The 5 Terms you Need to Know When Investing in Multi-Family Real Estate
Every industry has its own lingo and acronyms that can be confusing and difficult to understand. Multi-family real estate is a complex business with lots of intricate details that can be strenuous to navigate. Investing in property can be very intimidating when you don’t understand the lingo. We don’t expect our clients to be real estate experts because that’s what we’re here for. Lyon Stahl provides our clients with real estate expertise, to guide them toward financial freedom. To help keep clients as informed as possible, we’re breaking down 5 common and necessary real estate investment terms into a reader-friendly glossary to help limit concerns of misinformation to help clients make the most informed decisions.
1. Pro Forma
One of the first things investors should take into account when considering a potential real estate investment property is the projected cash flow, outlined in a real estate pro forma. A pro forma is a method of calculating financial outcomes to indicate current or projected values and allows investors to evaluate the overall profitability of a property. Simply put, a pro forma is a cash flow projection. Despite being constructed through different templates, excel sheets, or software, there are many common components that all real estate proformas include. The pro forma uses income data to create assumptions about the projected financials after operations were optimized.
2. Gross Rent Multiplier (GRM)
Gross rent multiplier (GRM) is the most useful and effective when comparing, valuing, and selecting potential investment properties. What differentiates GRM from other valuation methods is that it analyzes investment properties solely using its gross income. GRM is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses such as property taxes, insurance, and utilities. GRM indicates the number of years the property would take to pay itself off in gross received rent. Investors are looking for a lower GRM because it indicates a better opportunity at profitability. GRM is calculated by the asking price or the fair market value of the property divided by the estimated annual gross rental income.
3. Capitalization Rate (Cap Rate)
The capitalization rate (cap rate) is the most common measure to asses the potential profitability, return, and risk on a real estate investment property. The cap rate is computed based on the net income that the property is expected to generate. The cap rate formula is the net operating income of the building divided by its market value or purchase price. The cap rate represents the yield of a property over a period of one year, assuming that the property is purchased with cash and no leverage. Because the cap rate formula discounts debts, such as mortgage expenses, the cap rate is focused solely on the property alone, rather than the financing used to purchase the property. Cap rates also serve as beneficial measures of risk. By concentrating on the merits of the property’s financials, you are able to compare the risk of one property or market to another. A higher cap rate indicates a more risky investment, while a lower cap rate indicates a lower level of risk.
4. Debt Coverage Ratio (DCR)
Debt coverage ratio or debt service coverage ratio is the measure used by bank loan officers to determine income property loans. The debt coverage ratio indicates the investor’s ability to pay the property’s monthly mortgage payments by using the cash flow produced from the rental property. DCR compares a rental income property’s net operating income (NOI) and the total amount of the mortgage payments, indicating the relationship between a property’s NOI and the mortgage payment expressed as a ratio. The DCR is one of the most important factors used to determine whether or not an investor will be approved of a commercial mortgage request. The ratio helps guide bankers and lenders to understanding whether or not the property will generate enough cash flow to pay rental expenses. It also gives lenders insight on whether the investor will have enough left over to pay them back on the money borrowed. The DCR is computed by dividing the property’s NOI by a property’s annual debt service (which is the annual total of your mortgage payments).
Commercial lenders rely on the DCR to asses how large of a loan can be supported by the cash flow generated by the commercial property. Commercial lenders also use it to determine how much income coverage there is at a certain loan amount. DCR will always result in one of three ratios: greater than 1.0, exactly 1.0, and less than 1.0. The result of a CPR is an indication of whether a lender will accept or deny a loan amount. Generally, lenders require a DCR of between 1.25 and 1.35, meaning that the property should be able to generate 25% to 35% of excess cash to cover debt payments. Interpreting the results of a DCR is simple:
- A DCR of less than 1.0 is likely to be denied by lenders because it indicates that the generated cash flow is not enough to cover the property’s operating and rental expenses and have enough left over to cover mortgage payments. For example, if a property had a DCR of .75 that implies that the property is only able to cover 75% of the annual debt payments.
- A DCR that is greater than 1.0 indicates that the property produces enough cash flow to cover its operating expenses as well as an additional amount to cover the property’s debt payments. For example, a DCR that is 1.25 indicates that the property generates enough cash to cover operating expenses as well as 25% of the debt payments.
5. Value-add/ upside
Value-add is a term used to define the risk and return characteristics of a real estate investment. Value-add properties usually have little to no cash flow at the time of purchase but have the potential to produce large amounts of cash flow once the value is added. Buildings that have small cash flows at initial purchase usually have management problems, occupancy issues, deferred maintenance, or a combination of the three problems. These types of buildings are target properties for investors because they are seeking to increase cash flow overtime by repositioning the property through a variety of improvements. Repositioning property is a real estate investment strategy where investors attempt to change the position of the property in the marketplace through improvements of the property. Improvements range from making physical improvements, increasing efforts to occupy spaces, improving the management of the building to increase resident satisfaction or lowering operating expenses wherever possible. Value-add properties are very common among multi-family real estate investors because of their ability to offer revenue and value enhancements.
Because value-add investments appreciate in value, most successful value-add projects generally produce higher financial returns to investors than core investments. However, value-add properties tend to be accompanied by risk, mainly due to the fact that at the time of purchase the property is not producing at its highest potential. If the investor does not execute their plan to increase the property’s value and fails to meet projections then they could risk continuing to generate very low cash flows or having to sell the property at a lower price than expected. Most investors consider value-add projects to provide the perfect balance of risk and return because of the upside potential in the form of value appreciation.