Tag: cap rate

10 Mistakes To Avoid When You Invest in Real Estate

I’ve been involved in real estate for more than 40 years, much of it teaching about real estate investing, answering questions online, and supporting folks who use my company’s investment analysis software —so I’ve gotten to see a lot about how people think (and sometimes don’t think). From that experience, I want to share my list of “greatest hits,” mistakes that can really trip you up:

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1. Admiring the King’s New Clothes

I see a lot of first-timers get wrapped up in the aesthetics of a property. Is it an attractive, solid building? Is it in a desirable location? Would I be proud to tell people that this my property? Unfortunately, for some new investors, that’s where their critical evaluation ends. They see only what they want to see.

It’s nice to feel good about the commitment you’re going to make, but that warm feeling will quickly turn cold if the property is a money-draining albatross. Start, at the very least, by estimating its initial cash flow—all the money that will come in for the first year minus all the money that will go out. If that number isn’t comfortably positive, reconsider.

 

2. Almost Doing Your Due Diligence

Most investors will check out the physical condition of the property. Most will also check out the rent data and verify at least some of the expenses. But have you actually read the leases? Are you going to get yourself locked into a dicey deal with below-market rents for a number of years; or maybe with a tenant’s right of first refusal if you want to sell, or even a tenant bail-out option?

 

3. Almost Doing Your Due Diligence, Part 2

OK, you did a good job vetting the property, its finances and its leases. So what did you forget? Maybe you forgot about the market. This property doesn’t live in a vacuum, so you absolutely need to be looking at the ecosystem around it.

What are other landlords getting for units in similar properties? What’s your competition for tenants? What is the prevailing cap rate for properties of this type? What’s the business climate—are companies moving in, moving out—is employment strong? As the anvil salesman says in The Music Man, “You gotta know the territory.”

4. Using the Wrong Lingo

Deals frequently unravel because the parties are not speaking the same language. Real estate investing, like other business professions, has a vocabulary all its own—terms whose meaning is agreed upon by those who buy, sell, broker, or finance property on a regular basis. I’ve seen things like “net operating income after debt service.” The rest of us probably call that “cash flow.” Who knew?

If you misuse standard terms, or if you use terms that don’t exist in nature, you’re either going to…

     … experience what I call the Cool Hand Luke Syndrome (“What we’ve got here is a failure to communicate”) and never reach a meeting of the minds, or

     …  paint yourself as someone who has never done a deal before, doesn’t know what he or she is talking about, and shouldn’t be taken seriously (and maybe should be taken advantage of).

 

5. Not Looking at the Deal from the Perspective of the Other Players

Whether you’re trying to buy, sell, finance, or raise equity, you have to recognize that your point of view isn’t the only one that matters. You need to put yourself in the shoes of the other interested parties.

Try to understand what are the sticking points, the potential deal killers from their perspective. Perhaps then you can come up with a solution. Do you have a property to sell, and does your potential buyer seem concerned about some vacant space? How about guaranteeing the rent for a period of time?

 

6. Can’t See the Forest… 

I notice this one with a lot with folks who are trying to vet their first income property. You can think of this as another “perspective” mistake—in this case you need to adopt the perspective not of a potential buyer but rather of someone who has already bought this property and now is trying to run it. It was nice that the seller or broker gave you a list of operating costs, and most of them were probably accurate, but is that list complete?

Go back to it and think about costs that nobody volunteered. Who gets rid of the snow, manicures the landscaping, vacuums the hallways, hauls the trash, services the HVAC? And often you’ll see no line item for property management (“Oh, I do that myself”), but you need to figure in an allowance for management even if no cash currently changes hands. An appraiser would routinely add management as an expense, and you should, too, because it will effect the estimate of value.

 

7. Thinking About Your Rental Property the Way You Think About Your Home

I usually ask my grad students how many own their own home. After a few proudly raise their hands, I tell them they’re at a disadvantage and need to try to forget what they think they know about real estate. Bummer.

The value of a personal residence is driven by economic factors—some national, most local. That’s why an appraiser will use the “comparable sales” approach when estimating the value of a home. If all your neighbors’ houses have sold for around $300k, then yours will probably sell for something like that as well.

But income-producing property is valued on its ability to produce net income. It’s not going to rise in value just because of the passage of time. Too many novice investors think their investment properties are going to “appreciate” on their own, over time, just because. Think again.

You can create value in an income property by enhancing its cash flow. Very few investment vehicles give you this power, but you have to understand how it works if you want to take advantage of this wealth-building potential.

8. Being Nearsighted  

Current-year data is important, but I hear a lot of investors who insist that they will focus only on the current income and expenses when evaluating a potential investment property. They say that this data is concrete and verifiable, and any prediction about future performance is just an exercise in fortune telling.

Yes, an appraiser is going to look at the current revenue, expenses, and market cap rate to estimate value. But remember this: The appraiser’s job is to estimate value at a point in time. You, on the other hand, are almost certainly investing for a period that extends beyond the current moment, and should be interested in how you believe this property will perform over a number of years.

So, in addition to looking at current performance, you should be making several projections as to future performance—best case, worst case, and in-between scenarios. This is a topic for more detailed discussion, so stay tuned for that.

 

9. Missing the Obvious in Your Analysis

You’ve taken my advice to heart and done both short-term and long-term projections of cash flows. Now, get your head out of your spreadsheet and use your common sense. Ask yourself if the figures in your analysis actually make sense. Do they look reasonable?

