I received a note for sale on a multifamily property that is actually a foreclosure in embryo, but the note seller did not realize it because the note was only a few months old. This is not atypical, but actually quite common. When buying or selling multifamily properties one of the biggest mistakes beginners make is not realistically calculating whether or not you can afford the payments, or if your buyer can afford the payments. Although there are many aspects to buying and selling multifamily units, in this article I will address only two:

1. NOI or Net Operating Income and
2. DSCR (Debt Service Coverage Ratio) With a better understanding of DSCR, you can better determine if your buyer can afford the property if are selling , and more importantly, if YOU can afford the apartment if you are buying.

Let's start with the Net Operating Income. The NOI is probably the most important figure when analyzing apartments; and therefore MUST be calculated correctly. Why? Because the cap rate, value of the property, as well as determining whether the property itself can support the debt service is a function of the NOI. In a nutshell, NOI is calculated by taking the Gross Scheduled Income, which is assuming full occupancy of all the apartment units and translating this into an annual income. From the GSI, you subtract ALL expenses, including vacancies. The remainder is your NOI. There are methods of ensuring the NOI is accurate, but this is not the forum to address this topic.

For this article I am going to use round numbers for simplicity, but the following is a good representation of many of the small apartment notes I receive. For example, say you had a 10 unit apartment house which rents for $1,000 a unit. This is $10,000 a month. Remember all data must be converted to annual figures. If we multiply $10,000 by 12 months, we have a total of $120,000 which is your Gross Scheduled Income. A good rule of thumb is to subtract 40% from your GSI, and this will approximate your NOI. So subtracting $48,000 or 40% of $120,000, we are left with an NOI of $72,000. With a cap rate of 8%, this apartment house would be worth $900,000. (I do not have time in this issue to go into the all the details and methods of pricing apartments, but one method is dividing your NOI by your desired cap rate; this will give you one value of your multifamily property.)

In this particular scenario, the buyer put 20% down, and the seller carried a note for $720,000 @ 8% for 30 years, with payments of $5,283.10 monthly. Multiplying $5,283.10 by 12 months, and we get $63,397.26 for an annual debt service figure.

Now we are ready to calculate a Debt Service Coverage Ratio, which determines the ability of an apartment to pay off the mortgage. Typically a ratio of 1.25 is considered acceptable, and the higher the ratio, the better the ability a property will be able to service its debt. Conversely, the lower the ratio the more likely the note is going to go into default at some time. A 1:1 ratio means a complete "break even". In reality a figure this low is telling you that if you have to replace two light bulbs in one month, you will not be able to make your payments without going into your pocket, or creating deferred maintenance.

Deferred maintenance will snow ball into tenants moving out, which results in more vacancies. Of course, the result of increased vacancies is decreased income, which makes servicing the debt even more difficult. Sooner or later this note is going to default. It is that simple.

With this in mind, let's examine our "deal". We have a NOI of $72,000 and a debt service of $63,397.26. DSCR is calculated by dividing the NOI by your annual debt service. If we divide $72,000 by $63,397.26 we come up with a ratio of 1.14. THIS IS NOT GOOD. The property must run PERFECTLY EVERY MONTH or else there is going to be a problem with cash flow, and therefore servicing the debt. This is not mentioning there is NO MONEY LEFT to put into your pocket.

Properties DO NOT run perfectly every month. This is why lending institutions require a 1.25 DSCR. For this reason, the note the note holder was trying to sell was virtually worthless, except for those note buyers who offer deep, deep discounts to compensate for having to go through foreclosure. Just be aware when you are buying or selling multifamily properties to pay strict attention to the Debt Service Coverage Ratio. It will save you money, not to mention time and frustration.

I will be teaching a workshop on Apartment Buying for the Small Investor on Saturday, September 8th. I will be going into detail about how to calculate NOI, Cap Rates, Value of the Property, as well as financing and how to avoid traps. If you are interested in an inexpensive means to learn about apartments, this is for you.

It is from your input that I select topics for my articles. If you have a topic you would like me to discuss, CONTACT ME

I have a Get a Note Quote web page that can be filled out and submitted for professional pricing. Check it out.

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Current ARCHIVES (end of 2009-2012)

I received several responses on my last month's article on outsourcing. Thank you for your input. As one reader pointed out, I should have expanded my explanation to include how purchasing a less expensive sweater made in India, rather than a more expensive product made in America will actually create American jobs for those who export to India. It appears he was correct. Below is a comment I received that summarizes several others.

"Concerning your outsourcing article, you have missed that $35 went to India vs $50 staying in the US and being re-spent and re-spent and re-spent in the US. Outsourcing only works when the Indian company spends the $35 back in the US. The problem with outsourcing is that the US runs a trade deficit and people aren't mobile to go from where the jobs are lost to where the jobs are created. Also, their is a greater issue of our how this affects our families and communities. The US is facing the issue of, "Is the cheapest for everything ultimately the best for us as a people?" Most people would have said yes but we are now facing 20 years of a flat economy, where the middle class aren't going to leave a better life for their kids. Someone someday will have to pay for all our country's debt, and it will be future generations."

I have written other articles, explaining there is really no such thing as a "trade deficit", as well as America's exports are paid for by imports. In other words, ALL DOLLARS RETURN TO AMERCIA. With this in mind, outsourcing does not cost American jobs as a whole, but actually helps create American jobs. This topic is just another reminder of the wisdom of Frederic Bastiat's "What Is Seen, and What Is Not Seen". What is readily seen are the jobs which are hindered by outsourcing or purchasing foreign products. What is not readily seen are the Americian jobs which are saved or supported by outsourcing or importing foreign goods and services.

