If you are new to investing or have been investing for a while you have learned that real estate investing has its own set of math. Investing is not as much about having a warm and fuzzy feeling about a property but rather if the “numbers” support a decision to invest. You may have realized that there are a lot of “numbers” in this real estate math and getting the right numbers will lead you to make good investment decisions.
It can be easy to get lost in this sea of math and numbers especially if you are just looking to invest passively. While there are many rules of thumbs and benchmarks used in real estate investing, large multifamily apartments have their own set of math and numbers. To stop from diving into the deep end of this sea many investors use quick back of the envelope or back of the napkin calculations. In this article we discuss what these calculations are and why they are a useful tool to have.
What is a back of the envelope or back of the napkin calculation?
So, what exactly is a back of the envelope or back of the napkin calculation? Does it have to be on a napkin or on an envelope? Well no. It could be on a napkin, an envelope a sticky note or any crumpled piece of paper nearby that you can find.
The term back of the napkin/back of the envelope refers to the ease and quickness of the calculation – it is so easy, quick and simple that someone can do it in a few minutes on the back of a…you guessed it, a napkin. For those talented in math, they may still do the calculation completely in their head, however with the advent of smart phones, these calculations are more frequently done with a smartphone calculator.
A back of the envelope or back of the napkin (used interchangeably) calculation is a shorthand calculation that allows an investor to gain the big picture of the financial status of a deal. By using a back of the envelope calculation, you will be able to paint the “broad strokes” of the financial picture before diving into the detailed “finer strokes.”
Why do investors use these shortcut calculations?
As a new investor you may have realized already that you must look at a lot of deals and run the numbers on a lot of potential multifamily apartment acquisitions before you identify one that you want to invest in. It is a commonly stated experience that you must look at 100 deals before you find one that is worth investing in. You may have also realized that it takes a lot of time to fully underwrite and do a financial analysis on an investment opportunity to decide if you want to make an offer on the property.
Imagine that it takes you 1 hour per deal – that would be 100 hours of work. The reality is that to do a full underwriting probably will take you in the range of 3-4-hours. If you do the math on that you will be spending 300-400 hours just on deal analysis. That’s valuable time that could be used for connecting with other potential active investors to partner with on deals or passive investors that want to invest with you. That’s valuable time that you could be using for self-development and education and so much more.
Time is a limited and non-renewable resource; as we all know this truth, we are in search of methods that help to make the most effective and efficient use of our time. When you can identify if a deal is worth your time in less than 5 minutes you could save yourself 55-240 minutes of deal analysis. Multiply that time saving over hundreds of deals you will review, and you will see the benefit of being able to use back of the napkin calculations.
Experienced investors use this quick math all the time whether out in the field checking out properties, talking with a broker about a deal in the pipeline or just trading notes between investor friends.
There are literally millions of properties out there for a real estate investor to acquire. As an effective investor in real estate, you should already have certain criteria in what you look for in a property to invest in. Even after these criteria are in place you will still be left with hundreds of potential deals. If you can do this short cut math you will be able to quickly decide which deals you should move forward with and do a full underwriting or which ones you should pass on. If the asking prices are egregiously different compared to your back of the envelope calculation, then you will probably want to pass. However, if the prices are close to your calculation result then this deal may be worth a second level pass through and eventually a more in-depth detailed underwriting.
Multifamily Real Estate Back of The Envelope Calculations
There are 3 back of the envelope calculations that we will discuss. They involve 1. Reviewing the price of the apartment complex based on the actual profit and loss; 2. Reviewing the price of the apartment complex based on normalized profit and loss and 3. Reviewing the price based on market averages for price per door.
Back of the envelope calculations are not a perfect science. They are not meant to provide the same level of comfort as a full underwriting but are used to check the sensibility of the asking price/your offer price. You are most able to take advantage of these quick calculations if you already have a decent understanding of the market dynamics where you are investing. As we have already discussed in other articles, a market can make or break an otherwise average deal.
Price Based on Actuals (Profit and Loss - PnL)
The first back of the napkin calculation we will look at is the calculation of the property value based on the current actual profit and loss (PnL) of the property. It is important that you buy properties based on an understanding of the actual value. This calculation is performed by taking the annual net operating income (remaining income after subtracting all expenses from total revenues) and dividing it by the market cap rate (a measure of risk and expected return of a stabilized property. The cap rate should equal the expected return you would obtain if you purchased a property all cash.)
To do this calculation you will need to obtain the latest annual financial statements (specifically the profit and loss statement) of the property which will be provided by the broker or the owner (in a direct to owner purchase.) Ideally you would want the profit and loss (PnL) statement broken out month by month for at least the last 12 months. This is called the T-12. From this PnL you will be able to obtain the net operating income for the year.
You will also need the asking price of the property which can be supplied by the broker if it is not already disclosed on the offering materials.
Additionally, you will need the cap rate for the market for properties in the same submarket and of similar vintage and condition as the property that you are reviewing. This metric can be obtained from discussions with brokers and your understanding of the market after reviewing enough deals in the market you will have a good pulse on what an appropriate cap rate should be for your analysis.
