INVESTORS GUIDE
Multi-family residential property generally delivers the most stable returns, because no matter what the economic cycle, people always need a place to live. The result is that in normal markets, residential occupancy tends to stay reasonably high. Another factor contributing to the stability of residential property is that the loss of a single tenant has a minimal impact on the bottom line, whereas if you lose a tenant in any other type of property the negative effects can be much more significant. This section will cover two classifications, small 1-4 unit properties and 5 and more commonly referred to as commercial multi-family.
1-4 UNIT
OWNER OCCUPIED
An FHA mortgage can make it easier to buy a SMALL multifamily home.
The Federal Housing Administration mortgage program is administered by the U.S. Department of Housing and Urban Development. The FHA provides insurance on qualified mortgages, which allows the borrowers to obtain lower down payments and interest rates, plus more liberal qualifying requirements. FHA mortgages allow more people to buy these multifamily homes, which is beneficial to the public and the overall economy.
PROPERTY
REQUIREMENTS
A major eligibility requirement for obtaining a FHA mortgage is that the property being purchased has to be owner occupied. This simply means that the borrower has to actually make the property his residence and not just be an investor. However, this does not mean the property has to be a single family unit only. The FHA will qualify a property which contains up to four residential units. A special legal form, an Occupancy Declaration, is required to be signed and submitted as part of the mortgage application for properties with three to four units
OWNER OCUPANCY
REQUIREMENTS
The main FHA rule to satisfy the owner occupancy requirement is that the borrower make the property his principal residence, meaning he will regularly live there for the majority of the year. A seasonal or vacation property would not meet this requirement. The borrower must physically take occupancy within 60 days after the mortgage loan closes. The borrower must maintain this occupancy on a continuous basis for at least one year. FHA will allow some exceptions to this rule only for reasons of hardship.
RESIDENCE AND
INVESTMENT
The primary purpose of the owner occupancy rule is to prevent investors from utilizing the FHA mortgage program and its benefits. However, the FHA will give a mortgage for a property with up to four residential units, provided the borrower makes at least one of these units his home. This provides the borrower with the opportunity to use the FHA program to obtain a residence and an investment at the same time. This also allows the borrower to use the rental income from the other units towards the mortgage payments and thus can be very beneficial financially.
SPECIAL
PROVISIONS
The owner occupancy rule is satisfied if at least one person who signs the mortgage and loan agreement moves into the home. Thus, there can be co-borrowers on the loan who do not have to occupy the property. While the property's building is limited to four units, the size of the property's land is not limited. Planned Unit Development residences and FHA approved condominiums are also eligible for FHA mortgages and have the same owner occupancy requirements.
1-4 UNIT
NON-OWNER OCCUPIED
Occupying a property is very different from renting it out. The programs that exist as incentives to homeownership usually don't apply to rental property, making the two financing markets very different from each other. On the other hand, since the tax code treats your rental property similarly to the way that it treats a business, you also get a world of tax write-offs on a rental property that don't apply to owner-occupied houses.
WHAT CHANGES FROM
OWNER OCCUPANT TO NON OWNER OCCUPANT
APPRAISAL
The appraisal of a multi-unit property is based on the "income approach" to reach the value of the subject property. With this approach the appraiser determines the fair market rent of each unit size based on comparable rents to other properties. The market rent can be adjusted downward if concessions are usually given in the target market. The appraiser will then multiply the target rents by the median Gross Rent Multiplier (GRM) for the target market to arrive at the fair market value of the property.
MORTGAGE
REQUIREMENTS
When you buy a residence to live in, your lender typically looks at the value of the house and at your ability to pay the loan back. It can use private mortgage insurance or government-backed programs like Federal Housing Administration or Veterans Administration mortgages to let you buy a house with a low down payment and attractive interest rates. Investment property mortgages usually require sizable down payments and are usually closely tied to your credit. In addition, lenders also frequently look at the ability of the property's income to service the debt.
TAX
DEDUCTIONS
Owner-occupied residences have two main tax deductions -- the write-off for mortgage interest and the deduction for property taxes. To claim these deductions, you need to itemize deductions on your tax return, and you can lose the right to take them if you have a high income, are subject to the Alternative Minimum Tax or have a very large mortgage. When you have a rental property, all of your "ordinary and necessary expenses" are tax deductible. This includes all of your property tax, all of your mortgage interest and all of your operating expenses, including management. You can also claim a depreciation allowance that further reduces your tax liability.
