VALUING THE PROPERTY AND THE MEANING OF "CAP RATE"
First ..... It is very important to understand that what you pay for a property is not necessarily the value that a lender (or an appraiser) will place on the property. In most cases, you should never pay more for an income producing property than what is justified by the annual gross operating income (G.O.I.) and subsequently the Net Operating Income (N.O.I.) which is the net income after expenses, but not including debt service costs (amortization, depreciation and interest).
Most appraisers of income properties put the most weight on the income (rents) generated by the property. Secondly they consider other factors such as appreciation, neighborhood etc. Commercial lenders rely heavily on appraisals when making loans. As a buyer of income property, there are several important points to always remember.
You almost always make your money WHEN YOU BUY REAL ESTATE, NOT WHEN YOU SELL IT. Just like in the stock market, if you buy too high...... you can get slaughtered. Buy low---or pay the consequences when you are ready to sell. If you pay too much, the lender will only lend on the fair market value, so you will have to make up the difference with more down payment (cash). The details of this problem will be explained later in this Special Report.
Never get emotionally involved with a property because of its looks, or because of the stone lions at the entrance (apartment buildings) or because of the beautiful flower garden maintained by the owner. These are secondary considerations. Look for income property with good net operating income, positive cash flow and a high occupancy rate. Then buy the property on your terms at or below fair market value on your terms.
Have the patience to wait for the MOTIVATED SELLER. Buyers who pick up the bad habit of paying too much by buying from non-motivated sellers will constantly be trying to make up for the amount that they overpaid. They will never make real estate profits or fortunes. An occasional mistake is acceptable. Everyone makes mistakes. Getting into the habit of buying too high will be disastrous.
Have the ability to SELF-APPRAISE and VALUE the property based mainly on a formula using NET OPERATING INCOME. With this knowledge you can make the proper offer and buy the property at or below the fair market value. Further on in the Special Report, we will show you how to value the prospective property using Net Operating Income (N.O.I.) in a formula which is generally accepted by most lenders. Although there are some exceptions, do not base your offer price on the fact that residential real estate in the area is selling at astronomical prices. You are buying INCOME PROPERTY, not over valued residential real estate. LOW INCOME (rents) along with HIGH EXPENSES results in a LOW N.O.I. (Net Operating Income) and therefore deserves a LOW offering price. It is important that you have the discipline to be firm on your offer price and have the courage to move on if the seller insists on asking too much for the property.
The exception to this rule might be property in certain areas of Manhattan, San Francisco, Chicago or other large city where appraisal valuation may tend to favor location and appreciation over net operating income. The danger in buying such property is that the area may be currently overpriced and subject to a downturn in the real estate market, and you could be caught paying too much, no matter what the appraisal says. We feel that as a general rule, the average investor is better passing by such a property.
If you are a beginning income property investor, we recommend that you engage the services of an attorney with extensive real estate experience .... at least for your first few purchases. Such a professional will be able to furnish you with the proper buyer's Offer to Purchase agreement which is slanted to the buyer�s advantage. The normal Sales Agreement, Offer Contract etc. used by real estate agents are created for the seller, not the buyer. You want your Offer to Purchase document to be designed with you, the buyer, in mind. We also recommend that you consult an accountant to review the tax implications of owning commercial real estate.
EDUCATE YOURSELF - Barclay Associates highly recommends that you read as many books as possible about investment (and/or income producing) real estate. If you don't like to read, this will be difficult for you. However, please be aware that you can save thousands, maybe tens of thousands by reading about WHAT NOT TO DO. You can also save many YEARS of making mistakes because of lack of knowledge. Ask yourself this question..... would you walk into a casino and sit down at a blackjack table without any knowledge of the game? You could.... and you would be a guaranteed heavy loser. How can you expect to succeed in the field of investment real estate without any education in the field. Fortunately, there are literally hundreds of books out there covering all aspects of investment real estate property purchase and management. Check your local library, go to a Barnes and Noble bookstore or go to their website (bn.com).... see more on this below. Read, read, read. The statement "Knowledge is Power" is never truer than in the field of investment real estate. Stay away from seminars that cost in the thousands and promise you an overnight fortune in real estate. There just ain't no easy way. We cannot recommend any course or investment real estate book specifically, but there is one good and proven way to get your real estate education. I would recommend that you go to BN.com (Barnes and Noble) and look for books on income producing property or commercial real estate investment. Sort each category by "Best Sellers." Usually the best sellers are the most informative. Remember, you are looking to get the equivalent of five years of experience in a few months of reading. For a few hundred dollars you can probably buy a dozen or more good books on the subject. To save money look under the used book section for each book. Many good out-of-print titles are available through B & N's network of thousands of used book dealers. Read the online reviews by the publisher and readers. You can order online or go to a local B & N bookstore. It is a better value to get your real estate education in this manner. Then just sit down and "hit the books." Be prepared to read and keep reading every book you can find on real estate investing. Remember, A few hundred invested could save you tens of thousands in mistakes. Good luck and we wish you much success.
