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How do you know what a commercial income property is worth? How do
you know that you can get your desired return on your investment? Is
there a way to calculate the maximum you can pay for an investment
and still achieve your investment goals? This article will answer
these questions and more about valuing income property.
Many real estate investors determine the value of an income property
by using the capitalization rate, a.k.a the cap rate.
Example:
Say the property has an NOI "Net Operating Income" of $125,000, and
the price is $1,500,000.
$125,000/ $1,500,000 = 8.33% cap rate “rounded”
This does not tell you what your return will be if you use
financing. Also it doesn’t take into account the different finance
terms available to different investors?
What the cap rate above represents is merely the projected return
for one year as if the property were bought with all cash. Not many
of us buy property for all cash, so we have to break the deal down,
to find the cash on cash return on our actual investment using
leverage.
Now calculate the debt service to finance the investment, subtract
that from the NOI, and calculate the return.
In order to correctly find the cap rate and get equal comparison,
you must know the correct income and expenses for the property, and
that the calculations of each were done in the same way.
A wide range of cap rates for property types with different risk and
management requirements, which may or may not apply to the property
you are looking at, and certainly does not take into account your
own return requirements compared to the Market Cap Rate . So what do
you do when you've found a property that looks promising, and the
Seller tells you the cap rate is 11.1% and you better act fast? How
do you know if it is worth pursuing?
What's it worth to you?
The real question is not how much I (or another investor, or even an
appraiser) value a property at. Nor is it the value from a cap rate
estimated in the market. It's the value at which YOU can attain YOUR
investment goals, that is reflective of YOUR borrowing power, and
gives you an intelligent starting point for the analysis.
I promise you if you learn how to do this, it will give you a leg up
on 90% of the investors out there. Critical to this calculation is
that the NOI is figured consistently with industry norms. The
generally accepted definition of NOI is:
Gross Income - Operating Expenses = NOI
Please note that the operating expenses do not include debt service
or the interest component of debt service. Obviously, the income and
expenses must be verified, or all calculations that flow from them
will be flawed. Verifying the income is usually easier than the
expenses. Rent roll analysis and a contract contingency for tenant
estoppel letters at closing can settle the income stream
conclusively.
Your Realtors normal due diligence includes verifying with third
party suppliers as many of the expenses as possible. But take care
evaluating the operating expenses to uncover any anomalies that
exist under the present ownership.
Owners often take a management fee that may or may not be market
based; maintenance expenses may or may not include labor charges;
items such as "office expense," "professional fees," or "auto
expense" may or may not be property specific.
In short, before accepting the NOI presented, understand what is
behind the numbers. This is known as "normalizing" the numbers. You
can also tweak the numbers to reflect the way you will own and
manage the property.
No two investors will own and operate a property the same way. It is
entirely possible for two investors to look at the same property and
come up with two different NOI, and two widely divergent values, and
both are right.
That's why appraisers use comparable sales, replacement value, and
the income approach as part of a three-pronged method in estimating
value. They make the appraisal representative of the market
conditions and the typical requirements of investors and lenders
active in the market.
The third method, the income approach, is usually given the most
weight. That method is also known as the "band of investment" method
of estimating the present value of future cash flows. It addresses
the return required on both equity and debt, and leads to what can
be called a derived capitalization rate.
Deriving your cap rate
After you are reasonably certain that the NOI is accurate, Find the
derivative capitalization rate. It requires two more pieces of
information: You have to know the terms of financing available to
you and the return you want on your investment.
We then use these terms for both debt and equity to indicate the
value at one precise point in time--the instance of when the
operating numbers are calculated--to derive the cap rate that
reflects those terms. (The value in future years is another
discussion.) Deriving a cap rate works like a weighted average,
using the known required terms of debt and equity capital.
The bank's return: the loan constant
We need to know the terms of the financing available. From that we
can develop the loan constant, also called a mortgage constant. The
loan's constant, when multiplied by the loan amount, gives the
payment needed to fully repay the debt over the specified
amortization period.