I am going to address the "trade deficit" first. Remember, individuals and businesses trade with one another, not governments. Therefore, there is no such thing as a "trade deficit". When you purchased the sweater manufactured in India for $35, YOU gave the Indian merchant $35 and YOU received a sweater. Where is the trade deficit?

If you were bartering, things could be put in better perspective. For example, say you made shoes, then traded a pair of shoes for a sweater; where is the trade deficit? Does it matter who is wearing the shoes? No! It is only when currency is introduced into the equation that politicians try to introduce a "trade deficit". (The "trade deficit" is usually a code word for an American producer which wants to be protected from competition)

Because currency is a medium of exchange and not a good or service, when you purchased the sweater made in India, you merely substituted $35 for the shoes that you produced to trade for the sweater. Isn't it obvious YOU do not have a trade deficit whether you traded the shoes you produced for a sweater to a merchant in India or to your next door neighbor. The same holds true if you traded $35 for a sweater instead of shoes.

Let's examine this transaction further. When you purchased the sweater produced in India for $35, what happens to the $35? You paid for the sweater in dollars, but the Indian merchant's currency is in rupees, not dollars. Just as you cannot make purchases in America with rupees, the Indian merchant cannot make purchases in India with dollars. Without going into the dynamics of foreign currency exchange, suffice it to say the dollars you exchanged for your sweater will be returned to America in some form.

Using an import/export guide, I am going to use the exporting of machinery as an example. Remember, it is not the government that exports the machinery, but rather a business. The American manufacturer of machinery which exports its product to India cannot use the rupee in America; and therefore can only accept dollars. Where does the Indian customer who wants to purchase America machinery obtain the dollars; from the $35 you used to purchase the sweater from India.

For time and simplicity, let's assume there is a machine part that an American manufacturer will sell for $35 to an Indian company. Since the Indian company which desires machine parts needs dollars to make the purchase, it will exchange its rupees for the dollars you paid for the sweater to the Indian sweater manufacturer. The $35 is then given to the American machinery company for the machinery parts. In other words, the $35 returns to America. Where is the trade deficit? Is it becoming clear our imports are paid with exports and all dollars return to America? When these dollars are returned to America are they not spent and spent again in the United States? Of course they are.

Let's address further the false premise that outsourcing costs American jobs. In last month's issue, I showed how purchasing a sweater produced in America for $50 instead of purchasing a sweater made in India for $35 "saved" a job of the American sweater manufacturer, but it was actually at the expense of a local merchant where you would have spent the extra $15, not to mention you came out $15 less wealthy by purchasing the more expensive American product. In other words, the sweater manufacturing job was "saved" at the expense of a local merchant. Please review last month's issue.

Take this a step further. If you did not purchase the sweater manufactured in India, there would be no dollars for the Indian company to purchase the machine part made in America. To say it another way, not only is your purchase of the sweater made in India supporting a local job with the extra $15 you saved, your purchase also supports a job at the American machinery factory that exports to India. So rather than your purchasing the sweater made in India costing American jobs, it actually saves American jobs of those companies which export goods or services to India.

We pay for our imports with exports. Ignoring this axiom was a big mistake Hoover made at the onset of the Great Depression with the Smoot Hawley Act, which enacted protective tariffs on imports to America. Little did Hoover realize this "protection" was at the expense of those companies and farmers which exported their products. The result was the Great Depression spiraled into a tailspin.

When you visit the site listing the imports/exports to India , look at all the products and dollar amounts we export to India; imagine all the American jobs that are involved with these exports. Take a deep breath, then realize these jobs are being paid for by the products we import from India. In other words; outsourcing.

Lastly, the flat economy is not the result of purchasing goods or services at a cheaper price. Does not buying products at a cheaper price create more wealth by having more money to spend, save or invest? Rather, the flat economy is the result of a century of abandoning free market principles and adopting statist/collectivists concepts.

The result of free markets is prosperity, therefore a strong middle class. This should not be turned around to suggest a strong middle class being the cause of prosperity. Those who make this assertion mistake cause and effect. When you hear politicians from both sides ranting they want to "make the middle class stronger", then go on to outline government programs to implement change, do not accept their premise. Government programs are a direct contradiction to free markets, and will therefore not produce the desired results, no matter "how good their intentions", or how much "they care".

Governments worldwide are consuming more than the ability of producers to produce. Consumption cannot exceed production. In a nutshell, this is why our economy is flat and why unemployment continues to rise. It is correct that the country's debt will someday have to be addressed. My guess is ultimate default, but that is another topic for another article. Our debt does not result from purchasing better, cheaper products made outside America, but rather from our politicians, from both parties, buying votes with the wealth of the nation's producers. It cannot be said enough: CONSUMPTION CANNOT EXCEED PRODUCTION.

Thank all of you who commented this month. I got several requests to discuss other topics ranging from the high price of corn to dispelling the myth that innovation causes unemployment. I try to speak to all your requests. If you do have a comment postive or negative, contact me. It really makes my day to know it makes you 'think' when you read my newsletter.



Remember, if you know of someone who has a note to sell, I will pay referral fees at the least, and will also split my profits if you would like to "co broker" a Note with me.

Tom Henderson /a.k.a. THE NOTE PROFESSOR .

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