Power of the Cap Rate in Multifamily

blog Nov 15, 2019
There is one thing that sets the multifamily investing business apart from all others. That one thing is 'The Power of the Cap Rate'. 
 

The way I teach multifamily is different than everything else, everyone else. Because what I say is, multifamily is not real estate. It is not real estate. Let me put it to you this way. 

Let's say Dave owns a 100 apartment complex built in 1986. It has 60 one-bedrooms, 40 two-bedrooms, it has pitched roofs, separate entrances, individually metered. Great property. And Link owns an identical property across the street. Absolutely identical, built by the same builder. The fact that they're across the street has absolutely no meaning whatsoever on the difference in any value, okay? Location is the same. Whose property is more valuable? Link's, or Dave's? 

So we're talking about real estate here guys. So, they're right across the street from each other, which one's more valuable?

Well, it depends upon the NOI with the cash, the income, right? So if I told you that Dave's property was 100% occupied, and Link's property was 100% vacant, which one would you want to buy? 

Yeah, you want to buy Dave’s!

But the fact is, real estate is secondary to the equation. The thing that we're looking at is the cash flow. The way you need to look at multifamily property is - it is nothing more than a factory that produces a product that people buy, that we sell. 

And what is that product? 

A lease. It's really a contract, nothing happens in this business until that lease gets signed. We sell leases. And that lease provides us with cash flow. 

Think about that when you're out there looking at deals, don't turn away from a multifamily opportunity because you don't know what you're doing. You guys are in the business and you're going to see a whole lot of opportunities and you need to understand when I'm looking at a multifamily opportunity, it's all about the cash flow

That's it. 

So, I'm going to do two examples here, we're going to keep this short and fast and sweet. I'm going to give you two examples. 

The beautiful thing, and this is why I love multifamily, about multifamily is that it's based upon a simple formula. A simple algebraic formula. And let me show you what that formula is. 

Very simple, we need three variables in this formula. And you know how algebra works. When you have two variables, what does that mean? We can solve the third. Right, very simple. 

So here's the top variable that we all look at, and this one was already thrown out there - The net operating income. 

Now let's talk about what net operating income is. 

Income comes in, the form of rents. Expenses go out, in the form of operational expenses. What we have left over is what we call the NOI, okay? Net operating income. 

So what does that mean? What types of things do we put in that NOI calculation? Do we put in - Insurance? Utilities? Taxes? Property management? Mortgage? We have to determine what net operating income is, and it's based upon what is the income and what are the expenses. 

And in my courses, I teach that there's good income and there's bad income. Bad income, how can you get bad income? Well, if some of the income is based upon security deposit forfeiture income, is that good income to have? No. 

That means somebody destroyed the place and moved out and you had to steal his money. Steal his money? He destroyed your place. So there's bad income and there's good income. 

Now let's talk about the expenses a little bit. You know we talk about no mortgage. Well, why isn't a mortgage in the equation? Shouldn't it be part of the equation? And the answer's no. Because all we care about is the property as an investment. The mortgage is all based upon how you as an owner did the deal. 

Here we'll get back to Dave here. So Dave has to do a 100% loan, no money down deal, all right? So he has just over leveraged his property, leveraged it up to 100%, and now he's got to run that property and earn income off of it. But Link has gone out there and he has decided “I like this property as investment, I'm not going to take out a loan, I'm paying cash for the whole entire thing.” 

What impact do those two decisions have on whether that little old lady in Unit 1B pays the rent in time? Nothing. The property continues to operate the same exact way, so when we look at this property we want to know, how does it operate as an investment? We don't care about how these two guys financed it. We want to be able to look at that asset across many different spectrums. How does it compare to everyone else? Dave put his own spin on it. But Dave's spin has nothing to do with how we operate that property. It will eventually because Dave will run out of money. 

So that's how we calculate the first variable, the net operating income. 

Now the other variable that we have is the price, the purchase price. 

Keep in mind here, there's three prices on a multifamily property. 

  • There's the asking price, which as we say in my class is the biggest lie. Okay? Don't believe the asking price. I get so many of my new students, when they're still learning from me say: My offer after I did the evaluation, I'm off by 20% of the asking price, what should I do? Make the offer. Like, I'm not even close. Close to what? A lie? Just make the offer. So that's the purchase price. 

  • And there's our offer price

  • And the third price is the price that we settle on. So after we do that now we know what the two variables are, and we can solve for... 

This variable that everybody kind of shakes their head at, and some people get it and some people don't. It's called the cap rate. The capitalization rate

It's a way that we value multifamily property. There is no set number, it is driven by the market. It is not made up by mere mortals. You have to understand the market that you're working in to determine what the cap rate is. 

