Everyone always says that location is the most important aspect of evaluating a deal and there is a lot of truth to that claim. For a property to be profitable there needs to be demand from renters. That means the local population has to be steady or preferably growing. We also need to ensure that the property is in a location that will attract the right tenants. Is there shopping, transportation, and good schools around?
If we pay close attention to the location the likelihood of success is much greater.
If we feel satisfied with the location we need to closely evaluate the deal. First, we need to look at the financial performance of the property. We evaluate the income and expenses as they relate to the purchase price. Here we look for the income to be high enough to pay our expenses and generate a risk-adjusted return that meets our criteria. We typically would like to see an 8-10% cash on cash (CoC) return on our invested capital. If this investment is more of an appreciation play, we can accept a lower CoC.
The next aspect is the physical condition of the property. Many older apartment complexes require significant capital improvements to bring them up to modern standards. That could require a substantial amount of money to perform those repairs. That may not be a problem if our capital improvements result in higher rents and thus higher income.
These aspects need to be evaluated using a sound financial model and proper financial and physical due diligence.
The team that puts together the deal is also very important. If it is a smaller deal with just a couple of partners, evaluating the team is pretty straightforward. However, when we deal with syndications and larger properties the team and their experience is critical to the success of the deal. I wrote about this in my article How to Evaluate a Syndication Sponsor.
In summary, you want to ensure the team members have multifamily experience, a good track record, and the focus to make the deal a success.
Key Financial Metrics
Regardless of whether we are looking at a small deal done by an individual or a larger syndicated deal, paying attention to the key financial metrics is important. Here are the minimum metrics to review:
Rents: What are the current rents, and how much rent increase is projected? Are those projections realistic? It’s important to do a rent comparison with other properties in the local market.
Vacancy: What vacancy rates are typical in the market and are we considering them in our underwriting?
Expenses: Are we accurately accounting for all of the expenses associated with the property? A realistic expense ratio is about 50% of the income. Property taxes and other expenses may increase with a new owner.
Mortgage: The mortgage rate and amortization period will have a big impact on the profitability of the deal. Ensure that actual quotes from lenders are used.
Cash on Cash Return: The cash on cash return is the percentage return on the capital invested. It should be high enough to compensate for the risk we are taking by buying the property. 8-10% is a reasonable starting point.
Internal Rate of Return: This is a measure of the overall return of the deal from start to finish. We’d like to see 15-17%.
CAP Rate: This is the capitalization rate we are purchasing the property at. It should be similar to other properties in the market. CAP rates can range from 4% for luxury properties to 10% for run-down buildings in challenging areas. Typically, higher CAP rates generate a better return, up to a point where the risk becomes too high.
It’s important to review as many deals as possible to develop a good understanding of the characteristics of each deal and how different deals compare. Even passive investors should spend time evaluating various offerings to ensure that the right deal is chosen for investing.