Jonathan Cronin breaks down multifamily underwriting using the I/R×V formula: income divided by rate equals value. A $500,000 property at 6% cap rate generates $30,000 NOI; raising rents $200 per unit on 10 units adds $24,000 yearly. Buying at 7.5% cap and selling at 6% after boosting NOI can double your money.
Okay, so we bought something for 500,000. Now, on I over R times V. And I think this formula will really help you guys is you're trying to orient yourself around this. And I over R times V, where does the purchase price go? Right there or the value? So if I bought this for 500,000, so I mean, literally the first few times you do this, I would write I over R times V on your piece of paper and think about which spot do I put this number that it's that critical to to get this nailed down. So with I over R times V, our purchase price is 500k. Right? So we've got R here and we've got income up here. So for the sake of illustration, let's say that at $500,000 purchase price, we bought this at what cap rate do we want to buy this at? For your example, maybe 7%. For the sake of illustration, let's say that we bought this at a 7% cap rate. So JD, let's do 6%. Okay, so 6, 6%. So I over R times D, 6% goes here. Right? Where rate is, remember? And if we know two of them, we can calculate the third. So we take 6% 06 and we multiply that times 500,000. That equals $30,000 in NOI. So income is up here, 30,000. Now, for the sake of this illustration, what we're trying to calculate is what happens if I increase the rent by $200 a month per unit. And I think we said this through. We say this was a 10 unit. So if it's a 10 unit, then 10 times 200 equals $2,000 a month. And remember, this is always an annual number. So when we're looking at a monthly, we have to multiply that by 12. So that's 24,000. Yeah. Let me just say that when we use smaller numbers, the shifts aren't as dramatic. And so it can be a little harder to track because you have to get into decimal points to see the shifts. When we're using real small numbers, you'll calculate your current value and then you'll calculate value add six months later. And you improved it by like 150 bucks or something. You won't see a huge jump in cap rate. In a smaller dollar amount property, it will change. You just won't see the sort of dramatic shifts. But yeah, so $200 a month times 12, that comes to 2400. So we went from 30,000 to 3,000 or 32,400. So if I can buy a property for 500K. And I bought it at a 6% cap rate and it is returning $30,000 and I, I increase the net operating income to $32,400. This is the other challenge is that if I bought it at 6% cap rate, then I paid a higher price for it. Why? Because these have an inverse relationship. The cap rate goes down, the value goes up. If the value goes down, the cap rate goes up. So that's just the way that the math works. And well, that might have just blown your minds a little bit. I remember the first time I heard that, I was like, what? But I'm going to show you why that's the case. But let's just finish out this illustration here. So if I bought it at a 6% cap rate, then presumably either the occupancy was low and that's the reason I bought it at a 6% cap rate. Eduardo asked a good question and actually it's relevant. What do you think about deals with negative net operating income? So deals that are in the red, how can we make it work? Do you see any opportunity? Absolutely. As a matter of fact, I think it's a mistake to say I want to buy a property that's a 8% cap rate or 9% cap rate or 10% cap rate. One of our most successful properties, we bought it with a 2% cap rate. The first question that comes to my mind when it's a low cap rate is what's the occupancy? Net operating income is just the total income of the property. If I find a property that's got a 2% cap rate and it's at like 60% occupancy, it's a miracle it has net operating income at all. Right. A typical expense margin is 50%. So if I find a property that's got a 2% cap rate or a 1% cap rate and it's at 60% occupancy or 50% occupancy, their expenses are very conservative, they're under control. And if I can go in and lease that up to 80% occupancy, it's going to be a home run. So these things never work in isolation. Numbers like this are always part of a bigger story. And so it's never a yes or a no. And I think that's one of the struggles with cap rate is that it's variable, it's context dependent or contextual, depending on, on the specific situation. So let's finish out with this example though. If I bought it with 30,000 and I increased the net operating income to 32,400. Then if I kept it at a 6% cap rate, 32,455.06, then I've gone from 500,000 to 540,000. So I bought it for 500,000 with $30,000 net operating income. I increased it by 2,400, and I sold it at the same cap rate. I bought it. Now, you never want to do that. If at all possible, if you have to, fine. But ideally you would buy it. You would do one or two things. Going back to. To Eduardo's question. If I'm going to buy at a 6% cap rate, I'm going to expect that this change here is going to be more dramatic, right? Because why would I pay a 6% cap rate unless there was more upside potential on the net operating income? So if I bought it at 30 and I was able to take it to 40. Now, again, this isn't just from increasing the rents. This is from renegotiating the property management contract. This is from reducing my expenses. This is just generally for improving the operations of the property. So $10,000 over the course of a year or two years or three years is not a dramatic change. But I take it from $30,000 to $40,000 in this scenario. And if I. So if I bought it at a 6% cap rate and I sell it at a 6% cap rate, so that would be 40,000. Nico just said that. I agree. I just calculated that's a 1 to 16 ratio. So you're right there. Right? And so when I. When I go from $30,000 in net operating income to $40,000 in net operating income at 6% cap rate, then I've gone from a $500,000 purchase price, $666,000 sale price. Here's where this gets fun is when we say we bought a property that's valued at $500,000, okay. And is bringing in $30,000 in net operating income. And we bought it at a 7.5% cap rate. And that means that we pay $400,000 for this property. So $30,000 net operating income. I bought it at seven and a half cap, and I bought it for $400,000. Now I take this to, you know, $36,000. So again, not a huge jump, $6,000 per year, and I sell it at a 6% cap rate. So now 36,000 divided by 6%, I just make $200,000. So these aren't huge jumps. This is only $6,000 per year. And this is only one and a half percent on the cap rate. But I made a 50% return on investment. I went from 400,000. I made $200,000 between here. So I made a 50% return on Investment in this deal by increasing the net operating income by $6,000 and by improving the cap rate by one and a half percent. TOM Improving the cap rate by 1 and a half percent is very easy to do when you're buying directly from seller. When you're buying from a seller who's in, you know, financial stress or they're, they're in a hurry to sell, you know, 1%, 1 1/2% cap rate to somebody like that is not a big deal.
