Multifamily Valuation Explained
Multifamily refers to real estate that contains more than one household unit in the building, such as a duplex. But as far as lenders are concerned and for the purposes of this discussion, anything larger than 5 units is considered commercial multifamily. Private equity refers to the way in which these properties are acquired. Generally, a sponsor or manager like Mulligan Valley Capital is in charge of sourcing, acquiring, overseeing, and running a property. This is also referred to as a syndication, which is simply a group of people that pool their resources together to acquire something they might not be able to acquire on their own.
This arrangement is usually arranged as a General Partner/Limited Partner entity, in which the sponsor is the General Partner and the investors are Limited Partners. There are a number of different ways the partnership can be broken down, such as with preferred returns or IRR hurdles, however a basic structure that is easy to understand is one in which the General Partner gets somewhere around 20% of the deal and is in charge of all the day to day operations. The investors get 80% of the property but have limited rights in regard to decision-making. In exchange for investing their money, the investor receives a piece of the Limited Partnership in proportion to the amount of money they invested.
For example, if the Limited Partnership was 80% of the overall deal, and an investor owned 20% of the Limited Partnership, they would own 16% of the overall deal (.8*.2=.16).
There is one major difference in the way commercial real estate is valued compared to residential real estate. Residential real estate is valued based on the sale price of comparable properties in the area. Importantly, you can't control the price of a house all that much because you're limited in the amount of value you can physically add to it, and it is highly dependent on how other houses in the neighborhood are selling. In other words, you can't MAKE your house appreciate quickly without spending actual dollars to improve the property. Even then, the dollars you spend on improvements may only raise the value at a 1:1 ratio of dollars spent, which means you didn’t actually create value above and beyond its cost.
Commercial real estate on the other hand is different. It is valued based on the amount of money it makes. So, if you found an apartment building where all the rents were $100 below market rate, that asset is not performing at its full potential. Assuming you found it and assuming you bought it, you could raise the rents an average of $100/unit over the next year or so, and you would have very quickly increased the value of the property - no need to wait for the market or the apartment down the street.
The amount of value that you added through revenue increases is calculated based on what's called a capitalization rate, or cap rate for short. The cap rate is the expected return on investment before any debt considerations of an asset. The cap rate is influenced by the area the building is in and the age and type of building. The more desirable the area and the nicer the building, the LOWER the cap rate is because people will pay more for a nice building in a nice area, which therefore lowers the return. In other words, there are more people who would buy a brand-new building in San Diego than a 30-year-old building in Winslow, Arizona. The cap rate is calculated by dividing the income of the building by the purchase price. That's it.
So, if you had a building that made $100,000 in San Diego and a building that made $100,000 in Winslow, which one do you think you would pay more for? Probably the one in San Diego, because it's a more desirable place to live, and therefore the perceived risk of investing there is lower. So, if you paid $5,000,000 for a building in San Diego producing $100,000 in income, that would be a 2% cap rate. That same $100,000 in income in Winslow might only cost you $1,000,000 which would make it a 10% cap rate.
Here's the interesting part though - let's take our example of increasing the rents after we bought it. Let's assume we were able to add $15,000 per year in revenue to the building. How much does that $15,000 in revenue add in terms of value to the building? All you have to do is divide $15,000 by the cap rate for the area to get your answer.
For San Diego:
15,000/ 2% cap rate = $750,000
For Winslow:
15,000/10% cap rate= $150,000
Just by adding a little over $1,000 a month in revenue, you've added a TON of value to the building.
These are the types of things that sponsors are looking to do when they acquire a building with their investors. And unlike traditional financial advisors, multifamily sponsors don't make very much solely on managing the asset. They typically take a small management fee of 2% of the revenue collected by the building, NOT the overall value of the building. It's closer to a financial advisor charging a management fee on the money he makes for you, not the amount he manages. To put it simply, the sponsor gets paid only when YOU get paid.
This is a hard asset that you can see and touch, and it produces income. It is hard to reproduce, and insurance protects you against loss of the asset (is there insurance on stocks?).
