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
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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
Tagged with:
apartment & multifamily ,
cash flow ,
expenses ,
income ,
Karen Hanover ,
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