Different types of property and different types of assets have different cap rates. The better the area, the higher the price. When you're dealing with a low cap rate, that's a valuable asset. When you're dealing with a higher cap rate, that's a risky asset. And the reason why we use cap rates is because we want to know the risk. 

Those guys in school that you know were really really good at math, who couldn't make a buck but they needed a job. And so, they all became financial analysts on Wall Street and now they're making huge money. These guys needed a way to calculate out different types of investments across different spectrums. 

What we do with multifamily is we use the cap rate. We also look at the quality of the asset. 

So, this is a formula. 

When you understand this formula, you understand multifamily. You will never go wrong if you stick to this formula and you understand these three variables.

So let's take a look at what we do in multifamily is we categorize assets. We call them four categories of multifamily. 

  • Class A, that's where we all want to live. This building is a Class A hotel. What they've done to this is beautiful. 

  • Class B, is slightly lower than an A. It's been around a little bit longer and it gets less rent. 

  • Class C properties are properties that are tough to own and operate. I used to, I've owned all three classes. 

  • Class D is a non-performing asset. D is just a war zone. That's exactly what I say. D is the kind of property you don't want to own. I've owned all types. And I didn't know I was buying a D at the time, but it became a D, all right. 

So the thing that makes it from an A to a B to a C to a D, what is it? Time. 

Nobody goes out there and builds a Class C today. You build a Class A and you just wait 20 to 30 years and it becomes a lesser grade. So the cap rates on these properties start out like 2%. New York City - you're looking at two. Over here to C - 14% cap rate- but that's a better return, isn't it? It's also a lot more risk. Is a junk bond a good return? Versus a government bond? 

This is how we rank multifamily. 

So let's take a look at exactly how this cap rate works, and you'll see how this differs from the single family side to the multifamily side.

Let's take a look at Class A. In this particular case, this property that we're looking at, and everybody get your calculators out 'cause we're going to do a little bit of math. This property rents a two bedroom two bath rents for $2000 a month. This C class rents, same type of unit, for $750 per month. These are real numbers, you can go out there and find a C class property for two-bedroom. These are the market rents. This is what we call a top line number. 

But these properties are not commanding that, they're not getting it. Their leases, they're now trading these properties for $1900 a month and $650 a month. In other words, this is what we call the scheduled rent. This is what people's leases say. So why aren't they getting the 2000? Well they're trying to fill the units. So they're trying to be a little bit below market so they can fill the units. So the difference between the two numbers for either property is $100. Now you come along and you say: “Hey, I want to buy this property, because I see some great potential. I see that we can increase the rents. And if we increase the rents, NOI goes up, cap rate, we make more money.” 



All right. We want to increase our rents by 100 bucks. Now the market comes along and says: “You can't increase your rents by $100 on this property, without doing anything to it. You've got to rehab it, you've got to fix it up. And once you fix it up, then you'll command more rent.” 

Okay, well how much should I spend? Well, in order to do this, you're going to have to spend $3000 per unit. Not much of a difference in the rent, but still a 100 bucks. 

Well, what do I have to do to get that 100 bucks? Well you got to go clean it up and you know, make it look, gussy it up, and spend $3000 per unit. 

You look at this and you say: “Wait a minute. Why would I spend $3000 to get $100? That doesn't make any sense.” Well that's true in the single family world. Let me show you what happens in the multifamily world, okay? 

For 100 bucks, that's $1200 a year. Now remember what we said in the formula about the cap rate. So here, this Class A is a four cap, and this Class C is a 10 cap. What happens to my net worth as the owner of this property when I put $3000 in?

Don't just say increases, I want numbers, how much 'cause it's a formula, this is real, you can go to the bank with this. We use formulas in this business at work. 

Divide $1200 by 0.04 = $30,000

How about with the 10 cap, what happens? We get $12,000.

We both spent $3000 to get the same $100, but because the Class A property is trading at a four cap, when I walk into my bank and I show them my personal balance statement, I can show them that my net worth went up by $30,000 this year, just by increasing by $100. 

Now do you see the power of multifamily, as I call it the power of the cap rate? That's how we build wealth in multifamily. You increase the rents, you maintain it, you run a very good business. Over here on the Class C, the guy made $12,000. 

So go back to your original point that I was making about single family fix and flip. Why should I do $3000 for 100 bucks? We don't look at it that way, we hold these assets. And when we hold these assets our net worth goes up. You know what I'm going to do next here with this rent? I'm going to go up another 100 bucks. Now I'm worth $60,000 more. That is the power of the cap rate! That is how multifamily works, and that's why you do need to keep it in mind when you're out there looking at your deals.

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