Apartment & Multifamily investment requires excellent control of expenses to maximize cash flow. But, vacancy and credit loss are two items that need just as much attention, though they’re on the income side of the financial sheet.
It can be a lot easier to negotiate a better deal on landscaping services than to analyze and attack multiple issues that make up vacancy and credit losses. That’s because there can be marketing factors, as well as management failures in the interview and tenant selection processes.
Vacancy Costs in Apartment & Multifamily Investment
Vacancy costs are comprised of more than just units that aren’t rented at the time. There’s also the costs involved in rehab of the units between tenants. So, turnover is a part of vacancy loss. These two items comprise the marketing and tenant relations side of the vacancy loss picture.
How is the marketing working for the project? Has ownership been keeping up with changes in demographics that influence available tenant prospects? Is the marketing plan being regularly reviewed with new market information?
Are the advertising media being used still as effective as when they were first put into play? What could be done differently to generate interest and get empty units occupied? Does the math tell ownership that rent cuts would be better for cash flow than retaining empty units? Or, possibly a free rent promotion could fill the units, cutting vacancy loss.
Credit Loss in Apartment & Multifamily Investment
This is on the expense side, but credit loss many times begins with the interview and selection process. If vacancy loss is a problem, it can contribute to credit loss later if ownership relaxes their tenant selection criteria in order to fill units.
Sometimes, the dislike of taking appropriate eviction action can delay the turnover of a unit, increasing credit losses.
Are there adequate credit check and references follow-up practices? Are they being followed? Sometimes, if legally allowed, increasing deposit requirements for marginal tenants can help in this regard.
If some tenants are having rent payment problems that are temporary, can they pay with a credit card? If they can get over a rough patch with credit, it may keep an otherwise good tenant and cut credit losses.
Vacancy and credit losses are damaging to apartment & multifamily cash flow, so they should be attacked and resolved at every opportunity.
I’ll share more with you soon…
Warm Regards,
Karen Hanover, CCIM Candidate
Apartment Education Institute, President
One of the reasons that apartment & multifamily investing is available to a great many real estate investors is that cash flow is the primary consideration in loaning money on a purchase.
It isn’t about the credit score of the buyer, and it’s less about the standard residential concept of “loan-to-value.” Though appraised value is important, cash flow is critical. There are two ways in which lenders look at the cash flow.
These ratios indicate the ability of the property to generate enough cash to pay the monthly mortgage, as well as leave a profit for ownership.
Cash Flow Analysis, Stability and Future Risk
First, it’s very important to get the income and expense numbers “right.” Are all of the rents at market rates? If some tenants have been given special deals, or just generally the rents are all below market, then income could be better if rents are increased at expiration of leases.
Expenses should be appropriate, reflecting efficient management, reasonable repair costs, good turnover rehab practices, and no “sweetheart deals.”
Any expense categories that are out of line should be addressed, or a plan put in place to deal with them after purchase. When approaching a lender for an apartment or multifamily mortgage, documentation of the ability to raise rents and/or cut expenses quickly could result in a better mortgage deal, as cash flows can be expected to improve.
The next consideration is the expected stability of rents and cash flow into the future. Lenders hate risk, so a marketing plan, budgets, and projections of future vacancy and credit losses is critical. Once the current and projected cash flow is determined, two common ratios can be applied to see how lenders will look at the property for a mortgage.
DSCR – Debt Service Coverage Ratio
This ratio takes the net income from operations, or cash flow, and compares it to the expected mortgage payment. Most lenders want to see a ratio of at least 1.25-to-1 of cash flow over the mortgage payment. In other words, if the mortgage payment is to be $8000/month, then cash flow should be at least $10,000/month to yield this 1.25 DSCR.
Break-even Ratio
Here, the lender takes the annual operating expenses, adds the annual debt payments, and divides the total by the Gross Operating Income (GOI). What they’re going is seeing at what point the income overtakes the expenses, or the break-even. If the annual expenses are $35,000, and the debt payments total $72,000/year, a GOI, gross operating income of $150,000 would look like this:
($35,000 + $72,000) / $150,000 = 0.71, or 71%, the Break-even Ratio
Generally, lenders want a Break-even ratio lower than 80%.
