One of the absolute key advantages of the multifamily real estate is the valuation mechanism. Unlike single family which is valued by way of a process which looks at the sales price of like houses, the value of multifamily resides in the income – the more the income, the more the value.
A simple way to describe the difference in these thought processes is like this.
As a homeowner buying a single-family you think this way:
I am willing to pay for this house as much as other people have paid for similar houses in this neighborhood. If I can do this, I know I won’t be over-paying.
As an investor buying multifamily you this differently:
I am willing to pay for this income as much as other people have paid for similar houses in this neighborhood. If I can do this, I know I won’t be over-paying.
In terms of SFR this is easy to understand because we are simply talking about the price. However, when we start talking about income, there is an extra step because before we can know how much to pay we must somehow translate income into value.
We do this by asking another question:
How much can I pay for this income if I am willing to accept x% return on my investment?
Thus, if a property produces $10,000 of income, and you are willing to accept 10% return on your money, then you should be willing to pay $100,000 for the property because 10% return on $100k is $10,000. If, however, you are willing to accept a 5% return, then you would be okay paying $200,000 for the same property because $10,000 of income represents 5% of $200,000.
This is very rudimentary, of course, but it’ll suffice for today. Now…
Amazing Power of Capitalization
The coolest thing here is that since the value of multifamily is very much tied to the income it produces, by increasing the income at a property we can increase the value of the property. For example:
At the Silver Tree Apartments that we just bought, the laundry income last month was $1,800. Of this, because of the contract currently in place with the service provider, we had to pay out 50%, leaving us with bankable $800 of laundry income.
We’ve not made our final decision on this yet, but already we got them to commit to placing new machines at our property and adjusting the split to 75/25 in our favor. They ran the numbers on the demographics and they believe that in a remodeled space, with new machines we should be able to generate about $2,500 – $2,700.
Let’s use $2,500 of topline income. At a 25% split, we would need to pay them $625 per month for servicing and maintaining the equipment. This would leave the property with $1,875 of income.
What would this do
Considering that last month the property kept $900 of income from the laundry, $1,875 of income would create an additional monthly cash flow of $975.
Now, I know this doesn’t seem much when we consider that this property once stabilized would be producing hundreds of thousands of dollars of cash flow, depending on the financing we exercise, but think about this with me for a minute:
$975 per month of additional income is almost $12,000 per year. If you are a buyer paying for this income, and you are willing to accept a 10% return on our money, then this additional $12,000 of income represents $120,000 of additional value.
Cap Rate and NOI
Now, when I speak of the “rate of return you are willing to accept” what I am really talking about is the capitalization rate. And when I speak of “income” what I am referencing is the NOI. Since in this case there wouldn’t be any OpEx against the additional income, the entire bump of $975 would flow straight to the NOI and the CF.
Conclusion
The cap rate is obviously market-specific, and in Phoenix where Silver Three is it happens to be around 5%. If we do the math, the additional income of around $12,000 per year capitalizes into $240,000 of value at 5% cap rate.
Think about this. Some see an income of $975 and are happy about it but think nothing much of it. I look at an additional income of $975 and see $250,000 value.
This is the power of capitalization!
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