If you don’t know the answer as a real estate investor, you are in trouble. Real estate investment is not only a numbers game, successful real estate investment is about the numbers itself. While location is important, if the deal does not make sense financially it is a bad deal.
I am sure you have been approached by a real estate broker with the deal of the century!
We have this unique income property with an 11.30% cap rate!!! You must run now and buy it before someone else takes it!!!
Most real estate investors determine the value of an income property by using the capitalization rate or cap rate. However, cap rates is misused in real estate investing.
Meaningless numbers and percentages are worthless and can lead to poor investment decisions. The cap cate is a rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor’s potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property.
Cap Rate = Net Operating Income (NOI) / Purchase Cost
However, what does the cap rate represents? The cap rate above represents a projected return for one year in a 100% cash deal. However, how many investors do you know that acquire real estate 100% cash? Not many.
Unfortunately, cap rate is one of the rates that is misused by brokers in their attempt to provide a valuation for the real estate deal. The only way to have a meaningful cap rate(s) and be able to do meaningful comparisons is by having actual income and expenses in each of the properties being analyzed. Most brokers do not have access to this information and the actual information is not public information, so the only way is for you to get it is directly from the source.
How do you know you have a good deal?
Regardless of how much a property is appraised for or its valuation based on its advertised cap rate, your goal is to determine the value at which you can attain your investment goals.
So lets get started!
1. Determine the Net Operating Income (NOI) (Gross Income – Operating Expenses). Operating rental expenses do not include debt service or the interest component of debt service.
2. Verify the income and expenses, otherwise your calculations will be flawed. Income can be verified by performing rent roll analysis. Expenses will be more challenging but it can be done. Some of the information can be verified through the county records and utility providers.
3. Ask questions, for example how is the management fee determined, review maintenance expenses, and other expenses such as office expenses and professional fees which may not be property specific.
4. Determine the loan constant. From the loan financing we need to calculate what is called the “Loan Constant”. The loan constant is an interest factor used to calculate the true cost of borrowing. Given the choice of two loans, a borrower should opt for the one with the lower loan constant, since it will have the lower debt service requirement.
Annual Debt Service/Loan Principal Amount = Loan Constant
You might note here that the loan constant is basically the lender’s cap rate or return on his piece of the investment.
5. Determine the cash-on-cash return (aka Equity Constant) you want. The cash-on-cash rate is also known as the equity dividend rate or equity cap rate.Start with the return you want on your money: Say the cash-on-cash return you are seeking is 20%.
6. Calculate the “Derived Cap Rate”. The derived cap rate is the weighted average based on the loan-to-value ratio of each of the debt and equity positions in the transaction.
(LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant) = derived cap rate
Asking price = $1,150,000
NOI = $130,000
Advertised Cap Rate = 11.30%
Debt LTV = 75%
Interest Rate = 6.5%
Annual Debt Service = $90,160
Equity constant desired = 20%
Based on the information above, assuming that you verified the NOI, the valuation would be as follows:
Loan constant = $90,160 / $862,500 = 10.45333%
Derived Cap Rate = (75% X .1045333) + (25% X .20) = .0784 + .05 = .1284
Maximum Purchase Price = NOI / Derived Cap Rate = $130,000 / .1409 = $1,012,461
The asking price is close to your target of $1,012,461. Therefore, this deal would be worth studying further.
While the formula presented above is not a guarantee, it provides a better valuation method than the traditional formulas presented in the market. Also, other factors will influence the value of an income property, but the calculation above will eliminate wasted time on worthless overpriced deals or will give you a better negotiation tool in arriving to a better purchase price.