The Basics of Commercial Multifamily - And Why It's So Important

When investing in commercial multifamily, you want to have a strong grasp of the basics. Those who are overly eager to jump in without a strong understanding of the fundamentals leave themselves vulnerable to mistakes that could have been overcome. The allure to commercial real estate is undoubtedly the opportunity to create massive value by raising rents and cutting expenses, thereby increasing the Net Operating Income (NOI), which we will get to. The kicker is to understand how to do that and what impact your planned changes will have on that NOI.

The math behind multifamily is so important to understand - yet not overly complicated on the surface. There can be complicated formulas when you input the time value of money or when you bring sensitivity analysis into the mix, however, the basic math behind evaluation and operation on a strong multifamily asset is fairly straight forward. For the purpose of this article, when I mention commercial real estate, multifamily real estate, and apartments I really mean the same thing. Any 5+ unit multifamily property is commercial real estate, and it is multifamily real estate, and it is an apartment building. In this article, they are all interchangeable. 

So why are 5+ unit properties different you may ask? That’s because anything five units and above is considered commercial while anything four units and under is residential. Residential real estate and commercial real estate play by different rules, yet the principles are the same. This is an important distinction. The way commercial properties are valued and operated is different than that of residential properties. This is because commercial real estate is normally bought as an investment. These properties are valued on a multiple of the revenue they generate because they are bought and held to produce revenue for their owners. Residential properties, on the other hand, are usually bought to live in by the owner. 

This is important to understand because it is the fundamental difference that banks make when evaluating these types of properties, which in turn drives the lending terms and how they can be leveraged. Leverage is another important concept in this discussion, which we will get to later.

Now, let’s get into some of the math behind what makes commercial real estate different (and arguably better). 

Net Operating Income (NOI)

Net Operating Income (NOI) = Gross Revenue - Operating Expenses

Commercial real estate is normally valued using the income approach. This method uses the income a property generates to determine the market value of the property. The income used is the NET income of the property. 

The net income of a property is the difference between the gross income and the operating expenses. In other words, it is what’s left after taking out the operating expenses.

For this article, let’s use an imaginary 100 unit apartment complex as our running example from here on out. To demonstrate NOI, let’s say each unit in this 100 unit complex is rented for $900/month (ignore vacancy, repairs, debt service, etc for right now). In this case, the gross revenue for this 100 unit property is $90,000/month and $1,080,000/year. 

Now, let’s say after taking out your expenses for vacancy, repairs, etc. excluding debt service, your total operating expenses are $500,000/year. It is important to note that NOI does NOT take debt into account; the NOI is an indication of how the property is performing without any leverage. Because some investors may use all cash to buy an asset while other investors may leverage the purchase, the NOI remains unaffected by the debt structure. NOI is NOT cash flow (cash flow is the Gross Revenue - Operating Expenses - Debt Service). 

Taking the difference from your gross revenue and operating expenses you calculate your NOI to be $580,000. This is running a 46% expense ratio, which is completely reasonable especially if you repair the property as issues arise and do not defer maintenance. Oftentimes you will hear that the 50% rule applies to multifamily - meaning that 50% of the revenue is depleted by operating expenses. In my experience, and in operating my own portfolio, this is a fair assessment and a good rule of thumb to use. If you have an older, crappier property then your expense ratio may be much higher and if you have a nicely renovated property you can expect to have lower expenses. 

For a quick and dirty assessment, you can use the 50% rule as a quick guide in your assessment of a property. If expenses are reported at 25% you know the owner or broker is sorely mistaken and trying to make it look good to sell. In contrast, if you see that expenses are at 75% you can recognize pretty quickly that there is most likely a major fault in operation on the owner’s behalf and that you may have an opportunity to come in and cut expenses and correct the ship. 

I mention the 50% rule in this section because it can be a big help and a big time saver when you are looking at properties. In our previous example, if you used the 50% rule you would come up with an NOI of $540,000. This is very close to our actual number of $580,000. I recommend when you actually underwrite properties that you use the more conservative approach, aka us whatever NOI is lower. This will bake in a “fudge factor” for you so that if you miss something you have a cushion to fall on. 

Getting back from my tangent, this should give you a pretty good idea about NOI and how to calculate it. As a recap: NOI = Gross Revenue - Operating Expenses.

Capitalization Rate (Cap Rate)

Cap Rate = NOI / Asset Value

The cap rate is the return you would receive if you paid all cash for an asset. It’s also called the unleveraged return because it is the return you would get if you didn’t use financing. For example, if you paid $1,000,000 for a property that produced $100,000 in income each year, this would equate to a 10% cap rate or “10 cap”. 

