If you are thinking about building your real estate portfolio, or if you need an income stream, this three-part series of articles is for you. In my previous article, Part 1 of the series, I outlined why owning a multi-unit rental property could offer benefits that set it apart from single-family rental properties. I also discussed shopping for a multi-unit property, the contract, establishing an LLC or LLLP, and financing. In this article, Part 2 of this three-part series, I will discuss areas of consideration for financing and for evaluating a multi-unit property.
Quick rules of thumb that lenders — and you, as a potential buyer — need to look at include:
Debt Coverage Ratio
In single-family financing, the buyer’s ability to repay is the paramount issue. In multi-family, the lender is more interested in how the property will perform and the ability of the property to pay back the loan. One of the primary rules of thumb used is what is called the debt coverage ratio. The debt coverage ratio is determined by taking the annual rent less all the annual expenses. That number needs to be 1.2 times (or 120% of) the total debt service for the year.
A vacancy rate, based on the lender’s experience, is used in the calculation of the debt coverage ratio above. Often the vacancy rate in some market conditions will substantially change the loan to value that a lender might be willing to do. In addition, a lender might not allow closing with a large number of vacancies.
Capitalization Rate (referred to as the CAP rate)
The CAP rate is simply the net operating income from the property divided by the sales price. Net operating income is defined as gross income less total operating expenses and vacancy.
Cash on Cash Return
This is the cash return after annual expenses and debt service is paid divided by the amount of cash investment made.
Appraisals for multi-unit properties are much more expensive than in the single-family world. However, remember that when buying a 25-unit property, its appraisal is still much less expensive than 25 individual single-family appraisals. The single multi-unit appraisal contains a very detailed analysis of the “income approach” to value. In other words, the income is what creates the value for an apartment building!
A, B, C, and D Buildings
These are classifications generally used in the apartment industry. In general, Class A is at the newer end of the scale and D is the older end of the scale. Class A units typically don’t have many opportunities to create new value because they are already in great shape and there is nothing more to be done. Class B and C (10- to 30- year-old buildings) will typically have the greatest opportunities to add value. Class D can also have opportunities, but it takes more intensive due diligence to make sure you are avoiding major structural, electrical, or plumbing problems.
Part of your contract to purchase a multi-unit building will provide an opportunity to do inspections before closing on the property. Some of these inspections might just be the smart thing to do and others may be required by the lender. It is wise to know what tests your lender will typically require so you have a good idea as to what expenses there will be. Remember, inspectors are paid regardless of whether or not you complete the transaction, but if they find a “show stopper” they are worth every penny. The first inspection is usually a general inspection. The general inspector will go through all the units and look at all aspects of the building. Some parts of the building will likely require a specialist. Those areas might be for things such as the boiler or roof. You may want to have the property checked for lead-based paint, asbestos, aluminum wiring, pests, environmental items, and a variety of other issues.
In my next article, Part 3 and the final article in this three-part series, I will discuss considerations including insurance, closing day, and apartment management – all of which are critical to your ownership of a multi-unit property.
Be sure to pull together a team that includes a mortgage loan officer, financial planner, accountant, and Realtor to consult with as you move forward.
About Duane Duggan: Duane Duggan has been a Realtor® for RE/MAX of Boulder in Colorado since 1982 and has facilitated over 2,500 transactions over his career, the vast majority from repeat and referred clients. He has been awarded two of the highest honors bestowed by RE/MAX International: the Lifetime Achievement Award and the Circle of Legends Award. Living the life of a Realtor and being immersed in real estate led to the inception of his book, REALTOR® for Life. Also see his video podcasts about real estate topics on RE/MAX of Boulder’s YouTube channel.