While it is helpful to understand the following terms when Investing in Multi-Family Apartments it is not critical. An explanation has been included below and a quick google search can also provide many detailed explanations.
Cap Rate:
Is the rate of return expected to be generated on a real estate investment property. It is calculated by dividing the buildings net income by the property’s purchase price.
Cash-on-Cash return:
Is used to determine the rate of return on the initial capital you invest into the property. It is a yardstick to measure how good the investment is and is calculated by dividing the cash flow (the net operating income after all expenses, but before taxes) by the amount of cash initially invested Cash-on-Cash = Annual Net Operating Income/Initial investment.
An example is:
An investor purchases a $1,200,000 apartment complex with a $300,000 down payment. Each month, the cash flow from rentals, less expenses, is $5,000. Over the course of a year, the before-tax income would be $5,000 × 12 = $60,000, so the NOI (Net Operating Income)-on-cash return would be $60,000 / $300,000 = 0.20 = 20%.
However, if the investor used debt to service a portion of the asset, they would be required to make debt service payments and principal repayments.
i.e., mortgage payments. Because of this, the Cash-on-Cash return would be a lower figure. To calculate this, you divide the NOI after all mortgage payment expenses were deducted, by the total cash invested.
For example: If the investor made total mortgage payments (principal + interest) of $2,000 a month, then the Cash-on-Cash investment would be as follows: $2,000×12= $24,000. $60,000-$24,000= $36,000. $36,000 / $300,000 = 0.12 = 12%.
ROI or Return on Investment
Is a performance measurement used to evaluate the efficiency of an investment. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost. To calculate the ROI, take the net Profit and divide by the initial Investment * 100. So, if you invested $100,000 and after 3 years made $60,000 profit your ROI is $60,000/$!00,000 = 60%
Return on Equity
A good way to think of return on equity is by thinking how much your equity can earn you in a given year. How hard is your equity working for you ? If your $100,000 is earning you $10,000 that’s 10% return on your equity but if your $100,000 was earning you $12,000 that would be12%. In the second example your equity is working harder for you or another way of thinking about it is, it is performing better than the first example.
Depreciation enables you to deduct the cost and the capital improvements made to the property over the lifespan of the property thereby reducing you tax liability. In the commercial world the IRS has determined the lifespan of a Multi-Family Commercial Property is 39 years. Therefore, your costs and expenses would be divided by 39 and allow you to reduce your tax liability by this amount. For a more detailed and specific example it is highly advised that you consult with your tac advisor.
Cost Segregation
Cost Segregation can be an Investors best friend. It allows a taxpayer who owns real estate to reclassify certain parts of the asset as Section 1245 property and thereby apply a shorter useful lifespan for depreciation purposes. Cost segregation can accelerate deprecation thereby further reducing tax liability. In order to perform an accurate assessment of cost segregation on a Multi-Family building a cost segregation study is required and should be completed by expert.