Is that cash flow way less than you expected, is your IRR in the stratosphere, is your mortgage payment merely a pittance? If so, then chances are you’ve either messed up a formula or a cell reference, or entered data incorrectly. When I look at my students’ work, it’s not uncommon to see that some of them have entered the total monthly rent, when they really needed the annual amount. Or they’ve put too many decimal places in the mortgage rate. Don’t assume, just because you used a spreadsheet, that the results are correct. Garbage in…

 

10. Forgetting that Real Property is a Real Business

After all that hard work—property search, due diligence, financial analysis, negotiation, financing, closing—you are finally the owner/operator of an investment property. Perhaps this is the first business you have ever run. You need to treat it like a business.

The top line of your P&L—revenue—needs to be the top line of your to-do list. Is someone not paying the rent, giving you excuses? Don’t let it slide. Your chances of collecting decrease exponentially with the passage of time.

Keeping records on sticky notes? Poor record-keeping can be your undoing, especially at tax time. Invest in some bookkeeping software, such as Quickbooks, rather than relying on a DIY spreadsheet. And once you’ve got it, use it.

Keep your tenant applications, leases and other documents in an organized file. If you really want to be good, scan them and store them on a removable hard drive.

In short, if you want your real estate investment business to succeed, then treat it like a serious business.

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These are the ten real estate investor mistakes I’ve seen most often, but maybe you’ve seen (or committed!) some of your own. I invite you to share your cautionary tales and add them to our list – let’s call it Everything Else that Real Estate Investors Should Avoid.

 

—-Frank Gallinelli

 

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Find out more at www.realdata.com.

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Copyright 2018,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles and blog posts that appear on realdata.com is provided as general information and is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

New Podcast: Investing in Income-Producing Real Estate

I had the privilege recently of recording a video podcast with REICLub, where we discussed investing in income-producing real estate: deciding what kind of property you should buy, how to begin the analysis process, understanding the income stream, estimating value or worth, dealing with long-term projections, recognizing common pitfalls, investing with partners.

I invite you to view it here:

http://www.REIClub.com/FrankGallinelli

—Frank Gallinelli

Reserves for Replacement and Income-Property Investing

It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.


What are “Reserves for Replacement?”

Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.

A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.

Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”


Where do “Reserves for Replacement” Fit into Your Property Analysis?

This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.

reserves for replacement, after NOI

Now let’s move the reserves above the NOI line.

reserves for replacement, befeore NOI

The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.


Which Approach is Correct?

There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.

That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.

This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.

Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.


What Difference Does It Make?

Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:

Value = Net Operating Income / Cap Rate

Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:

Value = 55,000 / 0.07

Value = 785,712

Now let’s move the reserves above the NOI line, as in the second example.

Value = 45,000 / 0.07

Value = 642,855

With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.


Is Correct Always Right?

I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?

The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:

Debt Coverage Ratio = Net Operating Income / Annual Debt Service

In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.

It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves?

Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach. If the source of market cap rate data is the community of brokers handling commercial transactions, then the odds are strong that the NOI used to build that market data did not encorporate reserves. It is likely that the brokers were trained to put reserves below the NOI line; in addition, they would have little incentive to look for ways to diminish the NOI and hence the estimate of market value.


The Bottom Line – One Investor’s Opinion

What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?

At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.

For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?

Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.

In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”

How do you treat reserves when you evaluate an income-property investment?

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Using Cap Rate to Estimate the Value of an Investment Property

In recent posts I’ve been revisiting some key real estate investment metrics. Last time I discussed the finer points of Net Operating Income, and that topic should serve as an appropriate run-up to the subject of capitalization rates (aka cap rates). What are they and how do you use them?

Income capitalization is the technique typically used by commercial appraisers, and is a part of the decision-making process for most real estate investors as well. I invite you to jog over to an article I’ve written on the subject:

Estimating the Value of a Real Estate Investment Using Cap Rate

In addition, you can download Chapter 10 of my book, Mastering Real Estate Investment, which discusses cap rates and gives you several examples you can work through.

—Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Understanding Net Operating Income

My recent discussions here of cash flow, DCF, pro formas and the like have prompted some readers to ask for a review of the key metrics that underlie a good and thorough income-property analysis.

One of the downsides of hanging around in business too long — we’re closing in on our 33rd anniversary — is that some of our best material is now lurking off in the archives.  So, after digging around in our virtual attic, I’ve found several topics that go to the heart of the matter, and that attracted quite a few readers when they first appeared.

Topping that list is our article about Net Operating Income. Here is a trailer of sorts, with a link to the complete article:

Understanding Net Operating Income

In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.

We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.

Everyone in business or finance has encountered the term, “net income” and understands its general meaning, i.e., what is left over after expenses are deducted from revenue.

With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. …

read the rest of the article here—>>

—Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

The 50% Rule vs. Discounted Cash Flow Analysis

I like to read the discussions in a number of online real estate investment forums to see what issues are of interest to investors at all levels of experience. One topic that seems to excite a lot of commentary concerns the relative merits, or lack thereof, of projecting and analyzing the potential future cash flows from an investment property—call it Discounted Cash Flow (DCF) or pro forma analysis. Since I’ve spent a good part of my professional life teaching on this subject and providing software tools to accomplish such analyses, discussions like these jump out at me; and my last post promised a follow-up to my discourse on the income stream, so the saga continues.

