Multifamily Investing Part 2
In the previous post in this series, Multifamily Investing Part 1, I introduced multifamily investing as an asset class. We discussed demand drivers, class types, and risk profiles of multifamily housing. In another post, I presented a multifamily deal I personally invested in- see here. In this post, we’ll look at the profit centers and how sponsors and passive investors generate returns.
There are several ways for investors to profit from multifamily investments (and in commercial real estate in general). This post will focus on two.
Cash flow and appreciation.
There are other profit centers of real estate, including depreciation, amortization (principal pay down), and inflation hedge, but for the sake of discussion, we will leave these out of the current post.
A multifamily property generates revenue income through rents paid by the tenant. Just like single family rentals, a tenant signs a lease with terms ranging from one month to two years or more. Each month, the tenant pays rent to live in the apartment unit. Cash flow is the difference between the revenue and the property’s expenses, fees, and debt service. In a typical syndication deal, positive cash flow goes to the investor and is distributed quarterly. Cash flow may fluctuate throughout the hold period; in the early years of a value add deal, while the property is being repositioned, there may be little to no cash flow. As the property becomes stabilized, cash flow increases.
Cash flow is estimated in the proforma and is not guaranteed. The monthly rental rate is established based on the competitive set, or what other similar units charge in the neighboring community. As far as expenses, there are variable and fixed expenses. Variable expenses include administrative, contract services, marketing, payroll, repairs, turnover, utilities, management fees. Fixed expenses include insurance and taxes. Cash flow is also dependent on debt service, which is the monthly loan payment of the underlying senior debt. Depending on the debt structure, the payments can be interest only for the first couple of years, then interest plus principal in the later years. If there is insufficient income generated from the investment, the sponsor may not be able to distribute targeted cash flow to its investors. It’s important to know that the sponsor does not have an obligation to distribute cash flow.
At the project level, the metric Cash-on-cash (COC) is the percent that the property generates in cash return over the year.
Cash-on-cash = amount pre-tax cash flow / Total actual cash invested x 100%
As an example, a building may cost $5 million and generate $300k annual cash flow after expenses and debt service. If the building was an all cash purchase with no debt (unlevered), the projected annual cash-on-cash return is 300,000 / 5,000,000 = 6%
Now, if the same building was purchased with 50% leverage, the cash outlay is $2,500,000. Debt service is say $100k a year. The cash flow each year would be 300k-100k=200k
The cash-on-cash would be 200,000 / 2,500,000 = 8%. Leverage can increase cash-on-cash return. Note cash-on-cash return is a different metric than the internal rate of return (IRR) which takes into account the time value of money.
The value of a multifamily building is based on the income it generates. This is different than a single family home where value is based more on comps. In other words, a single family home rental income does not determine the price of the home. It’s worth what others are willing to pay for it. On the other hand, an apartment building’s price is highly dependent on the income it generates. First, a few definitions.
NOI (Net Operating Income) is defined as the difference between gross revenue (rents) and operating expenses but before debt service.
NOI = Gross Revenue – Operating expenses
NOI is sensitive to three factors:
- Occupancy- Increasing the buildings occupancy increases gross revenue.
- Rental rates- Increasing a unit’s rental rate increases gross revenue.
- Operating Expenses- Decreasing expenses lowers the operating expenses side of the equation.
CAP Rate: The CAP rate can be thought of as a rate of return for an investment. It is defined by this formula:
CAP rate = NOI / Price
CAP rates are based on market demand, class of property and geographic location. For example, a class B apartment building may have a CAP rate of 7 in one neighborhood, but a similar class apartment may have a CAP of rate of 5 in a different city. There other factors that can influence a CAP rate which is beyond the scope of this article
CAP rate = NOI / Price
Flipping things around,
Price = NOI / CAP rate
If we know the NOI and the existing CAP rate for similar nearby properties, we can calculate the price. Increasing the NOI directly increases the value of the property. This is the reason investors try to add value – by increasing net operating income.
Value Add (Forced Appreciation):
Value add is just precisely that- Adding value to a building to increase the NOI. This is also known as ‘forced appreciation’ and is a very important concept.
Examples of value add that increase the NOI include;
- Decreasing vacancy and raising existing under-market rents to current market value. A previously poorly managed property may have significant upside simply by filling up empty units and raising rents.