USE
LIMITATIONS
Both owner-occupied and rental properties are subject to a community's use and zoning restrictions, which can include limitations on noise, how you maintain the property and what kind of business, if any, you can conduct in the property. Rental properties fall subject to additional use restrictions. For the IRS to truly consider it a rental, your ability to stay in the property is usually limited to two weeks or less per year. Many local government agencies also impose additional restrictions and licensing requirements on rentals.
TAXES ON
HOME SALE
When you sell your owner-occupied residence, the IRS gives you a generous tax exclusion. Your first $250,000 of profit, or $500,000 if you are married and file a joint return, is completely tax-free provided you lived in the house as your primary residence for at least two of the past five years. Any gain over that amount is taxable at your capital gains tax rate.
TAXES ON
HOME SALE
All of your profit is taxable as a capital gain when you sell a rental property. In addition, if you sell it for more than your depreciated value, you will also have to pay depreciation recapture tax on the difference between what you originally paid for the property and its improvements and the depreciated value. However, if you use the proceeds of the sale of your rental to buy more rental property, you can structure the transaction as a tax-deferred exchange, carry your basis forward and defer all of your taxes. You can't do this with an owner-occupied residence.
COMMERCIAL
REAL ESTATE
Commercial real estate transactions involve many different issues during the process of getting to closing, including negotiating the terms of the deal, putting together the financing package, and drafting all of the required documents. However, a prospective buyer should be certain that he is getting the right property and that there are no hidden surprises. In order to accomplish this, there are certain items that must be considered before an initial offer ever is made. The critical items include:
RESEARCH
AREA RENTS
Obtain a broker’s analysis of current rental rates – As the past few years have shown, real estate values fluctuate wildly as market conditions change. It is important to understand whether the rental rates that are set at the time of acquisition of the property are realistic moving forward.
GET THE FINANCIALS EARLY
It is imperative to request financials before touring the property. Some information can be found on the listing sheet but is is usually not complete. Understanding the financials and comparing capitalization rates from other sold properties in the area will give you a pretty accurate value of the property as well as its ROI. We will cover evaluating a property later in this article.
DOES IT HAVE
SECTION 8 REQUIREMENTS
Knowing whether the property must provide a certain number of affordable housing units as part of an agreement with the local municipality or town is imperative. It is possible that the value of the property may be increased through the inclusion of more Section 8 housing units. However, having to offer a certain number of Section 8 units may decrease the anticipated rental income.
GET CURRENT
RENT ROLL
Prior to looking at the property you will want to get financials in order to determine the financial viability of the property. In addition when the property is being sold, it is critical to have the seller verify the current rent roll at closing in order for the purchaser to have a clear understanding of what leasehold rights are included in the deal. When the multi-family property has a limited number of tenants, it is likely that the purchaser will review individual leases, but when the number of individual units is significant, a review of individual lease terms is not practical, which is when the rent roll becomes critical.
GET CRIME REPORTS FROM LOCAL POLICE
Review local police and crime reports – Understanding the neighborhood in which the multi-family property is located enables the purchaser to anticipate problems with keeping the rental units occupied. It is important to go back a few years in order to get a clear picture of the challenges that may exist. Is there a growing drug problem? Have there been homicides in or around the property? These serious issues will prevent a purchaser from realizing the anticipated profits from the property. However, if there is a recent police initiative to clean up and revitalize an area, a purchaser may be able to acquire a property with great potential at a reduced price.
DETERMINE PROPERTY CLASS
-
A Properties: Newest, shiniest asset. They contain many amenities and cater to white-collar workers. Expect low cap rates, around 2-4. This class of asset is poor at cash flowing but has the ability to appreciate greatly. I tend to think that investors choose A properties to maintain their wealth, not create it.
​
-
B Properties: Built within the last 20 years, this class caters to a mix of white and blue-collar workers. This type of property may show a bit of deferred maintenance, but overall, it has a nice mix of cash flow and potential appreciation. Look for cap rates around 5-7.
​
-
C Properties: My first real estate brokers defined C properties as “crap” properties, but loved their ability to generate substantial cash flow. I tend to agree with his candid analysis. These properties are usually 30+ years old and have deferred maintenance issues. Cap rates hover between 8-10 on these properties.
​
-
D Properties: The lowest class of property. They are usually located in inner cities where it’s difficult to collect the rent and vacancy rates are high. These properties are highly management intensive, and the tenant base is often difficult to deal with. Investors get lured into investing in these properties due to the low prices, but soon realize they got more than they bargained for.
The goal is to increase the NOI by either increasing revenues or by decreasing expenses. You are trying to force the appreciation of the asset by increasing the NOI. The term that is thrown around to accomplish this task is “reposition.” When you reposition an asset, you are adding value by changing the appearance of the property or the operations of the property, all to increase the NOI. You are focusing on the value-adds to a property.
