This is the next article in my series on investing in Dayton area multi-family units and apartment buildings. My last article provided an overview of topics which this series will be addressing. I decided to write on this issue due to the fact that our area’s current real estate market appeals to many investors. This is due to both affordability and the “hot” nature of our market. In this article I will be discussing what is, for obvious reasons, an important question for many investors. That question is how to determine a price to offer for multi-family units, such as duplexes, or apartment buildings. If you are considering investing in our area, then contact me today to speak with a real estate agent.
There are many considerations which can help determine the value of a multi-family building. The first of these considerations is the rent/cash-flow provided in relation to the purchase price, the second is the condition of the property and the possible need for repairs and renovation, and third is the quality of the leases and the current status of tenants. Finally, it is important to consider what comparable properties have sold for. I will discuss each of these in turn.
Dayton area investors can use the cap rate and cash on cash formula to determine a fair value
There are several metrics that investors use to determine if a property is priced in a way that makes sense to explore further. On a single family property, many investors begin with the “1%” rule, meaning that the rent which a property yields should be at least 1% of the purchase price. Multi family properties get more complicated, and require further exploration. A common formula to start with is the cap rate, which is the ratio of a property’s net operating income to its purchase price (Cap Rate = Gross Operating income – expenses/purchase price). For example, if a property netted $10,000 for the year, and the property was purchased for $100,000, the cap rate would be 10%. If the owner paid all cash for the property, and rents remain the same, it would take 10 years to make their money back.
There is no hard and fast requirement when it comes to cap rates. Cap rates will be lower in more desirable areas, with higher income tenants, more well kept buildings, and lower risk areas. Cap rates will be highest in C or D class areas that are considered higher risk to the investor.
Of course, many investors do not pay for properties in all cash, and choose instead to use leverage. In this instance, the cash on cash formula allows investors to calculate how many years it will take to make their investment back. Cash on cash return equals annual pre tax cash flow divided by total cash invested. For example, an investor may buy a property for $100,000, and put 20% down, or $20,000. Let’s suppose that they are getting $800 in rent, but their mortgage payment is $400. In this scenario, their monthly cash flow would be $400, and the annual cash flow would be $4800 ($400 x 12). The annual cash flow of $4,800 divided by the initial down payment of $20,000 equals 24%. This means that it will take a little over four years for the investor to get their initial investment back, and begin to see a return. It also means that if rents remained the same, before taxes and expenses, the property’s profit would be $4,800 annually.
As with the cap rate, different investors will look for different cash on cash rate targets. It is important to remember that rates will vary depending on the area, building condition, and current market climate. It will be more difficult to find exceedingly high cash on cash rate returns in trendy areas, during strong seller markets, or when specific inventory is low. But these formulas can be a starting point to determine if a building is priced appropriately, and to determine if a property should be explored further.
The condition of a multi-family unit or apartment building can impact what Dayton area investors will pay for the property
The second step in determining a multi-family unit’s value is to consider the condition of the property. There are two ways in which a property’s condition impacts its value. First, one should consider any required improvements which must be made immediately and factor them into their calculations. Second, one should consider if optional improvements could be made in order to be able to raise a tenant’s rent and increase long term profitability.
When buying a multi family dwelling, it is likely that individual units will need cosmetic upgrades once the tenants move out. Dayton is also home to older buildings, and it is not unusual for multi family properties in this area to be built between 1910-1960. Common issues that come up include older windows, older roofs, older cabinets, leaky basements, etc. Immediate repairs that must be made to the property should be factored into your equations when making an offer. For example, suppose a property is for sale for $100,000, and the property brings in $15,000 in annual cash flow, making the cap rate 15%. But on further investigation the property is determined to need a new roof, two new furnaces, and a water heater and the estimate is $20,000. Suddenly, the real cost of the property would be $100,000 plus the $20,000 in immediate repairs, bringing the cap rate to 12.5% instead, and if you are using the cash on cash return formula, it will double your initial investment.
