The Most Important Formula in Multifamily Investing
Published on: Friday, December 18th, 2015
Three variables rule the day in multifamily. If you know two of them, you can calculate the third. The three variables are (1) purchase price, (2) net operating income (NOI), and (3) capitalization rate.
The NOI is the difference between the income and operating expenses. The capitalization rate is considered a reasonable return on investment (on the basis of both the investor’s alternative investment possibilities and the risk of the investment). It is used to determine and value real property through the capitalization process. We, of course, all know what the purchase price is.
Here is the formula you need to not only commit to memory but to understand how it works on a daily basis:
Purchase Price = Net Operating Income/Capitalization Rate (CAP Rate %)
If you don’t understand formulas or your eyes glaze over or you think that you don’t need to understand this because you will have someone else understand it for you, you might consider investing in something other than real estate. Like John Housemann said, “Here is a dime. Go call your mother and tell her that it is highly unlikely that you will become a successful real estate investor.”
Seriously, don’t abdicate your responsibility to understand the financial inner workings of this business. But if you do suffer from any of the statements listed above, then let me try to give you some real-life scenarios that will give you a better understanding of how important this formula is to your professional development.
Example #1 – Let’s say the type of property that you want to buy typically is trading at a cap rate of 7.5% in the market that you are working in. If the seller is asking $10,000,000 for the property, the Net Operating Income should be $750,000. How did we do? Check the broker’s property package and see what the property is generating for net operating income. Is the NOI lower than that? That means that the purchase price is too high. Renegotiate.
Example #2 – In this example, let’s suppose the cap rate is a nice even number like 10%. What happens when you increase the revenue by $1.00 or decrease the expenses by $1.00? In either case, your net operating income will increase by $1.00. Now plug that $1.00 and the 10% cap rate in to the above formula. What happens to the value of the property? It increased by $10.
Think about the power of that formula as it applies to your family. Increase the revenue of the property by any amount and that money goes into your pocket to live your life. Divide that increase in revenue by the cap rate and that is the amount of money that goes to your kids or grandkids or your favorite charity after you die. Pretty powerful formula, isn’t it?
Not only is this an important formula when you are looking to buy a property, but it is an important formula when you are running the property as well. When I sit down to formulate a budget for the year, I always know what the cap rate is at that particular time and look to see how I do with my net operating income calculations. Once I have these two numbers, I have an idea of what my property is worth. How does this new value compare to what I purchased the property for? Is the value increasing, decreasing, or staying the same? If the value is not meeting my investment objectives, can I trim on the expenses or increase the income and thereby increase the NOI which, as we saw above, increases the purchase price or value of the property?
That’s the beauty of multifamily. It should be an unemotional analysis of numbers. Who cares if the units are beautiful and the pool is “sparkling”? If the numbers don’t work, DON’T BUY IT! MOVE ON!