Multifamily apartment communities have been historically stable investments. This has led to increasing interest in the asset class and increased valuations. With increased valuations some metrics for potential profit and return on investment have decreased.
Learning multifamily investors have easily achieved 20-30+% returns in the past may bias your expectations for the future. If these numbers are no longer the norm, what is a good return? And does a good return mean it is a good deal?
How do you know if a deal is a good deal?
There are many ways to evaluate an investment including equations, formulas, ratios, and financial models . Ultimately, you are determining if the risk you are undertaking is worth the potential reward.
For newer investors, reviewing all this data can be overwhelming and time consuming. Unfortunately, there is no single number or formula that can give you a yes or no answer so this review must be done.
You can set minimum standards that filter out investments that would not meet your needs. Investment opportunities that meet these minimum criteria can then be evaluated more in depth to see if they are a “good deal”.
This process is called underwriting. It is a full analysis of an investment opportunity to determine if it is worthwhile. But first, how do we determine screening criteria to decide if an opportunity is worth the time and brain power needed for a full analysis? It starts with your goals.
What are your short and long term goals?
Investing is personal and each investor has a profile based on where they currently are, where they want to be and how quickly they want to get there. Where you currently are is a mix of your current portfolio’s returns, and your capacity to grow your portfolio through your knowledge, liquidity or both. Where you want to be is a combination of your short and long term goals.
Everyone has goals, if you don’t know what yours are then they are likely vague ideas that you have only subconsciously committed to.
With investing, it is important to be intentional about your goals. Determine what they are, as they will guide your investment strategy.
If you want to achieve those goals in a short time you may have to take on more risk to get a higher return. If your horizon to reach your goal is longer or you are already close to achieving it, taking excess risk may be unwarranted.
Someone who is younger or who has more disposable income, may have a higher risk tolerance. If your goal is to grow your portfolio quickly then higher risk may be necessary, if it is to maintain your wealth then a lower risk investment strategy may be more suitable.
Set your investment goal and then from there we can determine what type of returns are necessary to achieve that goal.
"Everyone has goals, if you don’t know what yours are then they are likely vague ideas that you have only subconsciously committed to. "
How is Return Measured?
Now that you have decided on a goal you can set your screening criteria for investment. If you plan to grow quickly and are not risk averse you may favor deals with higher returns. If your goal is capital preservation . you will focus on deals with lower risk and often lower returns.
Common metrics used to measure return include average annual return (AAR), internal rate of return (IRR), cash on cash return (COCR), and your return on investment (ROI).
IRR is the internal rate of return. This is a time sensitive measurement of the percentage of profit you make on an investment. The sooner your principal is returned or the larger the profit on the principal the higher this number will be.
COCR is the percentage of cashflow you make each year after all expenses have been paid. ROI is the total return you make including annual cashflows and profits from sale. AAR is the pro-rated version of this for the number of years the investment was held.
If your goal is annual or monthly cash flow you would look towards COCR. If your goal is wealth creation or preservation you would be more interested in IRR, ROI or AAR.
Reminder: No single metric determines if a deal is a good deal. All metrics should be considered as well as the market dynamics and experience of co-investors when deciding if a deal is a good deal.
What is a good return on a multifamily investment?
Someone looking to offset other investment income would benefit from an investment with high depreciation. If this is their most important deciding factor, they would be focused on capital preservation.
A good return for capital preservation would be in the 4-6% range annual COCR, or cashflow. The goal being a rate higher than the rate of inflation.
Someone seeking cashflow as a means of income may need 5-8% range COCR to consider a deal a good deal.
Someone who is seeking to build wealth over time, and does not need to rely on investment income to cover living expenses would be more focused on IRR, ROI or AAR. Expecting 12-14% may be reasonable in this category with total ROI expected to be slightly higher.
As returns go higher so does the risk. Depending on the duration of the investment and how soon you need to hit your goals you may need to see a higher return to feel a deal is worth pursuing.
The first goal for every investor should be capital preservation. If you decide to seek investments with higher returns that these weigh this decision against the risk of a potential negative return.
Having a portfolio with a majority of moderate risk investments with a smaller portion of high risk high return investments may allow you to get greater returns without excessive risk exposure.