I frequently see people lament that a cash flow pro forma is basically pointless.  You can’t predict the future; more specifically you can’t predict what a property’s revenue or expenses will be in any given year, so why bother trying? It’s a waste of time, so they say. I think this is an unnecessarily nihilistic take on investing, reducing attempts at thoughtful analysis to the level of palm reading and tarot cards.

The 50% Rule

Recently I have seen a lot of mention of a so-called “50% rule” as an alternative to DCF. If I understand it correctly, this rule says, “Take the gross rent and subtract 50%. That’s your Net Operating Income. Subtract your debt service and that’s your cash flow.”

So, 50% is supposed to account for your vacancy loss, operating expenses, reserves, and capital costs. Actually, these last two items aren’t part of NOI, but why quibble?

Somehow I can’t shake off the image of Michelangelo creating the Sistine Chapel ceiling with a paint roller.  Same level of precision.

Clearly, one set percentage—50% or anything else—could not possibly be appropriate for all property types, even in the same market. You would not expect your percentage of operating expenses for a triple-net-leased single-tenant building to be the same as that for an office building. Even within one property type, would you bet the farm on the expense percentage for a 100-unit apartment complex to be identical to that of a 6-unit multi-family house?

Let’s grant that a certain expense percentage might be typical for a given property type in a given location. Would you really be comfortable using that percentage to make a specific purchase decision?  It might work out if you were buying the entire market, but would you risk your investment capital on the assumption that the one property you want to buy is truly typical of the entire market?

Sadly, I find too many investors dismiss the importance of doing a Discounted Cash Flow Analysis and opt instead for this sort of very simplified—dare I say oversimplified—approach. Such a technique might suffice as a general guideline for smaller properties, but when one gets involved with true income properties—larger residential or just about any size commercial investment—I don’t see how you can commit a serious amount of cash without performing a DCF analysis as part of your decision-making process.

Due Diligence and DCF

I talk a lot in my books, articles, and podcasts about the importance of due diligence; and that process is really at the heart of making an intelligent and informed cash flow projection. You cannot know your future operating costs precisely, nor perhaps your revenue; but you can certainly make reasonable estimates that are not just global generalities but are specific to the investment you’re considering. Keep in mind that due diligence for a real estate investment has two distinct parts:

  • The property itself — What is the actual current revenue? Do the leases call for scheduled rent increases? What are the current, verified operating expenses, and what are reasonable estimates going forward? Does the physical condition of the property suggest capital expenditures will be needed during your expected holding period? Will you set aside reserves for those? What are the costs and terms of available financing for this property?
  • The market — Properties don’t live in a vacuum, so market data is crucial.  What are the prevailing rents for this type of property in this market (i.e., what is the competition)? What are the local vacancy levels, cap rates, and general economic trends?

Next, use that data to project current performance along with best-case, worst-case, and in-between scenarios of future performance. This is where you start to take the investment’s vital signs: Under what circumstances will the cash flow be adequate, is the debt coverage ratio strong enough to secure financing with a given down payment, what if a commercial tenant’s shaky business fails before their lease expires?

Use the projections not only to make a decision about an appropriate price and terms for the property, but also use the DCF to demonstrate (i.e., “sell”) your reasoning to the other parties involved in the transaction: to the seller if you’re the buyer, the buyer if you’re the seller; to the lender; or to your potential equity partners.

Investment is all about balancing risk and reward; and these, in turn, require a willingness to make investment decisions in an environment where you necessarily have to work with incomplete or imperfect information. If there were no uncertainties, then everyone would be a winner.

Uncertainties such as these, however, are in the context of the actual property and the actual market. They are not the random application of a universal constant that has no particular connection to the investment under consideration. Buying and operating an investment property involves commitment, and that should start with a thorough financial analysis. Projecting the potential future performance of an investment property, especially with multiple scenarios, is the best way to make an informed and intelligent decision.

— Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

Making the Case for Your Commercial Refinance, Part 2

In Part 1 of this article, you learned what information you need to assemble to get started with the process of refinancing your commercial property — information about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You also learned to use some of that information to estimate the current value of the property, then learned to take that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You got acquainted with Debt Coverage Ratio and mortgage constants and saw how to combine those to test your property’s income stream to find out if it’s strong enough to support your loan request.

Now you have some idea of what your property is worth and how likely it is to appeal to an equity partner or to satisfy a lender’s underwriting requirements. Your next task is to convey your evaluation to that potential partner or lender. You need to make your case with a professional presentation that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing.

Unless you’re a “flipper,” you can expect to be involved with this property for the long haul, more or less. It should come as no surprise, therefore, that a lender or investor will appreciate getting a sense of how you believe this property will perform over time. You’re not going to predict the future with precision, but in most situations you should be able to make some reasonable and realistic “pro forma” projections of future performance. There is no hard-and-fast rule, but I believe your projections should go out five to ten years. With commercial properties that have long-term leases in places, 20 years would not be unthinkable.

As we develop the pro-forma presentation through the rest of this article, we’ll be using the Standard Edition of RealData’s Real Estate Investment Analysis (REIA) software. Those readers who are familiar with the software will also note that I’ve taken a few liberties with the material I display, editing some of the images (for example, removing multiple mortgages) to allow you to keep your focus on just the key elements of this example.