Math – Annual actual Net Operating Income/Market Cap Rate=Price
There may be anomalies in the PnL that you may want to adjust for. A quick skim of the Trailing 12 financials and a conversation with the broker can help you identify if there should be any sort of adjustment to the PnL. Our next back of the envelope calculation helps to address some of the issues that a less than perfect PnL may create.
Price Based on Normalized Profit and Loss
After you have looked at the actuals you should take into consideration the averages or normalized expectations of profit and loss for a property of similar make as the one you are evaluating for purchase. This information could come from brokers, other investors, your property manager, or your understanding of the market from analyzing many deals or owning property in the market.
The goal of this calculation is to create a baseline of value assuming that a property was only able to operate as an average of the market.
You will need the average monthly rents and other income. Average rents can be obtained from the PnL statement, the rent roll (listing of all the units in the property and related rents) or broker operating memorandum. It is most prudent to obtain this number from the latest rent roll as it may be a more updated and accurate data source compared to the other sources.
Next you will need the average market vacancy rates (number of physically empty and physically occupied but non-paying units on a property). This data can be obtained from brokers, industry reports, property managers, or your experience.
Finally, you will need the market average expense ratio (expenses/net annual rents.) A property manager with a large portfolio in the market, or your personal portfolio in the market, would be a great insight into identifying the best expense ratio.
Math – you calculate the annual gross rents by multiplying the monthly rents X 12 X the number of units. Subtract the market vacancy rate. Add the annual other income (monthly other income X 12 X the number of units). The sum of these three inputs will give you the total effective income. You will subtract normalized expenses (market expense ratio X total income) and that will provide you a net operating income. Once you get the net operating income divide this number by the cap rate and that will provide you with the calculated value of the property.
Another variation of this calculation is to replace the average actual monthly rents with your target (reasonable) rents for the property and the average expense ratio with what you realistically have seen in your own portfolio and experience for a similar property.
If the property is severely off these averages, then this may be a clue that there is a lot of opportunity or a lack of opportunity in purchasing this property depending on what metric you are looking at. For example, if the property has a significantly low operating expense ratio compared to the average this may be indication that the owners are running the property very efficiently (or have poor accounting) and there is not much room for you to reduce the expenses. If the expense ratio is alarmingly high currently that may be an indicator your can decrease expenses and increase value.
Price Based on Market Price Per Door Averages
Next you will want to take a sanity check on the price per door you would potentially be paying for the building. This calculation will help you understand if pricing is reasonable with other market comparable properties based on sales comparisons.
The only new input you will need for this is the price per door market average for properties of similar make and location. This can be obtained from a broker or if you have access to data services such as CoStar you can obtain this data yourself. (You will also need the price of the property which you should have already obtained while doing the other calculations.)
Math – You simply multiply the market average price per door X the number of units = Price based on Price Per Door. You should compare this resulting price to the current asking price.
A second level review would include you looking at your all-in costs per door to take the property to a stabilized level compared to the average sales price per door for stabilized properties of similar condition.
Average of the Calculations
Finally, we look at the average of all three of those calculations. Triangulating these calculations together provides a final data point that can be used to compare against the asking price. Use of the average will help to normalize any outliers in the financial data that might skew your calculations.
Limitations of Back of The Envelope/Back of the Napkin Calculations
Back of the envelope calculations are inherently simple and due to their simple nature, they are not going to capture every detail that you would be interested in to analyze a deal. Use of a back of the napkin calculation needs to be accompanied by an understanding of the limitations of these shortcut calculations so that the user gets the most benefit of the calculation.
The calculations we discussed are aimed primarily at doing a sanity check on the price of a multifamily apartment complex. It does not capture some qualitative and quantitative considerations that may make you want to buy a deal despite a potentially elevated price compared to your back of the napkin calculation. The limitations of back of the envelope calculations on large multifamily apartments relate primarily to quantitative analysis of investment returns and considerations of the qualitative aspects of the investment opportunity.
Quantitative Limitations - Missing Evaluation of Returns
The calculations on value stop at net operating income. They do not consider debt payment and they do not consider how much cash gets paid to investors at an ongoing basis or at the sale of the property. These are of course important considerations because the return is the reason why you invest. To get these numbers you would want to do a more detailed underwriting. The assumption here is that if the pricing of the property is significantly overpriced you will not likely get a good return however there may be some qualitative considerations that may lead you to a different conclusion.
Qualitative Limitations - Missing Qualitative Considerations of Story and Potential of Property
You will hear many investors talk about the “story” of the property. It really is important to understand the story of the property – why is the owner selling, what are the drawbacks and highlight of the property, what potentials for value add exist, what is there beyond the numbers that could make this property a real deal?
You can ask these questions to your broker or may take notice while reviewing the property in person or via the operating memorandum. If you believe there are certain qualitative factors that can help to make a property more desirable, then you may want to go to a second level financial review to confirm your hunches. Some of these qualitative adjustments may come from simple changes in the inputs for example you may increase the number of the unit count if there are 10 model units that you could easily convert to operational apartments with minimal renovation cost.
Multifamily back of the envelope excel model
We have created a multifamily back of the envelope excel model that you can use at your leisure and pull up on your phone or computer to quickly run the numbers on a multifamily apartment investment opportunity. If you don’t have any napkins or envelopes near-by this will help you get the job done just as well.
Email us to receive your copy of the back of the envelope calculator.