stands 3 floors tall and has five 2-bedroom units and one 1-bedroom unit. Each unit is about 520 square feet. There’s enough parking for 6 cars. It would be nice to have more parking, but it’s not a must-have.
This building can be purchased for $675,000 at a 6.4% CAP rate. A 20% downpayment of $135,000 plus taxes and other fees (lawyer, inspection, appraisal, …) requires an initial investment of just under $150,000 to close the deal.
Here’s what the rents look like today: Unit 1 (1 bed): $730; Unit 2 (2 bed): $900; Unit 3 (2 bed): $900; Unit 4 (2 bed): $850; Unit 5 (2 bed): $900; and Unit 6 (2 bed): $814.
Coin operated laundry generates an average of $120 per month, totalling $1,440 per year.
Using a historical 2.75% vacancy rate (over the trailing 24 months, about 2 months of vacancy per year), the total revenue generated by this building is $62,658 x 0.9725 = $60,848 per year.
This building is heated by electricity, which means electricity and water are the only two utility services needed. Tenants pay to heat their own units. Otherwise, electricity and water come to $5,300 per year, insurance is $2,500 per year, property taxes are $6,120 per year and all other miscellaneous expense come to about $3,600 per year (snow plowing, repairs, maintenance, etc…). Expenses total $17,520 per year.
The net operating income (NOI) is a simple calculation: revenue minus expenses. So, $60,848 per year – $17,520 per year = $43,328 per year. That means, if the building were purchased with cash (no mortgage), the investor would make $43,328 per year. That’s a CAP rate of $43,328 / $675,000 = 6.4%.
Return on Cash
When I looked at this deal, you could mortgage the $540,000 over 25 years at 2.54% on a 5-year term. This translates to a monthly payment of $2,429.79, or $29,158 annually.
Doing the math, the computed net cashflow is = $43,328 – $29,158 = $14,170 per year.
The cash on cash return on investment is $14,170 / $150,000 = 9.4% per annum.
Keep in mind interest rates change, which this will affect the return on cash calculation. If interest rates increase significantly, this building might not be such a great deal at a price of $675,000. It all needs to get factored in. But as long as you’re above an 8% cash on cash return and it meets the above criteria, then the deal is probably worth buying.
Total Return on Investment
Considering the equity built from paying the mortgage — paid by the tenants — which increases year after year, we’re looking at increasing equity position every year. In the first year, it’s $15,694.42.
Altogether, the total money generated by this building in year one is $14,170 + $15,694.42 = $30,134.42, which yields an overall return on investment of $30,134.42 / $150,000 = 20% in the first year.
At this rate, the initial investment of $150,000 doubles in 5 years.
This is a good deal. In general, if a building meets the criteria mentioned above and generates at least 8% cash on cash, then I’d say the building is worth buying.
But what’s the long-term return on investment with this multi-family property?
Well, we can simplify this investment by looking at it as an annuity where the present value (initial investment) is $150,000 and the monthly payment we receive is $1,180.83 ($14,170 per year in free cash flow).
The next question becomes: what is the future value of this annuity? After 25 years, let’s assume the property sells for a 50% gain, which is conservative considering 25 years would have passed. That means a future value of $675,000 x 1.5 = 1,012,500. Computing the return over 300 periods (25 years x 12 payments per year), I calculate 13.53% per annum compounded annually. And this doesn’t include reinvesting the free cash flow!
If the building doubled in value, the return would be 14.34%.
Where else can you get anywhere from 13.53% to 14.34% per year, compounded annually, for 25 years?
I know what you’re thinking: great return, but real estate takes work. Of course there are other pros and cons to owning real estate. The cons include the work it takes to show the units to possible tenants plus time spent renovating, cleaning and upgrading. But the pros outweigh the cons. The pros include tax benefits in the form of depreciation and write-offs. The property will likely appreciate in value. You can reinvest the free cashflow, further increasing your gains. You can re-finance the mortgage and purchase more properties, increasing your gains further.
All things considered, there’s no question multi-family real estate is one of the best investments you can make.
Are you thinking of investing in multi-family real estate? Send me the deal and I’ll let you know what I think of it!