Terminology Multifamily Investors Should Know (Part 1)

This blog post is part one of what is going to be a multi-part blog series. The purpose of the series is to provide investors with the necessary terminology needed to speak confidently about multifamily real estate (and real estate in general). In addition, the terms that I highlight in this series will help investors vet deals so as to put their hard earned dollars to work to generate passive income. I will note that I have not put these terms in specific order, but rather leave it up to you to make sense of how these terms, in addition to the ones I will explain later in this blog series, fit together. With that being said, whenever someone is looking to invest in an asset they need to be able to understand exactly how their money is being allocated. As investors, we can’t simply blindly invest with the hopes that we will reap the benefits of our investment. Thus, in this post I will introduce five terms that are regularly used in the world of commercial real estate. The later posts of this series will continue to build upon the last. I hope that by the end of this post you will be one step closer to being able to vet and understand multifamily deals.

NOTE*- I will abbreviate multifamily to “MF” for simplicity’s sake.

Net Operating Income (NOI)

Net operating income (NOI) tells you how much money you make from a given investment property. NOI is a profitability metric and equals all revenue from a property, minus all operating expenses (OPEX). Operating expenses refers to expenses a property incurs through its normal business operations. OPEX includes line items such as payroll, insurance, taxes, marketing, property management fees (ranges from 3-10% depending on size), utilities, etc. NOI consists of rent collected as well as additional income such as that coming from laundry machines, pet fees, parking fees, etc. NOI excludes not only mortgage payments, but also interest on mortgage payments, taxes, and capital expenditures. It’s important to remember that when evaluating the strength of an investment, projected rents could prove to be inaccurate so it’s important to evaluate the feasibility of rent projections. For example, someone may think they could bump rents up by $100 two years into an investment, but that may prove to be false if that individual didn’t accurately evaluate market rents. The NOI metric is used solely to judge a building’s ability to generate revenue and profit. In the case an investor is taking advantage of financing options, it tells you if a specific investment will generate enough income to make mortgage payments. For example, if a property’s NOI is $50,000 and mortgage payments are $25,000, then you know you’ll have $25,000 pre-tax profit. I mention this term first because we will be using it when calculating the next term, capitalization rate.

Capitalization Rate (Cap Rate)

The capitalization rate (also known as cap rate) is used in the realm of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property without factoring in financing. For example, if a building has a 5% cap rate and you paid all cash then you can assume you will generate a 5% return on a yearly basis. However, after factoring in financing that 5% return would be lower because you would have to pay the bank principal and interest payments. This metric can be calculated by dividing the income produced from a property (NOI) by the price of a property. For example, if a property has a $1,000,000 purchase price and generates $50,000 in NOI then the cap rate would be 5% ($50,000/$1,000,000 = 5%). While this metric can be useful for comparing the relative value of similar properties in a market, it should not be used as the sole indicator of an investment’s strength because it does not account for leverage/financing, the time value of money, and future cash flows among other factors. Thus, in other terms, this metric indicates a property’s intrinsic, natural, and unlevered rate of return. Something to note is that since cap rates are based on the projected estimates of future income, they are subject to a large degree of variance/change. What this metric also indicates is the time it will take to recover the invested amount in a property. For instance, a property with a cap rate of 10% will take roughly 10 years to recover the amount invested. Hotter markets (those areas with high levels of population growth, job growth, etc.) typically have lower cap rates which means properties are valued higher and vice versa for less desirable markets. While intuitively it may seem that a higher cap rate is better since the return is higher, that is not necessarily true because an investor must factor in individual market factors (crime, access to transportation, job availability, etc.). Cap rates can be misleading in the ways that I’ve noted above and also when evaluating properties with unstable cash flows. The capitalization rate is only useful to the extent that a property’s income will remain stable over the long term. It does not take into account future risk such as depreciation or fluctuations in the rental market that could cause income to change. Nevertheless, using this knowledge you can better get a gauge of not only an investment’s strength, but also understand the market in which you are looking to invest in.