DETERMINING VALUE, DSCR ( Debt Service Coverage Ratio) AND ROI (Return on Investment)
Scenario: You found a 16 unit building with three bedrooms each, Due diligence uncovers that it is in a better then average neighbor hood where fair market rents average 1,000 for 3 bedrooms. The property needs updating but no major repairs. Current rent roll has each unit at 650.00 well below market value. Capitalization rates in the area average 8%. and the asking price is $1,000,000.00
Financials Show the Following
Annual Income:
​
Rent Roll 124,800
Other Income 2,200
Sub Total Income 127,000
*10% Vacancy - 12,480
​
Total Annual Income 114,520
(Cash Flow)
​
​
​
​
Take notice of the Items in red, 10% Vacancy Rate and 5% Management fee, most financials will not include these but the bank will automatically add them so you need to add them.
Financials Show the Following
Annual Expenses:
​
Taxes 4,300
Insurance 6,800
Water/Sewer 1,500
Electric (Common Area) 800
Rubbish Removal 2,000
*5% Management Fee + 6,240
​
Total Expenses 21,640
​
CASH FLOW -- EXPENSES = NET OPPERTING INCOME
Our Scenario:
​
Cash Flow 114,520
Expenses - 21,640
NOI 92,880
CALCULATING CAPITALIZATION RATE
NOI / Asking Price = CAP Rate
​
Our Scenario:
​
NOI 92,880
Asking price / 1,000,000
NOI 0.9288
​
CAP RATE 9.3%
DETERMINING VALUE
NOI / CAP Rate = Value
Now remember earlier we discovered the area CAP rate was 8% so lets determine the value based on that rate.
Our Scenario:
​
NOI 92,880
Market 8% CAP Rate / .08
NOI 1,161,000
As you can see this property is a winner. If you gave the seller asking price you would have 157,500 in additional equity at close. Chances are many people will also be attracted to this and offers may drive up the price. What many investors with capitol would see is the potential of the property which is referred to as REPOSITIONING Banks will only lend based on current rents no future rents. The experienced investor sees the earning potential in the property. He intends reposition his investment by brining the rents to market value. Lets look at the numbers again but lets bring the rents to market value.
Potencial Earnings if Rents were at Market Rent
​
Rent Roll 16 units at 1,000 x 12 192,000
Coin Laundry + 2,700
​
Sub Total Income 194,700
*10% Vacancy - 19,200
Expenses less Mgmt Fee - 15,400
5% Mgmt. Fee - 9,600
​
NOI 150,500
(Cash Flow)
​
​
NOI 150,500
8% Market Cap / .08
​
Property Value 1,881,250
Purchase Price 1,000,000
​
Market Equity 881,250
​
​
Now deals like this do come up and you can capitalize on the owner who trades income for long term tenants. The down side of this strategy is their position when they go to sell the property. The banks value the property based on current rents and not fair market rents, so the seller has undervalued his investment and can not get the most value from the property.
CALCULATING DEBT SERVICE
NOI / ANNUAL DEBT = DSCR
The debt service coverage ratio is one of the least understood underwriting requirements for new and even seasoned commercial real estate investors. Briefly, the debt service coverage ration simply compares the subject property's net operating income to the proposed mortgage debt service (on an annual basis). The lender wants to ensure there is sufficient cash flow to cover the new mortgage debt, and then some. Now lets use our scenario and calculate Debt Service Coverage Ratio (DSCR)
After our 25% downpayment We will be borrowing 750,000 at a 6% interest rate for 25 Years.
NOI
​
Cash Flow 114,520
Expenses - 21,640
NOI 92,880
Mortgage / 6% / 25 Year
​
Monthly P&I 4,384
Annual 52,608
​
DSCR
​
NOI 92,880
Mortgage / 52,608
1.76%
What this example tells us is that the cash flow generated by the property will cover the new commercial loan payment by 1.76x. The minimum DSCR most commercial mortgage lenders require is 1.20x. If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure. However in this case the buyer will have no problem securing the loan at the 75% Loan to Value (LTV)
CALCULATING RETURN ON INVESTMENT ROI
(NOI - ANNUAL PAYMENTS) / DOWN PAYMENT
Cash Flow
​
NOI 92,800
Annual Payments - 52,608
Cash Flow 40,192
ROI
​
Cash Flow 40,192
Down Payment / 250,000
Cash Flow .16%
Most investors are looking for returns in upper teens so this 16% return is acceptable, but just imagine where it would be if we used the numbers after the repositioning. Go ahead, see if you can calculate the ROI after repositioning.