We have already talked about the several different factors of how to figure out what makes a good multifamily home worth investing in, but what about the part where you start making money? If you want to make sure you are both spending AND earning wisely, you NEED to keep these aspects in mind.
Positive cash flow is not only important, it is critical. Over the years, we have seen people purchasing properties hoping to profit from appreciation. Although this sometimes works out, this is a gamble. Positive cash flow using current income and expenses is the only way to evaluate a building.
What goes into cash flow is income. Rental income comes from each unit, with many sellers increasing the sales price of their building by telling you the rents should be higher. However, if he/she could raise the rent with their current tenants, they would have already done that. Remember: use the current rents in your analysis.
You can also do market analysis to see how your rents could be increased. Rent increases takes time and oftentimes tenants move out when you increase the rent prices. You should allow 12 months for the rent increase to take effect. For help with this, you can use www.rentometer.com, a free service that assists you in analyzing potential rents. Rental ads are also a great way to find out what the market rent rates are like.
You can calculate your initial cash flow by: Total Gross Income minus Total Annual Operating Expenses equals Net Operating Income.
Expenses in Cash Flow
There are expenses that come with cash flow. For the property taxes, it is easy to verify them by calling the tax collector. Find out if there is an increase of the mill rate as well as if revaluation is prone to happen. Ask for the bill for your insurance and don’t forget to get the quote.
For water and sewer funds, ask for bills which last 12 months. For both snow removal and lawn maintenance, you can do it yourself or hire someone, ideally pricing an average $50 per months for 1 to 4 units. Trash removal is also an expense to keep in mind.
For the electric, gas, and oil bills, get them from owner. For electric, there is usually an owner’s meter and you may also be paying the electric bill when the unit is vacant. For both gas and oil, if the landlord is paying, include the expense for separating the systems so tenants pay for heat. Do not forget that you will be paying for both oil and gas even when the unit is vacant – especially in the winter.
Legal wise, there will usually be eviction fees. The better you run your building, the less the expense will be. If you decide to manage the building yourself, you deserve to be paid so use management fees for 5 to 10% of rents.
For repairs and maintenance, find out from the seller what they have been budgeting. The condition of the building will affect how much you should budget. If the building is totally renovated, you could budget for less. In general, it is recommended that you budget 10% of rents.
For vacancy, find out from the seller what their experience is; however, with your training, your vacancy rate should be less. Start out with budgeting 10% of rents until you have several years of experience with this building.
You should insert any other expenses that may be specific to the property.
When you are analyzing a rental property, you need to account for various costs. Firstly, they include the cost of repairs. Our previous blog post about Understanding Real Estate Costs goes into the skills in figuring out the repair fees. Besides that, when you have rental properties, you may have to repair the major systems right but you do not need to replace things like windows right away. The huge benefit of renting versus quick turn properties is that you could let the rental income pay for a lot of the smaller repairs. And remember: the BIG difference between retailing renovations and holding renovations is that you do not have to do your repairs all at once.
Secondly, the after repair value (ARV) has various considerations for a multifamily house. Sometimes you can compare three and four units together, however duplexes (two-family houses) are not comps for larger units. There is also the differing the number of bedrooms per unit. Appraisers often use this income approach to evaluate a rental property, referring to the amount of rent you are collecting for the building. Be sure to buy the property based on the current rents, and NOT based on what the rents could generate.
There are also the holding costs monthly which include property taxes, insurance, both water and sewer, and reserves (repairs, vacancy, management). Mortgage principal and interest in debt service also should be considered, as well as the net operating income (NOI) and the net cash flow that tells how much money is left after your bills are paid.
Acquisition costs are the same for both quick turn properties and rental properties, but there are differences you should remember. You will receive all security deposits the seller has and these funds can show up as a credit on your settlement statement. You will also receive the pro-rated rents for the month. For example, if you bought the property on the 5th of the month then you will receive 25 days of rent; this amount appearing as a credit on your settlement statement.
Should you put money down on a building? The more cash you use to buy a building, the less your debt service and the greater your cash flow will be. However, you want to conserve your cash so that you have reserves and so that you can buy more buildings. Owner financing usually gives you lower monthly payments. Also use the Analysis Spreadsheet which calculates the 1st and 2nd mortgages based on 30 year amortization schedules.
If you need more money before buying a property, you should be able to borrow up to 75% of fair market value from most banks – specifically local banks whose mission is to invest in your area. When you apply for a mortgage, the bank will consider your credit and income.
When you are applying for financing, you may hear the term DSCR (Debt Service Coverage Ratio). This calculation determines whether the property makes enough income to pay your mortgage. Usually banks want to see a DSCR of 1.2 of more. A negative DSCR means that you do not have enough income to pay for the mortgage. For future reference, use this equation to calculate your DSCR: DSCR = Net operating income/debt service.
Finally, a good recommendation is to put 25% of the money you earn into reserves. This accounts for funds put aside for capital improvements for things like the roof and furnace, the vacancies based on statistics on the average vacancy rate for your neighborhood you can get from your real estate agent, and the property management fees where you should be able to manage your own properties up until 25 units.
You should put 25% in reserves because mortgage companies only allow you to use 75% of rents to help you qualify for the mortgage. After the first year of ownership, you may not need to put so much money aside.