IT IS NOT AN INTEREST RATE, but a derivative of a specific interest
rate AND amortization period. When developing a derivative cap rate,
one must use the constant since it encompasses amortization and
rate, rather than just the rate.
Using just the interest rate would indicate an interest only payment
and distort the overall capitalization process. The formula for
developing a constant is:
Annual Debt Service/Loan Principal Amount = Loan Constant
You can use ANY principal amount for the calculation, then calculate
the debt service and complete the formula. The constant will be the
same for any loan amount. For example, say your bank says they will
generally make an acquisition loan at a two points over prime, with
twenty-year amortization, with a maximum loan amount of 75% of the
lower of cost or value.
Say prime is at its current 4.5%. That means the loan will have a
6.5% interest rate. Using a payment calculator or loan chart, find
the payment for those terms. On a loan for $10,000, the annual debt
service required is $894.72. Divide that by $10,000 to find the
constant.
894.72/10,000 = .08947
Using the terms given then, the loan constant for that loan would be
.08947 rounded to five digits.
The answer will be the same if you use $100,000 or any other number
as the principal amount. (One hint: do not use a principal number
with less than five digits, because the rounding will affect the
outcome.)
You might note here that the mortgage constant is basically the
lender's cap rate on his piece of the investment. Both the mortgage
constant and "cash-on-cash" rates for equity are "cap" rates in
their basic forms. A cap rate is any rate that capitalizes a single
year's income into value (as opposed to a yield rate).
Your return: cash-on-cash return
The next step is to provide for the return on the equity. Start with
the return you want on your money: Say the cash-on-cash return you
are seeking is 20%.
If an investor puts in $30,000 and requires a 20% pre-tax return,
then his annual cash in the pocket after paying the mortgage (but
before income taxes) would have to be $6,000. In this case, the
equity constant is .20.
Put it all together: Weighted average
Each of these cap rates is then weighted based on the loan-to-value
ratio of each of the debt and equity positions to build the "overall
cap rate." The formula looks like this:
(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity
constant)
= derived cap rate
To finish the example, using the mortgage terms given above, and the
desired 20% cash on cash return, the following would be the overall
cap rate with a 75% loan-to-value on the debt component:
(.75 x 0.08947) + (.25 x 0.20) = .1171
or
.0671 + .05 = .1171
To convert to a percentage, move the decimal two places, and
therefore, under the stated conditions, the required cap rate for
the property (income stream) is 11.71%. Using the normalized NOI
figure, then the indicated value is calculated with this formula:
NOI/Cap Rate = Maximum Purchase Price to achieve your investment
goal.
For the original deal above, the value would be calculated thusly to
attain the desired return:
$125,000/11.71% = $1, 067,464
The asking price of $1,125,000 is very close to my target of
$1,067,464. This is a deal that would definitely be worth taking a
look at.
The
other factors
Many factors can influence the value of an income property both
positively and negatively. Some of the more important include
maintenance; security of the income stream (strength of the tenants
and length of the leases); comparable sales in the area; general
economic and market conditions; and local market conditions; future
area development and or restrictions.
All these factors and more speak to the relative risk and effort
involved in the continuance of the income stream, and must be
investigated during the due diligence by yourself and your Realtor.
Increase the required return and the cap rate changes, and so does
the price. At this point you are writing your own paycheck.
In Closing
I hope you found this information useful and if you’re thinking of
buying or selling an income producing property here in the Central
Toronto area and would like a team of professionals representing
your best interests, you’ll give me a call.
Feel free to ask me any questions you might have about buying or
selling residential or commercial real estate.
Thanks for visiting my website.
Frank Jones
The information and opinions contained in this
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reliable, but their accuracy cannot be guaranteed. The publisher
assumes no responsibility for errors and omissions, or for
damages resulting from using the published information and
opinions. This web site is provided with the understanding that
it does not render legal, accounting, or other professional
advice. Whole or partial reproduction is forbidden without the
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