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If you’re like most real estate investors, you probably receive deal packages from real estate syndicators, also known as sponsors, on a regular basis. Often, these packages contain executive summaries that position the deals as excellent investment opportunities. This should come as no surprise, as the job of the real estate sponsor is to screen out the bad and average deals and only focus on deals that present true opportunity.
In most cases sponsors do not exaggerate, but rather, they’re just giving you the good points of their property. The due diligence is up to you, the investor, to determine whether what they’re telling you is accurate. The key, of course, is to know how to perform the due diligence so you have a true and accurate reading on what’s being offered. It’s important to understand the key metrics to always look at for any real estate investment, and the one metric that I see the majority of investors miss.
Measuring Potential Of Multifamily Investment Properties
When you look at the potential of a multifamily property, you’re really looking at how much income or profit it is generating for its owners. What should you be evaluating to determine that? Start with all the basic purchase information, like the price and any additional costs involved in renovating or repairs that need to be done.
According to Multifamily Executive magazine, you should also look at factors that might make you pass on the deal, like the condition of area schools, surrounding job market, property taxes and the age of the property. These are often deal-breakers if they reveal too much potential risk.
The loan is another key metric: What type of loan will you have to finance the property? This will spell out the loan totals, down payment, interest rate, closing costs and other fees. Make sure you are comfortable with the loan structure (fixed versus floating rate, long-term versus short-term, etc.). You should also receive a detailed expense report on the property, including property taxes, insurance, maintenance costs, property management costs and others.
The most important document on a multifamily property is the detailed income information. This will include itemized listings of rent payments, current vacancy rates and more. When looking at income, look at net operating income (NOI) without taking into account debt payments. That way, you’re looking at the property’s income independent of a particular buyer’s financing structure.
One caveat for investors is to ask for actual data and numbers in addition to pro forma data. Obviously, the seller or deal sponsor wants to make the numbers look their best, so they often resort to a pro forma, or estimate, of income and expenses. Prior to agreeing to any deal, get actual numbers from the sponsor.
Capitalization Rate (Cap Rate)
If there’s a single number that’s important when looking at a property purchase, it’s the cap rate. The cap rate is a return on investment value that’s independent of the financing information. It’s calculated by the following formula: Cap rate = NOI/property price. It’s the most “real” indicator of the amount of return a property will produce.
People often ask what a “good” cap rate would be. There’s no universal answer, and it depends on a variety of factors, but in general the current national cap rate is above 5%. Always compare cap rates on comparable multifamily investment properties in the area to see where your cap rate falls.
Exit Cap
The exit cap is a single number that the vast majority of investors forget to look at. Nevertheless, exit cap is one of the key factors in any underwriting that can significantly impact returns and can make the difference between an investment that fails and one that succeeds.
So what’s an exit cap? Exit cap is the cap rate that the sponsor anticipates the property will be sold for. It’s the ratio between the anticipated price of the property you invest in today and the property’s NOI at time of the future sale. The main challenge with exit cap is that it’s really hard to predict; there’s no guarantee that this number will be achieved, because nobody can predict what a property’s value will be in the future. However, the exit cap the sponsors use when they calculate the returns on any investments significantly affect the returns. Even the slightest change in exit cap can make or break a deal.
Despite the uncertainty, an investor should always ask the deal’s sponsor for the cap rate that the property was bought at, along with the anticipated exit cap. Once you have those numbers, see if the gap between the two is a reasonable one. A higher exit cap means lower real estate prices and a worse real estate market. Be conservative in the numbers. As a very conservative real estate investor and sponsor, I always assume that when I’ll want to sell the property, the real estate market will be worse than it is now, regardless of where we are in the cycle. Hence, I always assume an exit cap that’s 0.5% to 1% higher than the cap rate at purchase, depending on the strength of the market. If you use conservative assumptions and the deal still works, then you’re looking at a really great deal.
Summary
Scrutinize every deal that you’re presented with using as many real numbers as possible. Make sure you analyze the income information, as this is the most important metric in multifamily investment property deals. Be sure you look at the exit cap with a very conservative eye to see if you’re really looking at a potentially good deal. This is key to make sure you are successful as a real estate investor.