There are also instances in which an investor may wish to consider how optional repairs or improvements can make a property more valuable. These are instances in which making a small improvement may greatly improve the amount of rent which tenants may be willing to pay. Such improvements can be cosmetic or they may also take the form of providing more for the rent received. To prove this point I will give a personal example. I recently began including washer and dryer units with my rental properties. This required me to pay out money to purchase a washer and dryer before the tenant moved in. The extent to which the washer/dryer units increased the amount of rent I receive outweighed their cost. For example, a $57,000 home I purchased would likely have rented for $750-$775 per month. By adding a washer and dryer, however, I was able to receive $795 per month in rent. The new appliances cost a total of $800. Assuming the washer/dryer units last at least ten years, then I will receive up to an additional $5,400 in rent over that time for an $800 cash outlay. I can calculate my Return on Investment (ROI) by taking the gain from the investment, subtracting the cost, and then dividing by the cost of the investment (ROI=Investment Gain-Investment cost/Investment cost). For example, if I want to know the ROI of my investment over a ten year period, my investment gain from adding a washer/dryer is approximately $45 per month x 12 months a year x 10 years = $5,400 in additional income. $5,400 minus the initial investment cost of $800 equals $4,600. If I divide $4,600 by the initial $800 cost, my ROI equals 5.75 or a 575% return on my investment over 10 years.
This is a simplified example, but it shows how much a small investment can return in the long term. When making determinations about how much an improvement will pay off, an investor should consider how long they intend to hold the property, the current rental market their property is in, and if the proposed improvements will justify the rent increase.
A Dayton area multi-family unit’s value is impacted by its current renters
A third issue which investors should consider is whether a Dayton area multi-family unit is vacant or whether it already has tenants. In general, the more units a property contains, the more likely that at least some units will be filled. There are pros and cons to buying a fully occupied property, versus a property that has vacancies. In the first scenario, the property is already bringing in cash flow, and the new owner can delay making cosmetic improvements until the current tenants attrition out. This allows the new owner to build up a nest egg from rental income, to put towards improvements later down the line.
On the other hand, there can be transitional issues with current tenants when a building is sold. First, it is not unusual for rents to be below market value when a property is placed on the market. Prior to putting in an offer, a buyer must figure out why this is the case. It may be because the current owner has not kept up with current market rates, or it could be because the rental units are not to the standard to command top market rent. This information should be investigated by the potential buyer, and considered in their calculations prior to putting in an offer. Once an offer is put in, as part of a contract, the buyer should request copies of all current leases, profit and loss statements, and all available current financials. With all of my contracts, I require the seller to sign an additional addendum stating that all tenants are current on rent, and not being evicted, and place protections in my contract in the event anything changes within the escrow period. A buyer does not want to get stuck with poorly written leases, have to take over the legal fees for an inprocess eviction, or find out later that a large percentage of tenants are behind on rent payments.
Previous sales of comparable Dayton properties will guide a fair purchase price for buyers
Finally, comparable sales in any given area will help a buyer determine what to expect when it comes to cap rate and cash on cash returns. Every market is different, and the cap rate for investments in Dayton, Ohio is far different than in San Francisco, California. Looking at properties that have sold in the area of a building you are interested in will provide invaluable information. One, previous sales will provide guidance on if a property is fairly priced or significantly overpriced. Two, it will give you an idea of what average cap rates are for the specific neighborhood you are considering. Three, it will provide you an idea of if your goals are realistic, or if you need to look into a different area to get closer to the returns you desire.
If you are considering purchasing multi-family units in the area then contact me to speak with a Dayton real estate agent. I am an investor myself and I regularly assist other investors with finding local properties. I pride myself on providing quality service and I look forward to speaking with you. I also service the areas of Beavercreek, Centerville, Clayton, Englewood, Oakwood, Fairborn, Harrison Township, Huber Heights, Kettering, Miami Township, Miamisburg, Riverside, Springboro, Trotwood, Vandalia, Washington Township, West Carrollton, and Xenia.
Note: Nothing in this article, or on this website should be construed as investment or financial advice. The opinions shared on this website are the personal, and not professional, opinion of the author and are not associated with Keller Williams Advantage. Any investment decisions should be made after consulting with a certified financial/investment professional.