Cash Flow

Cash flow is similar to net operating income (NOI), however it is slightly different. While NOI is simply income minus operating expenditures (opex), cash flow takes into consideration debt payments, depreciation, taxes, etc. Thus, cash flow can be thought of as what is left after all expenses are paid. Real estate investments can generate positive or negative cash flow. When a property has positive cash flow its income exceeds all expenses while negative cash flow is the opposite. Positive cash flow is the goal for real estate investors because it means they’re making money on a property or properties owned. The wider the profit margin, the better the return on investment. Cash flow is the factor used in calculating the internal rate of return metric (IRR) metric which can be often found in pitch decks to investors. I won’t go much further into defining this term because much of what is factored into calculating cash flow I covered when I wrote about NOI. Also, I’ll reserve the next post to talk about more complex return metrics such as IRR. What’s important to remember here is that cash flow factors in all expenses (operating expenditures, debt service payments, depreciation, and taxes) as opposed to simply factoring in opex in the NOI calculation.

Debt Service Coverage Ratio (DSCR)

Debt service coverage ratio (DSCR), also known as debt coverage ratio (DCR), is a metric that looks at a property’s income compared to its debt obligations. This metric is calculated by dividing the annual net operating income (NOI) of a property by the annual debt obligation. For example, if a property has an NOI of $65,000 and the debt service is $40,000, then the DSCR is 1.625 ($65,000 / $40,000). Properties with a DSCR above one are considered to be profitable, while those with a DSCR of less than one are losing money. DSCR is an essential part of the decision-making process when a commercial or multifamily lender decides to issue a loan. In general, the majority of lenders like to see borrowers have a DSCR of at least 1.25x. The reason why lenders like to see this DSCR is that they can feel confident knowing that if a property experiences a lower NOI for whatever reason (higher vacancy, expenses, etc.), the debt can still be paid. The higher DSCR that a property is forecasted to have, the more likely a borrower is to get preferential debt terms. For example, if a property has a DSCR of 1.10, that property has a low margin of safety. The chance that higher expenses or vacancies cause them to not be able to make debt payments is too high for most lenders to feel safe. To mitigate the risk, the lender may want the borrower to put down more money so as to decrease the debt payments and strengthen the DSCR as a result. Remember, the larger the down payment an investor makes on a deal, the smaller the debt payments are.

As a side note, I introduced the term margin of safety in the last example and that term refers to the chances of losing money in an investment. The higher the margin of safety, the less likely chance there is to lose money in an investment. It’s important to understand that when vetting an MF deal that the property being analyzed needs to have an adequate DSCR (preferably above 1.35) so as to be confident that if things go south the debt can be paid and the bank won’t foreclose the property.

Cash-on-Cash (CoC)

A Cash-on-cash (CoC) return, sometimes referred to as cash yield, is a rate of return often used in real estate transactions that calculates the cash income earned on the cash invested in a property. In other words, CoC return measures the amount of cash flow relative to the amount of cash invested in a property investment and is calculated on a pre-tax basis. The cash-on-cash return metric measures only the return for the current period, typically one year, rather than the return over the life of an investment or project. This metric is calculated by taking the annual before tax cash flow and dividing it by the total cash invested. For example, if a property generates $26,000 in cash flow and the total amount invested is $260,000, then the cash-on-cash return would be 10% ($26,000/$260,000). CoC is considered relatively easy to understand and is one of the most important real estate return on investment (ROI) calculations. I should note, cash-on-cash can be used as a forecasting tool to set a return target. Calculations based on the standard return on investment (ROI) metric take into account total return while CoC on the other hand only measures the return on the actual cash invested, which provides a more accurate analysis of an investment’s performance. The cash-on-cash metric provides operators and investors with an analysis of the business plan for a property and the potential cash distributions over the life of an investment.

Conclusion

After explaining the terminology above I hope that you’re one step closer to being able to vet MF deals, as well as other real estate assets, so as to decide for yourself where to put your hard earned dollars. As noted previously, this post is simply part one of what will be a multi-part blog series on real estate terminology. In the next post I will cover equity, debt, appreciation, internal rate of return, and building classifications.

To reiterate, it’s of paramount importance that investors understand exactly what they’re getting themselves into. My hope is that by educating the reader not only do you get smarter, but you can pass off your new knowledge to others so everyone can learn. I hope you enjoyed reading this post as much as I have enjoyed writing it.