Nov 11
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One of the most popular articles on our website is an article discussing multi-family versus single family residential investment. We are focused on single family homes. We like the liquidity and simplicity of that investment. But there are a lot of reasons to like mulit-family too. A lot of people are drawn to the fact that you can qualify for financing based on the merits of the property not your own finances and the reduced risk of having multiple units to carry you through if there is a vacancy with multi-family property.
Since we don’t have much expertise to help you sort through the challenges surrounding mult-family investing – we brought in an expert who is eager to help! Here’s a guy who owns apartment buildings AND worked behind the scenes at CMHC to decide whether other people would get financing on their buildings. He knows A LOT about investing in multi-family buildings … and today he’s sharing insights on why cash flow matters more than cap rates – ESPECIALLY when you’re dealing with CMHC. And he’s a friend and colleague of ours … someone we’re proud to introduce you to.
Multi-Family Investing: It’s Cash Flow not Cap Rates That Matter the Most
Cash flow, as for any real estate investment is the ultimate goal. A good cash flow is what’s going to carry you through the good times, but especially through the bad ones. There’s a lot of uncertainty in the world’s economy and no one knows what can happen…
In the rest of my Multi-Family Blueprint (pickup a copy by clicking the link) we cover how value is derived from the property’s annual Net Operating Income. Now we are ready to take a closer look at the financial analysis that’s involved in more detail. Of course, if the data supporting the NOI you arrive at is unreliable, so is the value of the property. The most important thing to remember in this section is that every figure used in the cash flow analysis and financing application must be verified and supported with appropriate documentation. Let’s start with the income.
Income Verification
The property must generate a sustainable and a steady income stream for the investor. The bank and CMHC will also be looking for concrete evidence of that income stream in your financing application. As value is directly derived from the property’s current income (NOI), and not from projected income, it goes without saying that your rental income needs to be maximized. In other words you must ensure that your rents are at least at market level or even higher if it’s sustainable based on specific market conditions and what’s permitted by the relevant landlord tenant legislation in that market. Some jurisdictions (Provinces) have stringent rent increase ceilings.
In terms of required documentation for completing your due diligence and for financing purposes, I refer you to the resource list at the end of my report (you can download the complete Blueprint report here) which contains the website address for CMHC’s “Minimum Documentation Checklist”. In a purchase transaction, the vendor will supply the bulk of these documents to you.
On the one hand, the lender needs to establish the current income to determine the current value, but also the historical income trend as well to show how the property performed in the last 2 or 3 years. The point here is to demonstrate the stability of the income stream, hence confirm the value of the property. Accordingly this means obtaining from the vendor the property’s operating (income and expense) statements and rent rolls for the last three years. Make sure to have a current rent roll, signed and dated by either your property manager or the owner. If there is ancillary income such as laundry and/or parking, be sure to include this in the revenue.
There is one exception when CMHC will consider the property’s “projected rental income”, that is when rental increase notices have been given to tenants and the increases are effective within 3 months of the loan approval. Copies of the rental increase notices must however be provided to CMHC in support of the financing application and clearly indicate when the date when increases are effective. Once again, it would help you minimize your risk and if you included this information in your application you’d look pretty smart! The challenge is the vendor may not be willing or even able to give you that much information.
Expenses Verification
On the expense side, you’ll want copies of property taxes, insurance and utilities invoices for the most recent 12-month period. Here again, my advice is for you to attempt to get those for as far back as 3 years in order to enable you to develop a sound knowledge of the property’s historical expense profile.
For items such as property taxes, insurance and utilities (heat, water & sewer, and power), the lender will use the actual figures based on the operating statements and invoices provided to you by the vendor. For expenses such as wages & salaries (for caretaker), repair and maintenance (known as R & M), property management and often advertising, lenders and CMHC mostly will use industry expense benchmarks. These benchmarks are estimated on a “Per Unit Per Annum‟ (PUPA) basis and are specific to geographic areas. Your lender or broker should be familiar with those benchmarks. If not, they can contact CMHC‟s multifamily underwriting department to obtain them. What they will receive is a range of expense benchmarks for each category. My advice here is that it’s fine to use these benchmarks for financing purposes, however for your own operating budget I would rely on the actual expenses you have extracted from due diligence documents (historical operating statements).
