Property Investing 101

Numbers

Investment properties are generally valued using the Income Approach. Residential properties on the other hand are valued using the comparative market approach or the cost method (for newer properties).

There are two variants to the income valuation approach: 1) the direct capitilization method and 2) the gross income mulitiplier method.


1) Direct Cap Method

Cap rate equation:

Price = Net Operating Income/ Cap Rate
with cap rate = required rate of return - growth rate of NOI

Net operating income is...

+Gross income
-PPTY Taxes
- Insurance
-Maintenance
-Op Expenses (ppty mgmt fees, water, garbage)
-Vacancy Costs
=NOI

NOI excludes the cost of debt.

There is an inverse relationship between cap rate and price. The higher the cap rate, the lower the price.

Cap rates can be calculated three ways: market extraction technique, band of investment technique and the built-up technique.

Market Extraction Technique
Cap rates can be extracted from the price. For example, if a building's asking price is 1,050,000 and the NOI is 40,000 then,

1,050,000 = 40,000/ cap rate =>
cap rate = 3.8%

Band of Investment Technique
BOI utilizes the investor's weighted cost of capital (for you corporate finance people, this is familiar).

Cap rate (BOI) = (mortgage weight x mortgage cost) + (equity weight x equity cost)

Example:
Price $1,050,000
Mortgage = 525,000
Equity (cash) = 525,000
Interest rate = 6.7%
Required return on equity = 10%
Weight of each is 50% (half debt, half cash)
Cap rate = (.5 x 6.7%) + (.5 x 10%) = 8.35%

Given the cost of debt and the expected return of 10% for your cash investment, your expected return on total capital invested in the property would be 8.35% .

Return on equity can be extracted from the market cap rate. From the previous example
3.8% = (.5 x 6.7 %) + (.5 x ROE) => ROE = 0.9%

This doesn't look too good considering you can take your $525,000, put it into a savings account and earn at least 1.5% with less risk. But keep in mind the 3.8% market cap is based on NOI and does not consider property appreciation.


Built-up Technique

Cap (BU) = +Pure interest rate (US Govt bond adj for RE tax savings)
+Liquidity premium (compensation for illiquid nature of RE)
+ Recapture premium (depreciation minus appreciation)
+ Risk premium (premium required for exposure to invest risks)

These factors can be estimated using models. Sophisticated investors investing in large commerical properties may use this method.

So what conclusions can we gather from cap rates. Let us look at the 3.8% market cap rate calculated above. This is mostly based on a real property that my client was bidding on recently. A 4% cap rate would be considered good for this area. The ppty is yielding 3.8% with 100% cash (remember NOI is before debt financing). The interest rate on a commercial loan varies, but I can almost assure you that it will be higher than 3.8%. Debt financing for this 3 unit mixed use will cost anywhere between 5.49% to 8.00% fixed initially, then variable (banks rarely will lend 30 yr fixed on commercial ppty). I'll use 6.7% as the interest rate of debt on this ppty. The 3.8% cash yield versus 6.7% debt service does not sound so good. For this property to break even at a 6.7% mortgage with 30 yr amortization, the investor would have to put down a little over 55% in downpayment . Investors in SF can expect to put at least 40% down on a property due to prices being so high relative to rental income. You could pay cash but you would lose one of the benefits of property ownership- positive leveraging. I have excluded the package of benefits that induces investors to buy real estate in the first place (the big WHY?). I'll be talking more about this in the next blog posting.


2) Gross Rent (Income) Multiplier

GRM = Price/potential gross rent
gross rent can be annualized or per month
GRM excludes operating expenses

For our 3 unit mixed use the annual GRM will be
1,050,000/ 57,600= 18.23

GRM can be used to compare properties within a location or of similiar type. For example, if you looked at 3 unit mixed use buildings that have sold in that district within the last six months, with the annual income reported in the MLS, you'll find two buildings that sold for around 16.5 GRM and another that sold for a whopping 32 GRM. A buyer can see if a building's price is out of line with similiar properties in the area by taking it's annual income and multiplying it by an average GRM based on other properties. For example at 20x,

57,600 (annual rent) x 20 = 1,152,000 market price.

What conclusions can we draw from GRM? If you can find the data, it can useful to compare properties. The more data you have to find an average, the better. But in a city like SF I like to look at cash flow and appreciation potential. Prices can get outrageous and just because your paying the average GRM, doesn't mean you getting a good deal or making money.

If all these numbers are confusing you, drop me an email and I'll go over them. For you seasoned property investors, feel free to post a comment to this blog. There are a lot of people new to this game and would love to hear your two cents.