Multifamily Business Model – Part 1

I strongly believe that anyone investing in any asset class must understand the underlying business model. How money is made and comprehend the underlying risks before committing the funds. In this series, I will detail the various aspects of the business model & the risks involved.

The Basics

Unlike single family homes, multifamily real estate is valued based of its present and future income as well as the return expectations of the investors for that given market for a given period. Without getting too technical Cap Rate is the unleveraged return expected of an asset. An example will help you better understand.

Let’s say there is a 100 unit property which earning $1000 / unit per month.

And its annualized income will be (100 x 1000 x 12) = $1,200,000. (This is also called Operating Income)

Generally, at 50% expense ratio the expenses will be = $600,000 (this is also called Operating Expense)

Net Operating Income = Operating Income – Operating Expense

In this case its $1,200,000 – $600,000 = $600,000

Now if you have paid 12,000,000 (12 Million) to buy this property, the Cap Rate for this transaction is

Cap Rate = Net Operating Income / Purchase Price

= 600,000 / 12,000,000

= 0.05 or 5%

Remember we are not taking any loan or any interest payments into consideration. This is a very important point to keep in mind.

Now let’s say, if you want 6% return instead of 5% then you will personally value the same property at 10,000,000. Why? Because

Purchase Price = Net Operating Income / Cap Rate.

= 600,000 / 0.06

= 10,000,000

Now you understand that Cap Rate is nothing but the rate of return expectation of the market. And you also understand that the Purchase price can vary depending on the Cap Rate as well as the Net Operating Income.

Read the the next blog to learn how the value appreciation happens.

Side Note:

Operating Income

1. Rents

2. Other Income

Operating Expense

1. Repairs & Maintenance

2. Personnel Expense

3. Admin & Management Expense

4. Marketing Expense

5. Utilities

6. Insurance & Taxes

To your Legacy.