Knowing what a commercial Real Estate Income Producing Property may be worth?

How does the investor know what a real estate income property is really worth? Is there a way to calculate the maximum you can pay for an investment and still achieve your investment goal? Some tips to determine how to come to a general conclusion to move forward in a more formal manner below.
Among the many tools used by investors to gauge the worth of a real estate income producing property, one of the most popular is a capitalization rate. While It should be a guide post it certainly is not the end all in decision making While brokers, sellers and lenders alike are fond of quoting deals based on the “cap rate”, the way it is typically used they are simplifying the true use of a well known term.

The typical way a broker prices a property is to take the Net Operating Income (NOI), divide it by the sales price, there’s the cap rate. Example: Say the property has an NOI of $100,000, and the price is $1,000,000. Then $100,000/ $1,000,000 = 10% cap rate.

But what does that number tell you? Does it tell you what your return will be if you use financing? No. Does it take into account the different finance terms available to different investors? No. Then just what does it illustrate?

What the cap rate represents as used above is merely the projected return for one year as if the property were bought with all cash. Not many investors buy real estate income property for all cash, so we have to further analyze, usually by trial and error, to find the cash on cash return on our actual investment using debt. Then we calculate the debt service, subtract it from the Net Operating Income, and then calculate our return. If the debt terms change, or loan to value, or our return requirement, then the whole calculation has to be performed again

As a comparison tool it is almost impossible by any means to find out what other properties have sold for on the basis of the cap rate. In order to correctly calculate a cap rate we must know the correct income and expenses for the property, and that the calculations of each were done in the same way as will be illustrated below. A broker may have the details pertaining to several deals in the marketplace, and with enough information about enough deals the information may rise to the level of a market cap rate. This is what we call comps for the sale and must be searched out in different directions. So common sense says just estimating a range of cap rates for property types, which may or may not apply to the real estate income property you are looking at, and certainly does not take into account your own return requirements may not be accurate.

So what is the first thing a smart investor should do if a real estate income property looks promising, and the broker tells you the cap rate is 10% and you better move quickly? How do you know if it is worth pursuing? You may be looking at the wrong numbers, and spend a lot of time simply guessing. There is a better way.

What’s it Worth to YOU is the real question?

The real question in valuation is not how much you or other investors, or even an appraiser value a property , nor the value from a cap rate estimated in the market, but rather the value at which YOU can attain YOUR investment goals taking in consideration loan responsibility and cash on cash return expectations. A tool that will give you that answer to this calculation is that the NOI (Net Operating Income) is figured consistently with industry norms. The generally accepted definition of NOI is:

Gross Income minus Operating Expenses = NOI.

Please note that the operating expenses do not include debt service, or the interest component of debt service.

The true income and expenses must be verified, or all calculations that flow from them will be worthless. Verifying the income is usually easier than the expenses. Rent roll analysis and a contract contingency for tenant estoppel letters at closing can verify the income stream properly.

On the expense side of the equation, normal due diligence includes verifying with third party suppliers as many of the expenses as possible. Careful study must be taken in evaluating the operating expenses to uncover any unusual numbers that may 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” may or may not be property specific. In short, before accepting the NOI presented, effort must be made to understand what is behind the numbers. You can also correct the numbers to reflect the way you will own and manage the property. Investors will own and operate a property the different manners. It is entirely possible for two investors to look at the same property and come up with two different Noisy, and gain two different values, and both may be right.

That’s why comparable sales, replacement value and the income approach are part of a three-pronged determination in estimating value. Appraisers are charged with making the valuation 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. This method addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.

Determine Your Cap Rate

After the investor is reasonably certain that the NOI is accurate the best way to get an initial value indication is to use a “derived” capitalization rate. That requires two more pieces of information. You have to know the terms of financing and the return you want on your investment. We can 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.

Determining a cap rate works like a weighted average, using the known required terms of debt and equity capital.

The Lender’s Return: the Loan Constant

Start with the finance mechanism first. We need to know the terms of the financing available, and from that we can develop what is known as 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. This is not an interest rate, but a derivative of a specific interest rate AND amortization period. When arriving at a cap rate, one must use the constant since it includes 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

The investor 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 lender says they will generally make an acquisition loan at 2 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 4.5%. That means the loan will have a 6.5% interest rate. Using a payment calculator, 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 these numbers, the loan constant for that loan would be .08947 rounded to .089. The answer will be the same if you use $100,000 or any other number as the principal amount. The mortgage constant is basically the lender’s cap rate on his side 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 15%. The “cash-on-cash” rate is also known variously as the equity dividend rate, equity cap rate, and cash-throw-off rate. It represents the “cap” rate to the equity position, and to be consistent call it the equity constant. If an investor puts in $30,000 and requires a 15% pre-tax return, then his annual cash in the pocket after paying the mortgage would have to be $4,500.

In this case, the equity constant is .15.

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 15% 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 0.15) = .1046

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 10.46%. Using the normalized NOI figure, then the indicated value is calculated with this formula:

NOI/Cap Rate = Maximum Purchase Price

For the original deal above, the value would be calculated thusly to attain the desired return:

$100,000/10.46% = $957,000
The asking price of $1,000,000 is very close to the indicated value of $957,000. This is a deal that would definitely be worth pursuing.

Not a Perfect Formula Regardless

Many factors can influence the value of real estate income producing property both up and down. Some of the most important include deferred 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. These factors speak to the relative risk and effort involved in the continuance of the income stream. As risk or effort increases, so does the investor’s required return on equity. Increase the required equity return and the cap rate changes, and so does the value.

You should also now see why it is so critical to verify EXISTING income and expense BEFORE establishing value of the real estate income producing property. DO NOT however, use this as a “Perfect Formula”, and then stop your analysis after the calculation. Thorough due diligence in commercial income properties is still needed.