- Property improvement. The sponsor will spend money (termed capital expenditure) to remodel or upgrade interior and exterior features. These include kitchens, bathrooms, flooring, common areas, landscaping, pool, and then charge higher rents, boosting the NOI.
- Adding a laundry room with coin operated machines
- Adding paid parking or storage.
Examples of decreasing operating expenses:
- Changing property managers
- Separate utility metering
- Switching vendors for landscaping and sanitation.
Let’s go over an example of how increasing NOI translates to an increase in multifamily property value. I know this is overly simplistic, but this is only for teaching purposes.
In a 100 unit multifamily building, if you increase each unit’s rent by $20/month, that results in a $24,000 increase in revenue per year. (20 x 100 x 12).
At a CAP rate of 6, the property value increases by $400,000. (24,000 / 0.06).
If you increase rent by $100/month, that equates to $120,000 increase in revenue per year (100 x 100 x 12)
At a CAP rate of 6, the property value increases by $2,000,000. (120,000 / 0.06).
A sponsor purchases a multifamily for $8,000,000 and spends $675,000 on capital improvements. They raise rents (combination of bringing under-market rents to current value and increasing rents for remodeled units).
NOI is increased from
280,000 (current undermarket)
to 415,000 (current market value)
to 470,000 (1 year post rehab).
That’s a final difference of 190,000. At a cap rate of 6%, that translates to $3.2 million increase in property value. So that $675,000 in capital expenditure along with better property management allowed an increase of $3.2 million in property value. That’s assuming everything goes according to plan.
Properties can also appreciate due to economic and market forces. The sponsor can make a profit as the price of the property appreciates over time. This is again dependent on the CAP rate. As we’ve mentioned before, the CAP is specific to location, asset type, and class type. For example, if we know that the CAP rate for B class garden style apartment buildings in the west side of town is 7%, and we have the NOI, we can calculate the price.
Say the NOI is $700,000.
The price of the property will be $10 million.
Now let’s say the NOI stays the same, but in five years, properties have gradually appreciated in the area due to increasing demand. The CAP rate goes from 7% to 6.75% because that is the prevailing CAP rate for this asset class in this location. The price of the property is now $10,370,370 (700,000/.0675). This is called CAP rate compression.
On the flip side, it is possible that the property may depreciate if demand goes down. If the CAP rate for the above example goes from 7% to 7.25%, the price of the property goes down to $9,655,172 (700,000/.0725). This is called CAP rate expansion.
Typically a sponsor will not count on market appreciation in their pro forma. Instead, a good sponsor will conservatively factor in CAP rate expansion of a set number of basis points for each year of hold.
Profits to Sponsor:
Sponsors also make money through various fees and services which are charged to the LP investors. The main ones are the acquisition, disposition, and asset management fees. Other fees include construction, organization and offering, debt placement, and legal fees. The bulk of a sponsor’s profit, however, will be in the promote, or carried interest. This is the disproportionate share of the profit that the sponsor earns if the property performs well. This incentive pay creates an alignment of interest between the sponsor and the LP investor. You can read about waterfall promote structure in a previous post here. As a side note, when I evaluate a deal, it is important that the sponsor also contributes to the common equity on the capital stack. This side-by-side investment serves as “skin in the game” and further aligns interests between sponsor and investor. I like to see a minimum of 10% sponsor contribution of common equity.
The examples above describe value add deals. In a previous post, I wrote about other risk category investments including core, core plus, and opportunistic. In core and core plus investments, the profit is mainly from cash flow from rental / lease income. Opportunistic deals are essentially extreme value add projects; creating value by constructing a new building, filling it with tenants, stabilizing it, then selling for a profit.
Hopefully this gave you a basic overview of how investors profit from multifamily investments. There is a myriad of ways a sponsor creates value in an investment property, but the central principle is the same. When evaluating a deal, check out how the sponsor plans to increase NOI. Is it through increasing occupancy, raising rents, decreasing expenses, or renovation? Are the assumptions realistic? Are the CAP rates used in the calculations reasonable and does the proforma assume CAP rate expansion over the hold period? Does the sponsor provide a sensitivity analysis for different economic scenarios?
In the next post in this series, we will discuss the risks of multifamily investing.
Thanks for reading and best regards,
Invest in Life