The multifamily market has recovered better than most asset classes from the great recession and we’re seeing a seller’s market all across the country. With cap rates at historical lows, it’s more important than ever to be diligent when underwriting a multifamily investment.
Step 1 – Knowing My Exit Strategy – Beginning With The End In Mind
In order to underwrite a multifamily investment you must first determine your exit strategy. Are you going to hold the investment long term, fix and flip the asset, or hold and exit when the market cycle dictates it’s time to sell?
This will help you determine your investment criteria for purchasing the property. Do you want to hold for the highest rate of return over a long term? Do you plan to reinvest the capital somewhere else? Are you looking for the quickest exit for a cash on cash return, or do you want the best return for your investors during a market cycle?
There are other factors that can help you determine your exit strategy such as needing negative cash flows for tax savings, looking for a family legacy you can pass to your heirs, building wealth for retirement and more. All of these potential strategies are a crucial key to purchasing a multifamily property.
Step 2 – My Investment Criteria
So which is it? Are you building wealth or do you want quick cash? The reason you need to know this is so you can determine your risk and identify what cap rate you’re willing pay for a property.
One popular strategy is the Value Add Opportunity. If you have to rehab or upgrade the property, there is high vacancy, high expenses, low rents, or is in a less desirable area, then there is going to be more risk and therefore you may want to look at a higher acquisition cap rate.
If the property is well stabilized and in a good location, good condition, good tenants and good cash flow, there will be less risk therefore you can purchase with a lower cap rate. This has been the investment strategy for most institutional investors over the last few years.
Once you determine the cap rate you’re willing to pay for a property based on your investment criteria and exit strategy it’s time to start looking for a property and determine if the asking price is in the same ball park as your acquisition cap rate.
Step 3 – Determining YOUR Value For The Asset
So let’s say you have determined that you’re looking for a value add opportunity to hold for the rest of the market cycle and will sell just prior to the perceived peak of the market. You also determined that you’re acquisition cap rate, based on your risk threshold for this type of strategy, is 10%. How do I determine what I should pay for the property?
Most sellers will determine the asking price based on NEXT year’s net operating income (NOI) divided by the market cap rate. If we had a 100 unit property that has an NOI of $320,000, and the market cap rate is 8%, then the asking price would be $4,000,000. But you said your risk is only worth 10%.
Based on the NOI of $320,000 you will need to divide it by 10% which means the absolute most you’re willing to pay for the asset is $3,200,000, your strike price. If you feel that a 20% difference in price is worth pursuing, then go view the property and write an offer with the intentions of staying below your strike price.
These three steps can help you quickly look at an asset and determine if it’s something you should take down or move on to the next one. Of course, if you get the property under contract, you will need to conduct a thorough due diligence to make sure you’re purchasing what’s being presented.
The best practice is to hire a qualified real estate broker that specializes only in multifamily properties and let him/her help you in Underwriting A Multifamily Investment and assist in the transaction and due diligence phases so you’re confident that you can get the highest return for your investment.
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