Before you can analyze the merits of a for-sale listing you need to have a basic understanding of the property’s numbers. By that I mean you need to thoroughly understand:
- How a property is valued
- How a loan amount is calculated
- How a property’s cash-on-cash return is calculated
- How loan amortization impacts a property’s cash-on-cash return
- How leverage (the amount of debt borrowed to purchase the property) affects a property’s cash-on-cash return
“In your sleep”
You not only need to know the importance of these numbers, but you need to know how to do these calculations “in your sleep.” They need to become second nature to you.
This is the first part of a five part series on the five real estate calculations every investor needs to know. For some of you, this series will be very basic. You mastered these five real estate calculations long ago. You truly can do these calculations “in your sleep.”
However as I went through the process of writing these five articles I was surprised how many little tidbits I had forgotten, or maybe not forgotten but I hadn’t fully appreciated their significance. So for seasoned real estate professionals and investors don’t dismiss these articles out of hand as unworthy to read. I’m confident that there is content in these five blog posts that you will find of value.
CRE METRIC #1 – HOW A PROPERTY IS VALUED
In the simplest of terms a property’s estimated value is defined as:
So what the heck does that mean?
Net Operating Income (NOI) is the net rental income of a property after operating expenses are deducted. These expenses should include, among other things, property taxes, insurance, repairs and maintenance, utilities, on- and off-site management costs, general and administrative expenses, etc. NOI does not include the interest expense from the mortgage payment or depreciation. Another way of defining NOI is the net cash flow from the property before deducting debt service.
The Capitalization Rate
The Capitalization Rate, better known as the cap rate, is the ratio between the net operating income generated from a property and its current market value. The cap rate is calculated as follows:
So if you know two of these three factors, you solve for the third. If you are looking to purchase a property, the seller’s marketing flyer will show the asking price for the property. At some point in the negotiating process the seller will give you his historical operating statements from which you can determine the property’s NOI. With these two figures you can then calculate the seller’s proposed cap rate for the property.
For example, if you’re interested in purchasing an apartment with an asking price of $1,000,000 and an NOI of $60,000 then the property has a cap rate of:
$60,000 ÷ $1,000,000 = 6.0%
What does a property’s cap rate mean?
So you now know how to calculate a property’s cap rate but do you know what a 6.0% cap rate means? Is that a good cap rate for that property or isn’t it? Or a better way of putting it, what is a reasonable cap rate for this property? And more importantly, who determines what a reasonable cap rate is for a particular property type, its age, its condition and its location?
Ultimately, the market determines what cap rates should be. It’s a function of the law of supply and demand between willing sellers and willing buyers. If there are more buyers than sellers, a.k.a, a seller’s market, then asking prices generally increase over time. And conversely, if there are fewer buyers than sellers (think the Great Recession) values generally decline, sometimes rather quickly.
How are cap rates established?
Cap rates are established by a myriad of investors who decide in each real estate market how much they are willing to pay for an investment property of a particular property type, age, condition and location that generates a specific Net Operating Income. It’s as simple (or not so simple) as that.
So how do you use cap rates in such a way that it is not just an academic exercise in determining a property’s value? Let’s assume for a moment, that properties of similar characteristics have cap rates in the range of 6.5%, not 6.0%. Then you should counteroffer with the following:
$60,000 ÷ 6.5% = $923,000 (rounded)
This is just one real world example of how to use cap rates. It doesn’t mean the seller will accept your counteroffer, but it does provide justification for a lower price for the property.
The Game Buyers & Sellers Play
At its most basic level the sales process is the seller trying his very best to convince the buyer that the for-sale property has a better NOI than it actually has. It’s all a part of the real estate sales game. The seller’s goal is to maximize the sales price by either inflating the NOI as much as is reasonably possible. Or the seller can achieve the same result by using a cap rate that is below market for his property. Those are the only two variables he can manipulate.
On the other hand, a seasoned real estate investor is aware of this game. The first step in the buying ritual for him is to determine an accurate understanding of the property’s NOI. Once he has that figured out, his next step is to determine if there are any realistic adjustments he can make to increase the property’s NOI once he purchases the property.
Are rents below market? Is the property being poorly managed that if corrected would improve the property’s NOI? Are operating expenses above normal? If so, are there simple solutions to lowering these expenses within a normal range? If the buyer makes capital improvements how much could he expect rents to increase after improvements are completed? These are some of the questions he’s pondering. If he can find some logical reason for a higher future NOI then it’s possible that the overinflated asking price by the seller may in fact be reasonable. If not, then the buyer needs to walk away from negotiations if the seller is firm on his price.
Those are my thoughts. I welcome yours.