It also shows you your payback period for a given purchase. In the above example, if you bought a $1M property for all cash that produced $100,000 per year in net operating income, it would take you 10 years to get paid back. This is completely up to the investor whether that is a good deal or not. The cap rate is just another metric, albeit usually the most important, for an investor to measure the performance of an asset and their willingness to invest in it.

The cap rate is also an indication of the risk level for a given investment. Remember from your first econ class in high school the mantra “High risk, high return. Low risk, low return”? This is exactly how the cap rate operates. For example, a 5% cap rate indicates a much lower risk investment than a 10% cap rate. 

In general, in the multifamily space, you normally see A class properties around the 5% cap rate level while you see C class properties around the 10% cap rate level. In today’s market, the respective rates for each class of property are dropping, however. This indicates that investors are willing to take on more risk for a given investment given the revenue it produces. This is an important thing to note if you are out looking for properties in your market and see investors buying C class properties for 5% cap rates - that may spell trouble. 

Commercial Real Estate Valuation

The reason why NOI and cap rate are so important in the multifamily space is simple. They are the metrics that determine the properties value! 

Remember earlier when I said that commercial real estate uses the income approach? Let’s examine that more. By shifting around the cap rate formula, you get something that looks like this: 

Asset Value = NOI / Cap Rate

Let’s go back to our 100 unit apartment complex to examine why this is so powerful. We already know that this 100 unit complex rents for $900/month/unit for a total of $1,080,000/year with operating expenses of $500,000 and NOI of $580,000. Now let’s just assume this is a B class property and other B class properties in this area have sold for a 7% cap rate. When we apply this we see that $1,080,000 / 7% yields a $15,428,000 valuation. I know this seems extreme and these numbers are large. You may think that a 20 unit complex is more accomplishable for you. Maybe it is, but that’s beside the point, stick with me.

We were just able to determine the value of our 100 unit apartment complex using the simple formulas we just learned. How cool are we? What makes multifamily so powerful is the fact that you can substantially impact the value of these commercial assets by raising your NOI.

You can raise your NOI by 1) raising your gross income (aka raising rents) or 2) cutting expenses.

Let’s use our 100 unit apartment complex as another example. While each unit is currently rented at $900/month, you scan the marketplace and see that your units are under rented compared to other complexes in your immediate area. You plan to bring your rates to the market over the next year. You expect that you can reasonably raise rates by $50/month on each unit.

Not only that, but you realize you are paying out the wazoo for utilities because your water bill is astronomically high. To combat this, you plan to implement a Ratio Utility Billing System to bill back tenants for their water consumption. By doing so, you will be able to cut your expenses by $20/month/unit.

In total, you will be able to positively impact your NOI on the property by $70/month/unit. This equates to an $84,000 boost to your NOI. At the same 7% cap rate, you just added $1,2000,000 to the value of the property with no expense out of pocket but by utilizing data and acting on it.

Talk about powerful returns! Adding together the other benefits of owning this asset like cash flowing while this value-add play is being implemented, depreciation which lowers your tax bill, and the tenants paying down your existing mortgage and you have a killer deal. I think it would be naive to think adding the $1.2M in value, in this case, would come easy or without challenges, but nothing worth having comes easy!

Wrapping It Up

Without understanding NOI, Cap Rate, and how the two work together to determine a property's value will leave you grossly unprepared to venture into commercial multifamily. On the other hand, however, by taking the time to understand these concepts you put yourself in a position to capitalize and use the math to your advantage. These calculations are not difficult but they are paramount to your success. 

By leveraging the concepts discussed here you can make massive wakes and scale faster. That example $1.2M of equity created isn’t just pie in the sky, but the capital you can access by either selling or refinancing the property and put towards your next purchase at an even bigger multiplier. The only question to ask yourself is: What’s holding you back?

Blake Dailey is a multifamily real estate investor and host of the Multifamily Journey Podcast. He has reached his financial independence (Passive Income > Expenses) number through investing in real estate and aims to help others do the same. He helps passive investors impact their lifestyle and wealth by investing in multifamily real estate through his company Growth Vue Properties. Growth Vue seeks to help investors achieve the ultimate asset – Time – by making their money work so they don’t have to.

Find out about investing in multifamily with Blake at thegrowthvue.com or learn more about Blake, read his articles, or connect with him through his website at multifamilyjourney.com.