I’ll share more with you soon…
Warm Regards,
Karen Hanover, CCIM Candidate
Apartment Education Institute, President
Cash flow is king in apartment & multifamily investment. It’s used to determine cap rate, as well as DSCR, Debt Service Coverage Ratio. If the cap rate looks good, and the DSCR is 1.25 or better, lenders come to the table with mortgages.
Borrower credit scores and other income streams are not the decision criteria, it’s all about cash flows, their stability, and predicted long term performance. So, if cash flow is that important in apartment & multifamily property valuation and lending, it follows that accurate calculation of a project’s cash flow is quite important.
Though ferreting out hidden effects on cash flow can produce a negative result, it’s more likely that there are benefits to the buyer in locating hidden cash flow items that indicate better performance than the surface quick analysis might show.
These cash flow influence items can be on either the income or the expense side of the balance sheet. They consist of items that would increase income or decrease expenses, but they may not be obvious. Or, there are more likely just inefficiencies of operation that can be eliminated.
Another common expense-side situation would include expenses for owner perks that reduce taxes but could be eliminated after the purchase.
Income Side Cash Flow Items
Are the rents at market rates? It’s a revelation to some apartment & multifamily buyers to find that there is a significant portion of the project at lower than market rental rates.
Some owners find it easier or more comfortable to make rent concessions than to make improvements or re-market for new tenants when they lose some to rent increases. Though this can work the other way, with prevailing rates now lower than long term tenants are paying, it’s usually more of the depressed rates.
For a variety of reasons, there are tenants paying significantly less than a new tenant would pay for the same unit. Locating and monetizing these situations can change cash flow, cap rate, value and loan amount.
Expense Side Cash Flow Items
There is a lot of opportunity in this area. The costs of operation encompass a long list of expenses. From everyday management & maintenance, to repairs, re-let costs and more, there can be lucrative cash flow increases by locating and doing away with inefficiencies. The larger the project, the greater the impact.
Changing repair companies, or renegotiating costs of repairs can make a huge difference. There are other examples, but the best statement that can be made is to thoroughly analyze apartment & multifamily rents and expense items to locate cash flow problems that can be corrected.
I’ll share more with you soon…
Warm Regards,
Karen Hanover, CCIM Candidate
Apartment Education Institute, President
NOI, or Net Operating Income is a calculation to determine the approximate cash flow of an apartment or multifamily project by subtracting operating expenses from the gross operating income after subtraction of vacancy and credit losses.
The goal of the NOI calculation is to capture all of the operating expenses, subtracting them from rental income, and resulting in the cash flow after expenses.
Operating expenses can be grouped in many ways, and not everyone does this calculation the same way. But, an example list of operating expenses of an apartment or multifamily project would normally include:
Property Ownership Related Expenses
· Taxes, whether property, school or other taxes on property value or location
· Insurance to protect investment from fire, damage, theft and liability
· Licenses and permits to operate
Utilities or Fuel
· Electricity
· Natural Gas
· Water & Sewer
· Cable TV or Satellite TV services
· Trash removal
Maintenance & Repair
· Exterminating
· Landscaping
· Decorating
· Cleaning
· Pool/hot tub maintenance
· Grounds maintenance/snow removal
· Elevator services
· Parking lot cleaning and maintenance/repaving
· Maintenance supplies
· Repairs
Salaries & Management
· Contracted management services
· In-house management salaries
· Housekeeping and in-house landscaping services
· Office staff
· Security Services
· Bonuses and commissions
· Payroll taxes & other payroll burden
· Legal/accounting/professional
Advertising and Marketing
· Print and other media for advertising
· Marketing materials and design services
These comprise the Net Operating Income expenses without reserves for capital expenditures or reserves for improvements and remodel. Adding these reserves to the subtotal of those expenses listed above would result in the operating expenses. Subtract that total from the income from rents to get to the NOI, or Net Operating Income.
Using this NOI, the potential buyer of an apartment or multifamily property can do a cap rate calculation to help in valuation of the property.
Using the prevailing cap rate of recently-sold properties, the buyer can determine the approximate value of the property in relation to the asking price. As this NOI is the cash flow, the seller can also determine a probable asking price using the prevailing cap rate.
Lenders can also use this number to determine through DSCR, Debt Service Coverage Ratio, the amount to loan on the property in a purchase transaction.
I’ll share more with you soon…
Warm Regards,
Karen Hanover, CCIM Candidate
Apartment Education Institute, President
