How to Calculate and Decrease the Cap Rate on Your Multifamily Asset
Kate Forsyth, Regional Sales Manager
The financial market has changed drastically in the past year due to Covid-19 with an emphasis on less speculative valuing of investment properties and more reliance on hard numbers. Investors evaluating multifamily assets are far more conservative in valuing a potential purchase for income growth in both the short and long term. As a result, it is critical to understand a property’s net value and continually look for areas to improve cash flow.
While market location and prospective neighborhood improvements are enticing, today’s buyer is more interested in the capitalization rate (Cap Rate) as an accurate measure of worth. Cap Rate is defined as the ratio of a property’s net income relative to its purchase price. The obvious first step in understanding a property’s value is to calculate the Cap Rate.
Let’s take this example:
A property of 300 rental apartments with a gross annual rent of $300,000
According to a 2019 NAAHQ survey, a community spends an average of 38.4% of its income on operating costs. Of that amount, 6% is utilities. Recovery of utilities not billed directly by utility companies remains an immense opportunity for owners. Only 38% of owners are recovering these utilities revealing a large source of revenue to be tapped. And with at-home workers increasing usage, many owners see as much as a 30% increase in their bills. Including utilities no longer works mathematically for many a bottom line.
A property with an income of $300,000 will spend $115,200 in operating expenses.
The value of a property is calculated using a Gross Rent Multiplier or GRM. If the property is in a good neighborhood with good occupancy, take the Annual Income x a Range of 9-11 multipliers to get what the property value should be.
GRM = $300,000 x 11 = $3.3 million
Now put it all together to get your Cap Rate:
A Property with a Net Operating Income of $184,800/$3,300,000 valued asset = 6% Cap Rate
By adding a utility billing program for water/wastewater, you can add $25+ a unit to your income.
A Property with a water/waste-water utility billing now has a of $205,200/$3,300,000 valued asset = 6.21% Cap Rate
8 Tips to Increase a Property’s Income and Reduce Expenses to Improve the Cap Rate:
- Utility recovery can be made two ways where allowed by law: submetering and allocation. A 300-unit community with a cost of $300 annually per unit for water/wastewater and a $35,100 investment will recoup about $31,500 the first year, $85,500 year assuming turn-over of 35% and 95% occupancy. Simply put, submetering requires an investment and measures each apartment’s utility use, allowing the owner to bill the resident back. Typical payback is 12- 13 months. Allocation has no investment and is a billing method that assigns a portion of the utility expense to each apartment based on several possible calculations: by occupant count, square feet, number of bathrooms, etc. All residents signed up at move-in, and renewal would result in net income.
- Conservation of common areas in lighting, building envelope, insulation, and central system upgrades can significantly reduce utility expenses. Each likely upgrade would need to be carefully vetted to determine the payback so you would know exactly when to expect an increase in income.
- Watch for, identify, and fix utility spikes. Evaluate year-over-year usage and rate monthly to see if an account is increasing and dig in. Any variance 25% or greater should be evaluated, to a meter level if necessary. Data-driven utility expense software is advantageous for managing utilities.
- Additional income opportunities, with little to no investment are amenity fees, valet trash, paid parking for premium spots, storage, pet deposits, and premium apartment locations are easy to implement on new move-ins and renewals.
- Minimize turn-over and reduce vacancy. Keep in mind that every day an apartment sits vacant on a rent of $1,000 per month, you are losing approximately $32 a day. Make sure your residents are happy, and your leasing staff is dedicated, skilled, and focused on leasing as a top priority. To borrow a hospitality phrase – “Heads in beds!” – is what the daily goal should be.
- Carefully screen all residents through a proven application process to avoid delinquent payers and property damage.
- Never underestimate relentless collection actions – For example, if your residents know you will begin to call, email, and send letters five days after the rent was due, they will know you mean business.
- Identify and penalize utility theft. About 2% of residents fail to put utilities like electricity or gas into their name. It is critical to identify any residents have failed to transfer utilities into their name. Where allowable by law, you can bill back residents for this expense and add a reasonable penalty to incentivize them to get those accounts in their name.