8/10/2023
Article 33
Multifamily real estate investing offers a range of opportunities for generating cash flow, building wealth, and achieving financial goals. To navigate this dynamic market successfully, investors often rely on a set of rules of thumb – quick, practical guidelines – to assess potential deals and make informed decisions. In this article, we'll delve into some key rules of thumb utilized in multifamily real estate investing.
1. The 1% Rule:
One of the most well-known rules of thumb is the 1% rule. According to this guideline, the monthly rent for a multifamily property should ideally be at least 1% of the property's total acquisition cost. For instance, if you're considering a property that costs $500,000, the combined monthly rental income should be around $5,000. This rule helps investors quickly evaluate whether a property has the potential to generate sufficient income relative to its cost.
2. The 50% Rule:
The 50% rule estimates that roughly 50% of a property's rental income will be spent on operating expenses, excluding mortgage payments. This rule is a useful tool for estimating potential cash flow after accounting for maintenance, repairs, property management, insurance, and other expenses. While actual expenses may vary, the 50% rule provides a quick benchmark for preliminary financial analysis.
3. The Gross Rent Multiplier (GRM):
The Gross Rent Multiplier is calculated by dividing the property's purchase price by its gross annual rental income. This rule of thumb helps investors compare the relative affordability of different multifamily properties. A lower GRM indicates potentially better value. However, GRM doesn't consider operating expenses or financing costs, so it should be used alongside other metrics.
4. The Cap Rate:
The Capitalization Rate, or Cap Rate, is a fundamental metric for evaluating the return on investment in real estate. It's calculated by dividing the property's net operating income (NOI) by its purchase price. Cap rate indicates the potential annual return on an investment property without accounting for financing. Higher cap rates often suggest higher potential returns, but they also come with increased risk.
5. The Cash-on-Cash Return:
Cash-on-Cash Return measures the annual cash flow generated from an investment property relative to the initial cash investment. It's calculated by dividing the annual before-tax cash flow by the total cash invested, including down payment and closing costs. This rule of thumb helps investors assess the cash flow potential of a property and compare it to alternative investment opportunities.
6. The Debt Service Coverage Ratio (DSCR):
For investors seeking financing, the Debt Service Coverage Ratio is essential. It measures the property's ability to cover its debt obligations with rental income. A DSCR greater than 1 indicates that the property generates enough income to cover its debt payments. Lenders typically require a specific minimum DSCR before approving a loan.
7. The Rule of 72:
While not specific to real estate, the Rule of 72 can be applied to estimate how long it takes an investment to double in value. Divide 72 by the expected annual growth rate to get an approximation of the doubling period. This rule can be useful for estimating the potential appreciation of multifamily properties over time.
8. Market Rent vs. Actual Rent:
Investors often use a rule of thumb to compare the current rental income to the potential market rent for a property. If the market rent is significantly higher than the current rent, there might be an opportunity for increased cash flow through rent adjustments.
In conclusion, rules of thumb provide a convenient starting point for assessing multifamily real estate investment opportunities. However, they should be used as preliminary guidelines and not as substitutes for thorough due diligence and financial analysis. Each property is unique, and successful investors combine these rules with comprehensive research, market knowledge, and a clear understanding of their investment goals to make informed decisions in the multifamily real estate market.