Where to start? You’re dealing with rental property, so a rent roll would be a good place to begin. And let’s assume that “today” is January 1, 2009. List your rental units (or groups of units, if you have a large number) with the current rent amount and your estimate of how those rents will change over time. You’ll recall from the APOD you constructed earlier that you expect the total gross scheduled rent for this property to be $219,600 in the first year. For the sake of making this example worthwhile, assume that the property contains both residential and non-residential units, and therefore the total amount of revenue is divided between the two types.

With residential units — apartments, for example — the process of building your rent roll will be fairly straightforward. The rent for each unit of this type is usually a fixed monthly amount. Residential tenancy agreements are seldom long term, most often a one-year lease or even month-to-month occupancy. It’s reasonable to assume that you will try to increase your overall rents on an annual basis. For the first year, you have the following:

sample residential rents, first year

Demand for your apartments has always been strong, but you decide you want to be conservative in your estimate of how much more you can charge each year so you decide to project that these rents will rise at an annual rate of 3%.

sample residential rents, five years

This is a mixed-use property, which means it contains commercial as well as residential rentals. At street level, below the apartments, you have two retail spaces. The first of these is a hardware store, Nuts & Bolts. This store occupies 1,000 rentable square feet and currently pays $21.60 per square foot per year. Its lease calls for a rent increase to $23.50 in July of 2011 The second tenant is Last National Bank, which occupies 2,800 square feet at $25.00 per foot. This tenant’s rent is scheduled to rise to $28.00 per square foot in September of 2012.

Note how your handling of commercial rentals differs from residential. One difference is that you typically charge rent by the square foot rather than by the unit. In most U.S. markets, the rent is expressed in terms of dollars per square foot per year, although in some it is per square foot per month. A second difference is in the length of the lease. As noted earlier, a residential tenant’s commitment may be as little as month-to-month, and generally is not more than one or two years. Commercial tenants, in order to maintain and operate a business from their space, need the certainty that they can continue to occupy for a reasonable length of time. They also need to be able to plan their future cash flow. Hence a commercial lease will usually run for at least a few years, up to as many as 20 or 30.

With the information you have in hand about these commercial leases, you should be able to project the rent from the two commercial units for next several years.

sample commercial rents

The image above is a screen shot from a data-entry portion of the REIA software. This is one image where I haven’t done any editing, i.e., I haven’t removed line items unrelated to our example. I’ve left it complete so you could see that there are other considerations you might need to take into account when you deal with a commercial lease, such as expenses passed through to tenants, leasing commissions, and improvements to the space made by the landlord on behalf of the tenant. We don’t want this article to morph into a full-scale textbook, so we’ll continue to keep our example relatively simple. However, for more information on these and similar topics, you can view our educational articles at realdata.com or refer to the software user’s guide forReal Estate Investment Analysis.

You now have a forecast of the revenue from both the residential and commercial units, and can consolidate this data to include as part of your presentation to your lender or potential partner.

sample combined income

Recall that when you were estimating the value of the property you used something called an Annual Property Operating Data (APOD) form. That form displayed the total rental revenue, an allowance for vacancy and credit loss, and the likely operating expenses for the current year. To fit the needs of your extended presentation you can expand this form to as many years as you want.

For the purpose of this discussion you’ve been projecting out five years, so you’ll do the same with the APOD. You may want to refine your estimates on an almost item-by-items basis. For example, if property taxes, maintenance and insurance are among your greatest expenses, it makes sense to estimate their rates of growth individually. You probably have some history with these items that you can use for guidance. For some other expenses, such as accounting or trash removal, you may want to apply a general, inflation-based estimate. In this example, property management is one of your biggest costs. You know that it will be billed at $15,740 for the first year, but then as a percentage of collected rent — 7% in this case — for future years, so your estimate will just require that you apply the same rate. If you estimate the future rent reasonably well, then the property management fee will follow.

Let’s say you believe that property taxes will increase at 5% per year, and insurance and maintenance at 4%. For all other expenses, you project a 3% annual increase. Your extended APOD should look something like this:

sample APOD

If you owned this property debt-free, your analysis would be nearly complete. But in fact, your objective here is to build an effective case for refinancing your existing loan, so you really need to demonstrate what kind of cash flow this property will throw off with a new loan in place. You need to take this at least one step further.

Recall from the first section of this article that you estimated the value of the property at $1.45 million, and that you need to refinance your $975,000 loan at 7.75% for 15 years. With that information in hand you can complete the taxable income and cash flow sections of your pro forma.

sample taxable income

sample cash flow

These projections should help you make a strong case for approval of your new loan. With that new loan in place, your debt coverage ratio is more than ample in the first year, and improves each year thereafter. Your cash flow is strong, and it too grows each year. It’s strong enough, in fact, that you could even survive the loss of one of your commercial tenants without plunging into a negative cash flow.

Your Net Operating Income is also going up smartly. Perhaps your lender is concerned that the current prevailing cap rate of 11% will rise to 14% by 2013, possibly reducing the value of the property dangerously close to the amount of the mortgage. Does that look like a genuine cause for anxiety?

Remember your cap rate and LTV formulas for the first part of this article.

