Here is a simple way to analyze an investment opportunity that you might be considering in either a multi-family property or another income producing property. Every market is different and borrowers will all qualify for different loan structures as well, but the example set below is for a well-qualified borrower buying a four-plex (anything over this will require financing that won't be fixed on a 30 year mortgage). The assumptions made are: 4.125% interest rate (slightly higher than current market rate due to investment loan and not a primary loan), 25% down payment, 30 year fixed mortgage, taxes of $2500/yr, insurance of $840/yr, a vacancy rate of 5% and self-managed units. We are not including repairs, advertising, closing costs and lender fees, etc so this evaluation will look better than it actually is without those expenses accounted for. In this example, we are dealing with a four-plex in the university area of Missoula, MT where properties rent easily due to the University of Montana and the expensive price of Missoula real estate.
*The most unrealized aspects of investing in a property like this are the cost recovery (depreciation) you capture to offset income, thus reducing tax consequences for yourself and the principal pay-down that your tenants do for you.
Example: A four-plex is purchased for $320,000. All units are 2-bedroom 1-bathroom units in good shape and all rent for $800/month. Owner will pay for all sewer, water, and garbage ($100/mo) and the tenants will be responsible for their utilities, and they will be managed by the buyer.
Is this a smart investment? As an investor in multi-family or income-properties, quick ways to evaluate this situation are to compare the cash-on-cash return and the Cap Rate this investment has. The simple explanations to these two methods are: we want to know how much, in a percentage, each dollar invested is returning to us (cash put out returning X amount of cash from the investment) similar to what a bank expresses in their CD rates, and the Capitalization Rate (Cap Rate) is the Net Operating Income (NOI) divided by the purchase price. Cap rates are useful to measure how an investment does after all operating expenses (utilities, advertising, vacancy, taxes, etc) are removed from the gross income taken from that property but it does not include the debt service (mortgage). This point goes back to what I mentioned about different investors needing to put down more money or get different interest rates and finding the Cap Rate eliminates all of those discrepancies between borrowers and just tells you the amount left after all operating expenses have been paid. From that remaining balance, the debt service and profit is left to be paid out.
In our situation, the buyer needs to put down 25% of the sold price which is $80,000 (we are not including any of the other lending fees or closing costs in this example but those will add to the total amount invested thus lowering the return). Gross rents are $800/mo per unit *4 units*12 months =$38,400/yr (no vacancy accounted for yet). Total utilities are $1200/year and there is no management since they will be managed by the new buyer. The monthly mortage payment is $1163/mo on the financed portion ($320,000-$80,000)=$240,000
So here is the break-down:
Gross rents $38,400
5% vacancy -$1920
utilites -$1200
Taxes -$2500
Insurance -$840
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NOI $31,940
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Debt service/yr $-13,958
Reducing the NOI by the debt service leaves us with the profit: $17,982
So the Cap Rate is: NOI/purchase price --> $31,940/$320,000 = 9.98%
The cash-on-cash return is: Profit/money invested --> $17,982/$80,000 = 22.48%
The cost recovery of this property is the value of the improvements, land not included, divided by its useful life set by our tax codes of 27.5 years. If the building is worth $225,000 then that value divided by 27.5 = $8182 per year that you can use to offset other taxable income. Also, every year you own this and have your tenants paying rent, you knock down your principal amount on the loan by $4135!
This example is a great investment for someone looking to own real estate in a high-rent market but it is also great for people looking to obtain passive and perpetual income.
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