Commercial Real Estate or “CRE” can be categorized into four subcategories: office, industrial, multifamily, and retail. This article will focus primarily on multifamily residential housing, and the pertinent details to look for as an investor. When done correctly, an investment in real estate has the potential to be extremely lucrative.
When looking for a property, investors should have an idea of what parameters they want their future investment to achieve. When an investment property is presented or advertised the first thing that should be looked at is the Capitalization Rate. The “Cap Rate,” as its most commonly called, tells investors the rate of return they should expect in a year assuming all income and expenses stated by the seller of the property are true.
Capitalization Rate = Net Operating Income / Property Market Price
Cap Rates can range depending on the market and area. Lower cap rate properties are perceived as a safer place to invest money; however, they are very stagnant in growth. Properties with a higher cap rate may have a greater potential for growth but can be deemed riskier than the aforementioned.
Net Operating Income = Income – Expenses
After finding a suitable cap rate, it’s important to look at the expenses compared to income. A multifamily property’s expenses tend to be 40% of total income on average. If you see expenses that are lower, the owner may be either overstating the income or understating expenses. On the contrary, if the expenses are much higher, it may indicate that the property is mismanaged, which could present opportunities for an investor.
Regarding rental income, an investor should do research on the surrounding area and see if current rent costs are cheaper than that of neighboring rentals. If so, rents could be increased over time, which is another advantage in purchasing the property. Note, an investor should only consider the current income of the property when assessing the market value.
After getting comfortable with the financials, it’s equally important to look at the unit mix of the property. The unit mix is the breakdown of the different unit types at the property. Apartments typically range in size from studio to five-bedroom. A studio apartment is usually occupied by a single person and combines sleeping, living, and kitchen areas. Investors may not consider this type of unit ideal because the tenants tend to be short-term, with a greater risk of turnover. The next size is a one-bedroom unit which some may consider the most common unit type. They are popular amongst college students, senior citizens, and couples. An optimal unit size is a two-bedroom unit. They’re ideal for most demographics, cost-effective for tenants and easy to rent out. Families are more likely to rent this unit and care for it as their home. Three-, four, and five-bedroom units may also be available in some properties. The more bedrooms, the higher the amount of rent can be charged.
A 2 to 1 ratio of two-bedroom and one-bedroom apartments are ideal. One-bedrooms are easy to rent due to the appeal to single individuals and couples; two-bedrooms also appeal to couples and families with children.
After finding a property with a sufficient Cap Rate, NOI, and Unit Mix it’s imperative to perform due diligence. Before making a large investment, an investor should make sure all information reported by the property owner is reliable and true. If found that expenses will be incurred that were not reported by the seller, it can be used as a bargaining chip to lower the purchase price. On the other hand, if there are certain expenses the current owner faces that won’t be incurred or will at lower costs, it’s another reason to consider investing in the property.