Value = Net Operating Income / Capitalization Rate
Value in 2013 = 177,839 / 0.14
Value = 1,270,279

So, if cap rates rise to 14% and your NOI is indeed 177,839, then the property should still have a value of about 1.27 million. This is not good news for you, but does the lender have reason to lose sleep?

What will your loan balance be at the end of 2013? You will have been dutifully paying it down from now until five years hence, so surely you will have made a dent. If you return to the REIA software, you’ll find that it includes amortization schedules for all of your property loans. It also tracks the end-of-year balance for each loan as part of its resale analysis, so let’s look at that:

sample mortgage payoff

You will owe $764,719 at the end of 2013. Your property, if cap rates do rise to 14%, will be worth about $1,270,000. Recall that your lender required a Loan-to-Value Ratio of 75% when you applied for the loan. Will it be time to reach for the antacids?

Loan-to-Value Ratio = Loan Amount / Property’s Appraised Amount
Loan-to-Value Ratio at EOY 2013 = 764,719 / 1,270,000
Loan-to-Value Ratio at EOY 2013 = 60.2%

Your LTV looks even better at EOY 2013 than it did when you originally applied for the loan. It’s time to find a polite way to tell the lender to stop looking for excuses. Your loan request is solid and needs to be approved.

You’ve assembled a good deal of data to support your loan request, but don’t forget that a major part of your objective here is to present it in the most effective way. Start by trying to boil it all down. Simplify and summarize. Think of this part of the process as the real estate equivalent of the “elevator pitch.” Ultimately you’re going to need to provide the loan officer with every detail, but you may not get a chance to tell the whole story unless you can convey the essentials in the time it takes to ride the elevator. You need an executive summary.

sample executive summary

This report gives a very direct one-page summary of basic information about the property and its financial metrics. Your lender can see immediately the amount of the loan you’re looking for, the LTV and Debt Coverage Ratio, the Net Operating Income and the cash flow. This report doesn’t supply the underlying supporting data to justify these numbers — that’s why it’s a summary — but taken at face value it tells the loan officer whether there is any reason to give your request a serious look.

An alternative is a report we call the “Real Estate Business Plan,” and it too looks very different from the rows and columns of numbers usually associated with a pro forma. You might assemble information into a report like this in a situation where you still want to make your initial approach with what is essentially still an overview of the property, but one that provides a bit more detail than the one-page summary. Just as with the Executive Summary, you want to provide enough information to be effective, but not so much that you discourage the recipient from actually reading the document.

We designed this report to focus on property description, sources and uses of funds, financing, cash flows, and rates of return, and to simplify its presentation by displaying only the data that is pertinent to the holding period you specify. So, even though the software can deliver projections of up to 20 years, if you want a report based on a five-year holding period, you get a nice, clean presentation with no extraneous labels or data, as you see in this excerpt:

sample business plan, part 1

 

sample business plan, part 2

 

sample business plan, part 3

 

At the beginning of our discussion of pro formas and presentations, I said that you needed to deliver a package that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing. You may have already inferred from the progress of this article that the process of building the presentation runs in a direction that’s essentially opposite from the process of delivery. You need to begin, as we did here, at the most granular level of detail: defining individual unit rents and item-by-item operating expenses, first as they currently exist, then as you project them to grow.

That is why you built your rent roll first, then your extended APOD, then your cash flow projections. Next, you distilled this information into summary formats — the Executive Summary and the Real Estate Business Plan.

You built your case by going from the specific to the general. You’ll typically present your case for financing, however, by going the other way. You start with the Summary or Business Plan type of report, which provides enough information to introduce your request without burying the loan officer in a mountain of tiny numbers. When that loan officer says, “Where did you get these revenue projections?” you’ve got your rent roll. When she says, “How did you come up with this NOI?” you’ve got your APOD. And you can do the same for your cash flow and debt coverage, and resale value and rates of return, and more.

You’ve got it all covered.

Before we conclude this discussion, a brief reality check is in order. The example we just worked through was a happy case study because the property’s income stream justified the financing you sought. All the number crunching in the world, however, won’t transform a troubled investment into a good one. A detailed analysis can, however, still be helpful because it can show you what level of revenue you need to reach, or what level of cost-cutting you have to achieve to bring the property into positive cash flow territory and get it back on its feet. But whatever you do, don’t try to “enhance” the numbers to make the property look good. You’re not going to fool the lender and there’s not much point in fooling yourself.

So, what did you learn in Part 2 of this article? You learned to build a rent roll, one style for residential units and another for commercial. You learned to develop pro forma projections by extending your current-year estimates of revenue, operating expenses, and cash flows into the future. Perhaps most important, you learned about creating presentations out of those pro forma projections — presentations that are readable and effective, and that can help you make you case for financing your investment property.

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Making the Case for Your Commercial Refinance, Part 1

Since we released the original version of our Real Estate Investment Analysis software in 1982, our focus has been on pro forma financial analysis of real estate investments and of development properties – projecting the numbers out over time to help users gain a sense of what kind of investment performance they might expect from a particular property or project.

And for lo, these many years, our customers (and from time to time, we ourselves) have used the software to help make decisions as to whether or not to buy a property, and at what price and on what terms. Customers have used it to model how things might play out in the worst case, or in the best case, or somewhere in between. They have used it also to compare alternative investment opportunities.

This type of decision-making process has by far been the most common use of our software. More and more, however, we’ve seen an increased use of these pro formas for the purpose of making presentations to potential equity partners and to lenders.