In Table 3 in the report, I give you a sample cash flow analysis with very realistic numbers, at least in my market, for a “stabilized” property, meaning it is assumed that all major improvements have been completed. Appreciate that operating expenses will vary based on construction type, age and condition of the property. I want to point out to you a very critical number, that of the “operating expense ratio” which in my example sits at a reasonable 44.33% of EGI. The operating expense ratio is calculated by dividing the total operating expenses ($85,500) by the EGI ($192,850). The operating expense ratio may vary between 40% and 50% generally. Any property with a ratio below 40% should be analyzed very carefully to ensure nothing was forgotten in the analysis. For my properties, I follow the operating expense ratio on an on-going basis to gauge the efficiency of my properties as any savings, especially in utility expenses, automatically leads to increased revenue (NOI) and thereby increased value of my property. I give you a personal example of that further below.
Once you’ve determined with certainty your income and expenses, the difference between the two is the NOI. You’re now in a position to determine what the debt coverage ratio (DCR) is.
Servicing the Debt
Investors of small income properties (1 to 4 units) eventually get “maxed out”, or reach their credit limit because banks use the borrower‟s gross annual income to calculate their total debt service ratio (TDSR).
In the report, I’ve included a sample cash flow analysis spreadsheet for a 20-unit building with realistic numbers, which represents “a very good deal” as the property generates an excellent annual cash flow of $46,719 per year and has a debt coverage ratio (DCR) of 1.77. The DCR is calculated as follows:
A different way of looking at the above example is to say that the property generates an annual income stream (NOI) 1.77 times the annual mortgage payment.
CMHC’s mortgage insurance guidelines for DCR requirements are as follows:
- DCR of 1.10: for properties of 5 to 6 units (or DCR of 1.20 for refinance)
- DCR of 1.30: for term of less than 10 years for properties of 6 units or more
- DCR of 1.20: for term of 10 years or more for properties of 6 units or more
NOTE: CMHC’s guidelines are precisely that, guidelines only and they’re not cast in stone. CMHC has complete discretion to modify these guidelines to fit the specific risk profile of every deal on a case-by-case basis. Accordingly, the same applies to the DCR requirement, which can be increased if necessary to mitigate the overall risk of the deal. I have underwritten loans in challenging markets where the DCR requirement was increased on an ad hoc basis above the published DCR guidelines because of the added perceived risk.
AND – a NOTE About CAP RATES & Why You Shouldn’t Get Hung Up on Them for Your Deals:
Cap rates are used as benchmarks ONLY in determining whether the value of the property fits in the range values observed in recent transactions. It‟s simply an estimation of current value. That’s all! My best advice with regards to Cap rates is:
“DON’T GET HUNG UP ON CAP RATES!”
The reason I’m saying this is because at the end of the day, you don’t get to choose the Cap rate. The bank and/or CMHC do and there’s nothing you can do about it. For financing purposes, however, you need to know what are the prevailing market cap rates in your market to enable you to run your initial numbers. If you don’t have any data on Cap rates, the best way to get this information is to ask your mortgage broker or lender to supply you with those. If the deal is going to be CMHC-insured your broker / lender can call CMHC’s multifamily underwriting department and ask for the current prevailing Cap rates.
WARNING!
When asked for prevailing Cap rates in any given market, CMHC will not commit to any specific Cap rate until it has had a chance to analyze the actual deal supported with relevant documentation and developed a specific risk profile (4 risk factors). What they’ll likely give you is a range of Cap rates that CMHC has been using recently in that market. The problem with that is that the range you are going to get will most likely be very wide that it’s almost a futile exercise. In that situation, consider picking a Cap rate in the middle of the range you’ve been provided to run your numbers. Be prepared if CMHC ends up using a higher rate than what you expected, which will result into a lower loan amount for you.
One last comment I want to make on Cap rates is that investors also consider them to be a “market risk indicator”. In high-risk markets investors will expect investment assets, such as multifamily properties, to be valued using a higher Cap rate that translates into a lower price as a means to mitigate their investment risk. In this regard, CMHC’s approach to the market risk is no different. For example, when underwriting properties in smaller or remote northern markets that may be considered riskier CMHC will tend to utilize a higher Cap rate to reflect the added level of risk.
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