Let us begin with the purchase of an apartment building. The same principals would apply to Mixed use properties, self storage facilities, mobile home parks, office buildings and other income properties. Remember the term "cap rate." It stands for capitalization rate. The meaning is really quite simple. We can compare it with the term "P/E ratio (price/earnings)" in the stock market. A P/E of 40 means that the stock is selling at 40 times current earnings. It also means that at the current earnings rate; it will take an investor 40 years to get his or her money back. The average P/E of the Standard and Poor stock index over the years is about 15 ..... not 40. Just like paying too much for property can mean disaster, paying too much for a stock with a high P/E usually means you get slaughtered. The dot.com market catastrophe was caused by greedy investors paying too much while caught in a frenzy of optimism. Each buyer was working on the "greater fool" theory which means they were sure that a greater fool would come along and pay too much for their stock when they needed to sell.
But we�re not here to talk about the stock market...... we�re interested in income producing property as our investment. However the same rules apply. Just substitute the "cap rate" for the "P/E ratio." However the cap rate used to value property works just the opposite of the P/E ratio. A cap rate that is too low means that you may be paying too much for the property. The cap rates listed below are generally used by lenders when making loan decisions. You may allow yourself some leeway if you have a very strong reason to believe the property is worth more.
A "9 cap rate" (.09) is a number considered fair and workable by many lenders when loaning on apartment buildings (multi family properties). Occasionally you may be able to go as low as an 8.5 cap rate on apartments, but this should be the exception not the norm.
A "10 cap rate" (.10) is a number considered fair and workable by many lenders when appraising most other types of income property.
You�ve heard the term loan-to-value (LTV). You may not know what it means. It simply means that the commercial property lender will loan a percentage of the best estimate (fair) value of the property to you so that you can buy your apartment building or other income property. A LTV of 80% means that you will have to put up 20% as a down payment and the lender will finance 80%. The catch is the "V" in LTV. The "V" stands for VALUE. The lender, using a professional appraisal as a guide will place a value on the property. It doesn�t matter what you think the property is worth, or what the seller thinks it is worth; what matters is what the LENDER feels it is worth.
Here�s an example of an overpriced building which will be turned down by most lenders. The apartment building has an annual N.O.I. (Net Operating Income) of $67,000. Remember, the N.O.I. does not include interest expenses on current debt owed by the seller. The building is 98% occupied and you have a FICO credit score of 712 (a very good score). You have calculated the N.O.I. using income and expense figures furnished by the seller. You have then made some adjustments to come up with that you feel is a fair N.O.I. We will explain later in this Special Report how you calculate and apply these adjustments. The resulting N.O.I. is $67,000. You then DIVIDE the $67,000 by .09 (the "9 cap rate"). use the 9 cap for multi-family (apartments) and divide by .10 (10 cap) for other income property. The division give you a fair value figure of $744,444. ($67,000 NOI divided by .09).You use this figure as your "target" when making your first offer. The target is the most you will be willing to pay for the property. You decide to start the negotiations by offering 5% below your target (your calculation results in $707,222), so you round it off and make an initial offer of $707,000. The seller is represented by a Realtor who informs you that you just don�t understand. You must have forgotten that the asking price is $1,000,000. The seller would be insulted if he, the Realtor, takes such as offer to his seller. Actually, the seller�s numbers showed an N.O.I. of $77,000, which you feel is too high because the seller left out some key expense figures. Additionally, the seller used a "7.5 cap rate" instead of a "9 cap." The asking price was calculated by the seller by dividing $77,000 (too high in your opinion) by .075 (7.5 cap rate) which you feel is much too low. The seller�s calculations result in a property value of $1,026,666. The seller rounded off the asking price to $1,000,000. The Realtor says that a 7-1/2 cap is generally used in this neighborhood because of the tremendous appreciation of residential real estate in the area. You tell him your offer stands and the Realtor takes the offer to the seller. After a few small concessions in price, the seller rejects the offer, negotiations break down and fortunately you never buy this overpriced apartment building offered by a non-motivated seller.
Why is the seller pricing the property at $1,000,000?. Because he is operating on the "greater fool" theory and is looking for an inexperienced investor to buy his overpriced building. Now...... to demonstrate a point, let�s say that you had disregarded your original calculations, come up in price and finally pay the seller $950,000 for the building. Now you approach Barclay Associates for the commercial loan. We inform you that a lender will loan you (the "L" in LTV) 80% of $740,000 value and might go as high as $750,000. Using $750,000 at 80%, you can get a first mortgage of $600,000. Since you are paying $950,000 instead of your top target price of $744,000, this simply means that you need to come up with a huge down payment of $350,000 (Sale price of $950,000 less a $600,000 mortgage) instead of your original down payment of only 148,800 if you had stuck to your original top target of $744,000.
You want to live in the real world of successful income property investors. You want to win and get rich and retire rich down the road. To do this you must BUY LOW. Here�s another statement often made by sellers, or their agents, when trying to sell property at an overpriced amount..