Which brings us at last to the point of this article. When the economy is blazing away at warp speed, everything is – or at least seems – a bit easier. Forecasts are easier to meet, and partners and lenders are easier to find. But sometimes the economy is not so good, and presents us with new challenges. At this writing, we find ourselves in the middle of a bad case of credit lockjaw. Nothing lasts forever (which in this instance is a good thing), so eventually our credit markets and overall economy will rediscover their equilibrium.

This is all fine, unless you’re holding a property today with a mortgage that will balloon in the near future. In that case, you need to find a new loan, and you’re probably going to have to work for it. That means doing some homework, understanding the process, and building the most compelling case you can for approval of that new loan.

If you were trying to refinance your home, you would be dealing with recent sales of comparable houses, your personal income and debt, and your credit score. With the possible exception of working to get your credit report in order, there’s not a great deal you would do personally to build a case for your re-fi. With an income property, however, a carefully prepared presentation can go a long way in helping you convince a lender – or even a new equity partner – that you have a viable investment.

Re-enter your friend, the pro forma analysis. You may have thought he was on vacation until sales of real estate revived, but in fact he’s as busy as ever with financing and partnerships. If the numbers do indeed work for a property whose balloon is coming due – and sorry, don’t expect to transform a bad investment into a good one with just a pile of color charts – then a detailed pro forma may be that property’s best friend.

Don’t even think about starting that pro forma until you’ve done a bit of legwork and preparation. First you’re going to need some information that is external to the property itself. You need to know the prevailing market capitalization rate for properties of the same type as yours (i.e., office, retail, apartment, industrial, etc.) and in the same market. This information will be critical to estimating the current value of the property. Perhaps the best place to seek this information is from a local commercial appraiser. The bank will certainly use an appraiser, and the appraiser will certainly use a cap rate, so don’t get left out of the party. For the sake of the example we’re going to construct here, say that the commercial appraiser tells you the prevailing cap rate for properties like yours in your market is 11%.

Next you need to learn about underwriting criteria from your potential lenders. Specifically, you need to know the probable interest rate and term of the new loan; the lender’s maximum Loan-to-Value Ratio; and the lender’s minimum required Debt Coverage Ratio. Don’t assume that these criteria will be identical across all lenders or across all property types. In fact, they probably will not. It should not surprise you that different lenders quote different interest rates, but you must also recognize that the same lender may be willing to lend 80% of the value of an apartment complex, but only 65% of the value of a shopping center. Know the lender’s terms before you ask for the loan.

For the purpose of this example, let’s say you’ve called your current lender and found that their maximum Loan-to-Value Ratio for a property like yours is 75%. They require a Debt Coverage Ratio of at least 1.20, and if all looks good, they will loan at 7.75% for 15 years.

We’ll discuss these criteria in detail in a moment, but for now let’s stay focused on collecting information, this time about the property itself. You need to assemble the amount of actual current rent income from each unit and identify the market rent of currently vacant units. You need to make realistic estimates of rental income for the next several years, taking into account the terms of leases now in place. You must figure your current year’s operating expenses, keeping in mind that certain expenditures such as debt payments, capital improvements and commissions should not be included. Nor should you include depreciation or amortization of loan points, which are deductions but not operating expenses. Once again, you have to make some realistic estimates as to how these expenses may change over the next several years. Finally, of course, you have to learn the balance of your current mortgage, so you’ll know how much of a re-fi you require.

Let’s return now to the underwriting criteria you identified, and start with the Loan-to-Value Ratio (LTV):

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price

If this is a re-fi, then there is no “selling price,” so the value here will be the amount for which the property is appraised. If your financial institution has not taken leave of its senses (in general, if it has not appeared in the headlines or before a Congressional subcommittee in the last six months), then it should be reluctant to loan you or anyone else 100% of the value of a property. They expect you to have some skin in the game, and the question is merely how much.

The lender will quote you their maximum LTV, and before you get anywhere near an application form, you are going to perform your own calculation with your particular property. How much of a loan do you need to replace the existing financing, and how does that relate to the current value of the property?

It should be clear enough that the lower your actual LTV, the more likely you are to secure the loan. The lower the LTV, the more you, the borrower have to lose and the less likely you are to walk away. A low LTV may even earn you more favorable terms. You know how much of a loan you need, so to determine the LTV of your proposed loan, you must estimate the value of the property. Find that value with the same method the lender’s appraiser is likely to use: by applying a capitalization rate to the Net Operating Income (NOI). You already called around to find the prevailing market cap rate, so now you need to calculate the NOI. The most direct way to do this is with the venerable APOD form, where you list your annual income and expenses:

sample APOD for commercial refinance

The total of your scheduled rent income for this year should be $219,600, but because of vacancy and credit losses you will actually collect $210,816. Your various operating expenses total $51,050, leaving you a Net Operating Income of $159,766.

Remember that an appraiser told you the prevailing cap rate for this type of property in your market area is 11%. You have what you need to estimate the value of the property:

Value = Net Operating Income / Capitalization Rate
Value = 159,766 / 0.11
Value = 1,452,418

Round that off to $1.45 million.

You’re ready now to perform your first underwriting calculation. Recall that your lender’s maximum Loan-to-Value Ratio is 75%. Your current loan – the one that is about to balloon – has a balance of $975,000.

