BY LANCE EDWARDS— Your approach when buying a multifamily property should be to only buy properties that will cash flow.
You want to be able to pay for them and leave some cash at the end of the day. As a buyer, you want the cap rate to be greater than the prevailing interest rate plus two percent. Cash flow is what is paid after you subtract the debt service from your net operating income, or NOI.
Here’s an example of this principle in action: Let’s say you purchase a 10-unit property for $220,000. The NOI is $27,000 per year. The debt service is $22,000 per year (this is principle and interest payment). You will take $27,000 and subtract $22,000 and you will have $5,000 per year as your cash flow.
That’s not a great cash flow but in this deal there is no cash out of your pocket.
In order to determine your cash flow, you need to keep in mind the cap rate. Your minimum cap rate needs to be greater than nine percent. If you follow that rule, then your property will cash flow.
If it costs seven percent to buy the property and the property returns nine percent or more, then there is enough to pay the interest and principle of the loan. The property has enough to pay itself.
You should use 10 percent as your minimum cap rate. If the interest rate were to go down then that 10 percent rule would change. The market cap rate would change if the interest rate changed drastically. So your formula for determining cash flow is loan interest rate + two percent.
The reason you need to have a two percent buffer is that you want to have a principle and interest payment. Some of the payment is going to interest and some of it is going to principle. The principle is paying down your equity, but from a cash flow standpoint you want to make sure there is money leftover. The more buffer you have the more money you are going to make.
There are people who buy at lower cap rates but they buy on the basis of appreciation. They have other things that they consider such as the area that the multifamily property is in so they will pay less. That is what may drive our market rate down. The competition for deals may go up so the market cap rate may shift down.
If your market cap rate goes down, that is good for you. A decreased market cap rate drives your equity up. It causes your existing properties to be worth more. If the interest rates go down, the value of your property goes up because your market cap rate went down. You can still buy properties above that spread.
Your goal with multifamily properties is to turn a nice profit with as little of your own money as you can. The important thing when examining a multifamily deal is to try and design the deal so that there is cash flow after everything is said and done and the numbers are all crunched.