"Look, the average rent for each apartment is $650.00 a month. I�ve been a little busy with my regular full time job and haven�t raised them to the $700.00 which they are worth. I know a smart, hard-working person like you can get them up to $700.00 in six months. Also, don�t let the 75% occupancy rate bother you. You can bring that up to 95% in a few months. You just need to advertise more and renters will pour in." This is the statement of a con artist who believes (or hopes) that you were born yesterday. Of course, he is basing his asking price on 95% occupancy with an average rent of $700.00 He has continually mismanaged his property and now he wants you, the buyer, to pay too much BECAUSE OF HIS STUPIDITY AND MISTAKES. He wants you to be his "greater fool."
Remember how real estate fortunes are made and why income property is a wonderful time-proven investment. You increase your net worth by small, fair RENT INCREASES. You concentrate on keeping turnover low and tenants happy. As you increase rents you also IMPROVE THE PROPERTY. New carpets, new appliance, painting, etc. The same rules work for all types of income property, not just apartment buildings. As an example, here�s the scenario with an apartment building. Over a period of time increase the rent from $650 to $685 per month in a 50 unit apartment building and you increase the Gross Operating Income (G.O.I.) $17,500 per year. Let�s assume that annual expenses to upgrade cost $5,000 per year. This means that you net an additional $12,500 annually . Using a 9 cap calculation ($12,500 divided by .09), you have increased your net worth (equity) by $138.888. Even at 75% LTV a lender will loan or allow you an extra $104,166 (75% of your increased equity) which you can use as a down payment on your next apartment building or other income property.
You make your real estate fortune in income properties by continually increasing income by upgrading the property so that you can justify rent increases, and by lowering operating expenses. When buying property you make every attempt to buy the property at or below the fair value. To do this you usually need a motivated seller.
You DO NOT pay a seller too much for a property that he has clearly mismanaged. Why should you make HIS FORTUNE by paying too much. HE HASN'T EARNED IT.
CALCULATING THE N.O.I. - Arriving at a true Income and Expense statement.
One of the methods used by appraisers when making an appraisal of an income producing property is the income approach. If you attempt to use the same method when valuing a property for purchase, you will be more likely to buy the property at a fair price and you will also be more apt to arrive at a value that will be accepted by a lender. The calculations below are only our opinion of how to value a property. You may allow yourself some leeway, say 5 to 10% more or less, if you so desire.
Current month's total rent roll, including vacant units at market rent times 12 (results in annual fully occupied total rental income).
Less at least a 5% vacancy factor (7-10% vacancy factor if in fact the property is 7-10% vacant or more). If the property is fully occupied then subtract a minimum 5% vacancy factor. anyway. If the property is 25% vacant, then subtract 25% from the fully occupied number. This give you the EGI (effective Gross Income).
Also ADD separately (if any- laundry, storage, parking and vending income).
Other common expense categories (based on an apartment building-will vary for other income property) Real Estate Taxes, Water and Sewer, Common area utilities, Insurance, Legal and Accounting, Advertising, Telephone, Licenses, Heat (if owner pays), Electricity (if owner pays), Cable TV, Supplies, Elevator expense, Pest control.
Total Gross Operating Income is $220,000.
Therefore the N.O.I. is $150,000.
If an apartment building, divide $150,000 by .09 (9 cap) which gives a value of $1,666,666.
If another type of income property, divide $150,000 by .10 (10 cap) which give a value of $1,500,000.
Use the above valuation, less 5% to 10% as your opening offer. The above valuations will be your "target" or the maximum amount you will pay for the property. You may make an occasional exception to these calculation rules, but remember to never make the exception the rule. Sticking to the above calculation rules will mean you will rule out some properties; but also remember that if you pay too much you will not be able to get sufficient financing anyway. Most properties eliminated by the N.O.I. valuation rules usually are not priced right for an informed buyer. They are priced right for the seller and his Realtor.
DISCLAIMER - The material on this page and throughout the web site is for informational purposes only and covers a wide variety of information on various property and business financing topics. Although some of the information might involve tax, legal, accounting or similar issues, Barclay Associates absolutely does not intend this web site to be an advisory service web site. Our opinion on any financial matters may not fit your own particular circumstances. Cap Rates and property valuation calculations are our best estimate, but are only estimates and may vary in specific situations. Barclay Associates is not an investment advisor and any copy on this page or any other page on our website is purely informational and is not to be considered investment advice. Barclay Associates is not, and does not claim to be, professional property appraisers. We never give legal or tax related advice. We strongly encourage you to consult with your own professional advisors (attorney, accountant, appraiser, Realtor etc.) concerning any transaction involving commercial mortgages or business financing. Barclay Associates publishes this page on our website in response to many requests from current and prospective clients. The opinions and information contained on this page are based on our experience and will apply to many situations. However, any statements or information contained on this page is strictly the opinion of Barclay Associates, and there may be exceptions which makes the information inapplicable to your own particular situation. Barclay Associates will not be held responsible in any way, and will be held harmless from, any decisions made by the reader based on information on this page, which might result in a financial or other type of loss.