Multifamily Investment Terms
See below for an introduction to some basic multifamily real estate
investment terms. Any questions? Please feel free to contact us. We’re happy to help.
- Net Operating Income
- Debt Service Coverage Ratio
- Loan-to-Value Ratio
- Capitalization Rate (cap rate)
- Cash-on-Cash Return
- Gross Rent Multiplier
Net Operating Income
The net operating income (NOI) is the cash flow that remains after a property’s operating expenses are subtracted from operating income. NOI is an important investment concept, as it’s used as the basis for several other key investment calculations.
Net Operating Income = Operating Income – Operating Expenses
Operating income is the income that results from monthly rents, parking fees, laundry income, parking fees, etc.
Operating expenses are those expenses that are related to the operation of the property, such as taxes, utilities, insurance, maintenance, management fees, payroll and administrative expenses. Note loan payments, amortization and appreciation are not considered operating expenses.
Many times sellers of multifamily real estate publish the net operating income associated with a particular property. As an investor, it’s important to know the details behind this number. Specifically:
- Are are all operating expenses realistically accounted for in the calculation?
- Is the operating income based on the ideal scenario with a vacancy rate equal to zero?
- Or is it based on historical performance which accounts for the actual vacancy rate?
- You Realtor can help you uncover the answers to these questions.
Debt Service Coverage Ratio
Net operating income (NOI) is the cash that remains after accounting for all revenues and expenses related to a property’s operations. Note loan payments are not considered operating expenses; they do not contribute to the expenses that are used to determine NOI.
However, loan payments are used to determine a property’s debt service coverage ratio (DSCR). The debt service coverage ratio is a ratio that measures the cash that is available after all loan payments are taken into account. In other words:
DSCR = (Net Operating Income)/(Annual Loan Payments)
The debt service coverage ratio is important because in addition to setting a maximum loan-to-value ratio, most lenders will require a minimum debt service coverage ratio before a loan can be issued.
For example, suppose a lender requires a minimum DSCR of 1.25.
Now suppose the annual net operating income for the subject property is $30,000, and the annual payments for the desired loan are $25,000.
DSCR = ($30,000)/($25,000) = 1.2
In this case the DSCR does not meet the lender’s minimum requirements. The financed amount would need to be reduced in order to bring the annual loan payments down and the DSCR up to the lender’s minimum standard of 1.25.
The Loan-To-Value Ratio (LTV) is ratio that measures the amount of debt on a property as a percentage of the property’s value.
In other words:
LTV = (debt)/(property value)
Along with the Debt Service Coverage Ratio, LTV is a key constraint that lenders use to determine the terms of a loan.
For example, let’s suppose a subject income property can be purchased for $500,000, and an appraisal supports this purchase price. And let’s assume a lender requires a maximum LTV of 75%.
The maximum amount the lender will finance based on an LTV of 75% is $375,000.
(.75)*($500,000) = $375,000
Keep in mind that along with the maximum LTV requirement, the lender will also have a requirement for a minimum Debt Service Coverage Ratio.
Capitalization Rate (Cap Rate)
The capitalization rate (cap rate) measures a multifamily property’s unleveraged (ie all cash) interest rate return. This measure is the ratio of net operating income to the purchase price of the property. In other words:
Cap rate = (net operating income)/(all cash purchase price)
For example, suppose an investor is considering a property priced at $550,000. The listing for this property states an annual net operating income of $55,000. In this case the cap rate is equal to 10%.
Cap rate = ($55,000)/($550,000) = 10%
If the investor were to purchase this property with cash only, he would receive a 10% interest rate return on his invested equity of $550,000.
It’s not uncommon for two different properties to have two very different capitalization rates. Properties that require a higher level of investor risk tend to have higher cap rates. For example, a property with a lot of deferred maintenance and a history of vacancies will tend to have a higher cap rate than a property that is very well maintained with a very stable rental history. The investor that takes on more risk will require a higher return on his investment.
Cap rates are rising in our market. That’s because supply is high and demand is much lower compared to a few years ago, making it a great time to invest.
Cash-on-cash return measures a property’s interest rate return on invested equity (ie cash). Cash-on-cash return is determined by taking the ratio of the annual net cash flow to the invested equity (cash).
As an equation:
Cash-on-cash return = (annual net cash flow)/(invested equity)
Let’s suppose an investor purchases a property for $550,000, putting 20% down in cash ($110,000). Also suppose the property cash flows $750 per month or $9,000 per year under this scenario.
Cash-on-cash return = ($9,000)/($110,000) = 8.2%
Another way to state this is the investor receives an interest rate of 8.2% on his investment of $110,000.
Now suppose the investor, instead of financing his investment, decides to pay all cash ($550,000). Also suppose the property cash flows $3,250 per month or $39,000 per year under this scenario.
Cash-on-cash return = ($39,000)/($550,000) = 7.1%.
Comparing the two scenarios above, the investor receives a better return when he finances his investment. Plus financing the investment allows the investor to conserve his cash.
Gross Rent Multiplier
The gross rent multiplier offers a quick way to measure a property’s revenue-generating value relative to purchase price. The gross rent muliplier is calculated as follows:
GRM = (Sales Price)/(Gross Annual Income)
For example, suppose a property is purchased for $200,000, and it produces $25,000 in gross income per year.
GRM = ($200,000)/($25,000) = 8.0
Smaller gross rent multipliers indicate investors are able to purchase properties at better values.