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price
Loan-to-Value Ratio = 975,000 / 1,450,000
Loan-to-Value Ratio = 67.2%

Assuming the lender’s appraiser agrees with your estimate of value, you’ve cleared your first hurdle. Being a cautious individual, however, you want to know your worst-case scenario. What is the lowest appraisal that would still allow your $975,000 re-fi to meet the lender’s LTV requirement? Simply transpose the formula to solve for a different variable:

Property’s Appraised Amount = Loan Amount / Loan-to-Value Ratio
Property’s Appraised Amount = 975,000 / 0.75
Property’s Appraised Amount = 1,300.000

Any appraisal over $1.3 million will be good enough to satisfy the 75% Loan-to-Value requirement.

You will want to build a pro forma that goes out a least five years, so you can demonstrate to the lender that your anticipated cash flow and debt coverage are solid and likely to stay that way. Before you do so, however, there is a formula you can use that will give you a quick estimate of the maximum loan amount that the property’s current income can support. Remember that the strength of an income property lies in the strength of its income stream. This is how the lender will look at your proposal, so it’s what you need to do as well. Here is the formula:

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)

You know that your Net Operating Income is $159,766, and the lender has told you the Minimum Debt Coverage Ratio is 1.20. But what’s this Monthly Mortgage Constant?

A mortgage constant is the periodic payment amount on a loan of $1 at a particular interest rate and term. If you know the constant for a loan of $1, you can multiply it by the actual number of dollars of the loan to find the payment amount.

Readers of my books have access to a web site with a variety of tools, including a table of mortgage constants. You can also calculate the Mortgage Constant using this formula in Microsoft Excel:

=PMT(Periodic Rate, Number of Periods, -1)

In the Excel formula, the amount of the loan must be entered as a negative number. In the case of a mortgage constant, we want to use a loan of $1, hence the -1. In the case of a loan at 7.75% for 15 years, the formula would look like this:

=PMT(0.0775/12, 180, -1) = 0.00941276

Since this loan is going to be paid monthly, you express both the rate and the number of periods as monthly amount. Format your answer to display at least eight decimal places.

Now you have all the elements to plug into the formula for maximum loan amount: the Net Operating Income, the minimum Debt Coverage Ratio, and the Mortgage Constant.

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)
Maximum Loan Amount = 159,766 / 1.20/ (0.00941276 x 12) Maximum Loan Amount = 133,138.33 / (0.00941276 x 12)
Maximum Loan Amount = 133,138.33 / 0.11295312 Maximum Loan Amount = 1,178,704

Keep in mind that rounding could alter your answer by a few dollars.

(An aside: If you’re the sort of person who does not like to play with long formulas, or who tends to tap calculator keys with a closed fist, we have a solution for you. The RealData Real Estate Calculator – Deluxe Edition, will do all of these underwriting calculations for you, as well as perform a host of other useful real estate functions, including amortization schedules for loans with a variety of terms. There are sixteen modules in the Calculator. Find more info at http://realdata.com/p/calculator.)

Your lender will surely round this result, probably down to something like $1.175 million. But you’re looking for just $975,000, so it appears that your income stream will support this loan request. You will want to verify this by calculating the property’s Debt Coverage Ratio going out five or more years. You’ll do that as part of your property pro forma, in the next installment of this article.

Up to this point, however, you’ve accomplished quite a bit: You learned what information you need to assemble about your lender’s underwriting process, about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You’ve learned to use some of that information to estimate the current value of the property, then taken that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You’ve learned about another underwriting metric, Debt Coverage Ratio, and about mortgage constants. You’ve seen how to combine those to test your property’s income stream to see if it’s strong enough to support your loan request.

Not bad for an hour or two of work.

Next time you’ll see how to assemble this information and more into the kind of professional presentation you can give to a potential lender or equity partner.

Copyright 2009, RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Understanding Net Operating Income (NOI)

In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.

We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.

Everyone in business or finance has encountered the term, “net income” and understands its general meaning, i.e., what is left over after expenses are deducted from revenue.

With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of dollars a property returns in a given year if the property were to be purchased for all cash and before consideration of income taxes or capital recovery. By more formal definition, it is a property’s Gross Operating Income less the sum of all operating expenses.

We have now succeeded in confounding our readers and compounding their problem by replacing one undefined term with two.

Let’s take these two new terms one at a time:

Gross Operating Income: Definitions are like artichokes. You need to peel the layers off one at a time. In this case, take the Gross Scheduled Income, which is the property’s annual income if all space were in fact rented and all of the rent actually collected. Subtract from this amount an allowance for vacancy and credit loss. The result is the Gross Operating Income.

Operating Expenses: This is the term that causes the greatest mischief. Many people say, “If I have to pay it, then it’s an operating expense.” That is not always true. To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to insure its ability to continue to produce income. Loan payments, depreciation and capital expenditures are not considered operating expenses.

For example, utilities, supplies, snow removal and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not – they are capital expenditures. Property tax is an operating expense, but your personal income-tax liability generated by the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.

Subtract the Operating Expenses from the Gross Operating Income and you have the NOI.

Why all the nitpicking? Because NOI is essential to apprehending the market value of a piece of income-producing real estate. That market value is a function of its “income stream,” and NOI is all about income stream. As heartless as it may sound, a real estate investment is not a felicitous assemblage of bricks, boards, bx cables and bathroom fixtures. It is an income stream generated by the operation of the property, independent of external factors such as financing and income taxes.

