Our last post focused on why buying and holding assets with low-cost debt is good in an inflationary environment. Today, I want to dive a little bit deeper into one of my favorite investment strategies: multifamily investment.
What is multifamily investment?
Any property that has more than one family living in it is a multi family investment. There are four common classes of multifamily: a single-family home with a basement or second-floor suite, small residential buildings that go from 2 to 4 units, 5 to 30 unit buildings (often classed as commercial), and 30+ unit apartment towers. Most commonly, we will be searching for properties in the first two classes and sometimes in the third, as 30+ unit apartment towers are often owned by institutional investors and mega-corporations.
Why multifamily?
Multifamily is appealing for a variety of reasons. Let's break it down.
There are more people paying rent. If one family runs into trouble and rent is late, there are other streams of revenue that don’t leave you paying all the expenses out of your pocket.
There are more opportunities to increase revenue. You can install coin laundry, add paid parking spaces, add an additional unit, add paid storage space, renovate existing units to increase rent, the list goes on.
Buying multifamily is less speculative than in single-family homes. For single-family homes, the price increases or decreases year over year almost purely on supply and demand and what people are willing to pay for them. Multifamily (especially 3 units and up) are bought and sold primarily based on capitalization rates and income generation. Therefore, it is easier to gauge the value of the building in concrete terms and it is easier to know how much value you are adding when doing renovations.
What is a capitalization rate?
Glad you asked. A capitalization rate (cap rate) is a simple calculation done to determine the value of a multifamily building. It is the net operating income (NOI) divided by the purchase price or value of the building. NOI is the gross income generated from the building minus operating expenses (excluding mortgage payments). Think taxes, insurance, lawn maintenance/snow removal, utilities, average vacancies, property management, and maintenance. How does this help? Most buildings within an area generally sell at around the same cap rate. In a seller’s market, cap rates shrink, and in a buyer’s market, cap rates tend to rise. For instance, a cap rate between 4% and 5% is common in this market. Let’s look at an example below.
Here we have gross rents of $5,000 a month. When we factor in all our expenses, we are left with $3,507.50 as a monthly net income. Cap rates work on a yearly basis, so let’s multiply by 12. This equals a yearly NOI of $42,090. If we know that average cap rates in our area are 4.5%, we can divide the NOI by the known cap rate, which gives us a value of $935,333.33. How can we get more for the property when we decide to sell it? By raising the cap rate! We do this by either increasing the income through renovations, tenant turnover, value-added services like laundry, or by decreasing our expenses.
Another quick calculation that we want to look at is the management expense ratio (MER). The MER is simply the expenses divided by the gross income. In this example, we would divide $1,342.50 by $5,000. This tells us that our expenses are approximately 27% of our actual income. We typically look for a value less than 40%.
Financing Multifamily
There are some unique strategies that come into play when financing multifamily buildings. The best way to get all your options is to speak to a mortgage broker that is well-versed in financing multifamily buildings. Here is a quick overview.
Debt Coverage Ratio (DCR)
Debt coverage ratio is one of the primary factors the bank is going to look at when qualifying you for a property like this. DCR is calculated by dividing the NOI by the annual mortgage payments. The bank likes a DCR of approximately 1.25% and higher. In our example above, we have a NOI of $42,090, however, we used some soft costs such as vacancy and repairs in that calculation. The bank is going to look at hard costs only. If we remove the soft costs, we are left with a NOI of $46,800. If we purchase the property at $940,000 with 20% down, we have a principal and interest payment of $36,240 yearly (30-year amortization at 2.64%). That leaves us with a DCR of 1.29%.
Vender Take Back (VTB)
When buying larger buildings, a VTB can sometimes be taken advantage of. This happens when the seller agrees to finance a part of the project at a mutually agreeable interest rate. This works in the seller’s favor by spreading out the income over several years and reducing his taxes. This helps the buyer as well because it can be difficult to come up with a large down payment on a several-million-dollar building.
Down Payment Requirements
Different lenders have different terms that change frequently; however, in general, with a residential property up to 4 units, you will be required to put down 20% of the purchase price. Once you start getting above 4 units, the building can be classified as commercial, which may mean the bank will only lend up to 65% loan to value in some cases, especially if it is mixed-use. Think commercial storefront with residential units above. The caveat to this is CMHC financing.
CMHC Financing
CMHC financing is available for larger residential buildings 5 to 7+ units. While there is a cost to this that gets tacked on to the mortgage, there are a few benefits that go along with it. First, you get better interest rates when your mortgage is insured through CMHC. You can get amortization up to 40 years, which can reduce your monthly costs and increase your cash flow. You can finance up to 85% loan to value (LTV), reducing your out-of-pocket expenses and increasing your return on investment (ROI). Your mortgage broker or bank will have more information on whether this option is right for you.
Multifamily investment can be an exciting way to build and consolidate wealth through real estate. There are many ways to invest in multifamily, and there are different approaches depending on what your goals are. It can also be difficult to find larger good quality multifamily buildings as they mostly do not get posted on MLS. They are primarily traded off-market through back channels and can be difficult to find if you don’t know where to look.
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I'd love to hear your thoughts on this! Have a great week while working past those obstacles on your climb to success. Let's Grow Together!
Jonathan Beam
Real Estate Investor and Entrepreneur
Jonathan Beam is a real estate investor in the Niagara region who is passionate about helping you achieve financial freedom through real estate. He works with new and experienced investors to formulate a plan that fits your specific situation and provides market guidance and consultation on the best places and strategies to pursue within the Niagara Region. Book a free, half hour no obligation consultation to see how he can help you to achieve your goals. His travels are available at www.realestateandrepeat.com
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