If you invest in real estate you are going to look at, and pass on, a lot of deals. There is no way around it. The only way to filter deals efficiently is to develop an analysis funnel. The analysis funnel has a simple principle. You will not accept most deals and thus need to eliminate quickly at the top and as you move down the funnel you create more refined criteria.
So now I’ll go through my levels of deal analysis for multifamily. You can find a link to our single family guide here. If you have any additional steps let me know. I’m always open to improving. Once you create a process, let brokers know in your market. Brokers like dealing with owners that have a crystal clear vision of the type of property they want to find.
The first criteria is the market you are looking at. Sometimes that is determined based on where you live or where you grew up. For new investors I recommend to start out investing where they know. Other times it’s based on a detailed analysis of national markets taking in market criteria. This is a whole ‘nother post but let me give you a quick list of things to consider:
For me I invest in Houston, because I grew up and live here. It’s the third largest city in the US and has good deals within the many submarkets of the city. I also manage, educate, and partner with investors in the Houston area. All of these factors will make it unlikely I ever completely leave this market. I will give one word of warning. You are much more likely to lose substantially if you go into an unknown to you market.
Once you have decided on a market you no longer need to revisit this step every deal.
Multifamily is a bit trickier than single family. You are going to need to develop relationships with brokers for small and large complexes. Loopnet is a great place to start. You will need to understand the details of your market such as price per door, areas with appreciation opportunities, class of the building, tenant quality, management issues, etc. Once you examine these criteria, pick the unit size that is right for you. We classify properties as:
Now note in the grand scheme of things 80 unit plus is not large, but we are looking at deals from $4-20M in the Houston market. Many large firms won't look at anything that isn't 250 doors or more.
Now that we have our market and property criteria we will receive leads. The first analysis we will do is what I call my back of the napkin calculation. These are quick calculations that can be done in a few minutes. This will eliminate the majority of deals.
This is calculated by taking the average rent of the complex and dividing into the per door price. Let me give you an example. Say a 10 unit is listed for $10M. That is a per door price of 100,000 ($10M/10). Then I will get the current rent roll (never use the pro-forma) and figure out the average rent. Let’s say it’s $950 per month. This means the average rent to door price ratio is 0.95% ($950/$100,000). I try and find average rent to door ratios of 1.25% or more.
This is the number one way I see new investors lose money. They want a homerun deal on their first property. Don’t make this mistake. It will always cost you more money and time than you think to get your property remodeled. I’ve done over $3M in real estate improvement projects. I am just now starting to feel comfortable about timelines and costs. It’s very difficult to get right. For these types of projects I look at my return on capital. How much money am I going to have to put in and what will be the increase in property value? These formulas are a bit more complicated
Cash in the deal (purchase cash plus rehab, and holding cost) / new after repair value = Return on capital
My criteria is going to change based on how much rehab work is required. The more work the higher return I need to justify doing the project. I like for light rehab to be 15-20% return and major to be 25%+. The more inputs you have into your formulas the easier it is to fudge the numbers to get the outcome you want. I recommend that you own at least 3 houses/micro apartments with no or very light (carpet, cabinet paint, backsplash, etc.) rehab work before getting into major projects. Or work with someone who is experienced.
Next I’ll do a quick cash flow calculation. This is a way to determine the as is performance. Note that if rents are extremely under market it indicates you need to perform significant rehab. Use the current rents. Class C tenants and Class B tenants don’t work well together it takes time to fully transition to new rents.
Current rents X 50-55% for expenses = Projected net income less debt service
I’ll calculate the top end and low end of that. Again it all depends on the opportunity, but I try and find something that will cash flow as is with significant upside. If there is significant development in the area then that makes me more excited.
Also around this time I ask myself How can this deal go bad? I want to start thinking about what my biggest risks are.
If I feel like the deal has potential I will try and back in what I think investors will make on the deal. I always solve for the investors first and then figure out what I can get on the back end. If you invest in multifamily you have to take care of investors first, protect their money, and make sure they get paid before you. You want to have a pool of investors that invest in all your deals. The investors who spend 90% of their time fundraising aren’t taking down very good deals.
The investor return for me depends on the risk of the deal, holding period, and other qualitative factors. This is part of the underwriting process so I just do some quick calculations to see my range. I’ll usually assume investors would want a 6-8% return on their investment as well as a true return of 20%+. I can then throw this in the calculator.
(Quick Cash Flow X Investor size of deal) / investor capital required = year 1 COCR
I will then tweak variables to solve for that value.
Part two to follow soon!