In truth, investors don’t decide to buy properties; they decide to buy the income streams of those properties. This is not such a radical notion. When was the last time you chose a stock based upon the aesthetics of the stock certificate? (“Broker, what do you have in a nice mauve filigree border?”) Never. You buy the anticipated economic benefits. The same is true of investors in income-producing real estate.

Those readers who have not yet been lulled to sleep by this dissertation will alertly point out that they have in fact observed changes in the value of income property precipitated by changes in mortgage interest rates and in tax laws. Doesn’t that observation contradict our assertion about external factors?

Go back to our earlier article on the use of capitalization rates, and you will recall that there are two elements to the value equation: the NOI and the cap rate. The NOI represents a return on the purchase price of the property; and the cap rate is the rate of that return. Hence, a property with a $1,000,000 purchase price and a $100,000 NOI has a 10% capitalization rate. However, the investor will purchase that property for $1,000,000 only if he or she judges 10% to be a satisfactory return.

What happens if interest rates go up? In that case, there may be other opportunities competing for the investor’s capital  – bonds, for example –  and that investor may now be interested in this same piece of property only if its return is higher, say 12%. Apply the 12% cap rate (PV = NOI / Cap Rate), and now the investor is willing to pay about $833,000. External circumstances have not affected the operation of the property or the NOI. They have affected the rate of return that the buyer will demand, and it is that change that impacts the market value of the property.

In short, the NOI expresses an objective measure of a property’s income stream while the required capitalization rate is the investor’s subjective estimate of how well his capital must perform. The former is mostly science, subject to definition and formula, while the latter is largely art, affected by factors outside the property, such as market conditions and federal tax policies. The two work together to give us our estimate of market value.

— Frank Gallinelli

####

Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2005, 2013,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

 

Estimating the Value of a Real Estate Investment Using Cap Rate

Why do you invest in income-producing real estate? Perhaps you are looking for cash flow. Possibly you anticipate some tax benefits. Almost certainly, you expect to realize a capital gain, selling the property at some future time for a profit.

Your projection of the future worth of the property, therefore, can be a vital element in your investment decision.

APPRECIATION

A fairly simple approach to this issue is the use of an appreciation rate. You bought the property today for X dollars. You make a conservative estimate as to the rate of appreciation, apply that rate to your original cost and improvements and come up with presumed future value.

The use of appreciation as a predictor of future value typically makes sense when the desirability of the subject property is based on something other than its rental income. The most common example, of course, is the single-family residence. Consider also a single-user rental property such as a small retail building on a main thoroughfare. The owner of a business operating as a tenant in such a location is probably willing to spend more for the building than an investor would pay. In general, rate of appreciation as a predictor of future value may be appropriate when comparable sales work well as a measure of present value (i.e., “Commercial buildings on Main Street are selling for $200 per square foot by next year they will be up to $225.”).

INCOME CAPITALIZATION

With most other types of income-producing real estate, what you paid for the property is not likely to make much of an impression on a new buyer. Witness the rapid run-up and even faster collapse of prices in the late ‘80s, and again in 2008. The typical investor will be interested in the income that the property can generate now and into the future. He or she is not buying a building, but rather its income stream.

That investor is likely to use capitalization of income as one method of estimating value. You have probably heard this referred to as a “Cap Rate” method. It assumes that an investment property’s value bears a direct relation to the property’s ability to throw off net income.

Mathematically, a property’s simple capitalization rate is the ratio between its net operating income (NOI) and its present value:

Cap. Rate = NOI/Present Value

Net operating income is the gross scheduled income less vacancy and credit loss and less operating expenses. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that you might realize if you bought the property for all cash. If you purchase a property for $100,000 and have a NOI of $10,000, then your simple capitalization rate is 10%.

To use capitalization to predict value requires just a transposition of the formula:

Present Value = NOI/Cap. Rate

The projected value in any given year is equal to the expected NOI divided by the investor’s required capitalization rate.

To use capitalization rate as a predictor of future value, in short, is to use this logic: “I am buying this property with the expectation that its net operating income will represent a return on my investment. It is reasonable to assume that whoever buys the property from me in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate).”

If you project that the property will yield a NOI of $27,000, and that a new buyer will require a 9% rate of return (capitalization rate), then you will estimate a resale price of $300,000.

You must never forget that, while the algebra involved here is simple, the judgments you need to make in order to achieve an accurate prediction of value are more complex. Your assumptions as to future years’ income and expenses have to be realistic.

The same is true of your estimate of a new buyer’s required cap rate. Look at the investment from the new buyer’s point of view and remember that there are other opportunities competing for his dollar. Would you buy an office building with a projected cap rate of 9% if you could buy a bond that yields 7%? What if mutual funds are rocking and rolling at 15% and more? To attract a buyer, your property may need to be priced so that its cap rate is competitive with alternative investment options. The higher the cap rate, the lower the price. In our example above, the property with the $27,000 NOI capitalized at 12% might attract an offer of $225,000.

Our discussion here has been limited to simple or “market” capitalization rates. If you would like to delve further into this topic you may want to look into “band of investment” or derived cap rates. In addition, follow our blog as we go into greater depth as to how investors look at a property’s projected long-term income stream when deciding if and on what terms to purchase an income property.

—Frank Gallinelli

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