A FEW BASICS
The first question is: Just what is Commercial Real Estate? The next question is, what is Investment Real Estate? Sometimes they are the same and sometimes they are not. Commercial real estate is generally defined as any property that is used for the purpose of commerce. For example, an office building, a warehouse, retail store, shopping center or an apartment building with five or more units. Investment real estate is generally defined as property that is purchased for the income it produces. This can range from the purchase of a single-family home that is used as a rental, to a major shopping mall or office tower. It does not include the home you own and occupy.
While the valuation of a single family home is most often established by the sales of comparable homes in the same area, larger commercial property is usually valued by the income it produces. The more money it makes, the more it is worth. Simple, right? Well, sort of. Let’s start with an explanation of the general process of real estate valuation. Keep in mind that what an appraiser says is defined as “an opinion of value based on supportable evidence and approved methods.” It is important to understand that the appraiser does not establish a property’s worth but rather verifies what the market indicates.
There are three processes of valuation an appraiser will use to determine the value of any piece of real estate.
1. COST – The cost to build a similar piece of real estate.
2. MARKET – Based on the closed sales of similar properties in similar condition and areas. This is called the comparable or market value.
3. INCOME - The property value based on the Net Operating Income (NOI) the property produces. An appraiser will use all three processes, but select only the one (or, at most two) that most accurately reflects the market value. They are never averaged.
Net Operating Income (NOI)
As an investor in real estate, you will be particularly interested in the Net Operating Income (NOI) in order to determine a property’s worth to you. Simply put, the NOI represents a property’s profitability. It is the money that is available to the investor after all of the operating expenses have been deducted from the rental income. Important? Sure! It’s “money in the bank” or money to pay the mortgage. If you paid all cash for the property, the NOI would be the “return” on your investment just as if you had deposited your money into a savings account.
Here is an easy way to compute the Net Operating Income:
Start with the total income that would be generated if the property is fully occupied. Then subtract any money lost due to vacancies, uncollected rents or other credit losses. The remainder constitutes the money available to operate the property. From this figure, subtract all operating expenses, such as routine maintenance and property taxes. What is left is called the Net Operating Income (NOI).
Now let's look at the NOI as it relates to the process of choosing an investment property, along with its two commonly used shirt-tail cousins, the CAP Rate (Capitalization Rate) and the GRM (Gross Rent Multiplier).
CAP Rate
With a savings account, the money you earn is called the “interest” and is expressed as a percentage rate. In Real Estate, the return on an investment is also expressed as a percentage and is called the CAP rate or Capitalization Rate. So, how do we get the CAP rate? Well, the cap rate is derived by dividing the NOI by the asking price of the property. For example, if the asking price of a property is $1,000,000 and the NOI is $100,000, you would compute the CAP Rate as follows:
(NOI) $100,000 ÷ (Asking Price) $1,000,000 = .10 or 10%
This just means that if you were to pay all cash for the property your return on that investment would be 10%. In general, the higher the CAP rate the better the deal. As an investor you may decide not to look at any properties with less than a certain CAP rate, thereby concentrating your search efforts on the most viable investment opportunities for you.
Gross Rent Multiplier (GRM)
Another handy tool that can help you decide which properties should get your attention is the Gross Rent Multiplier (GRM). This calculation estimates a property’s value as a multiple of its annual gross rental income. The relevance of the GRM is dependent on knowing the average GRM’s of recently sold similar properties in the same area. You can quickly figure the GRM of any property by dividing the selling price by the annual gross income. It goes like this:
(Selling Price) $750,000 ÷ (Annual Gross Income) $65,000 = GRM of 11.5.
Unlike CAP Rates, the lower the GRM the better. If you know that the average GRM in a specific area is around 11.5, you wouldn’t spend your time looking at properties with higher GRM’s. Both of these calculations help to narrow the field of potential properties to fit the investor’s specific criteria, especially during the
initial phase of looking at income property. They do not, however, tell the complete story. A more detailed analysis of all the variables will be important as the search process goes forward.
So what, you ask? How much money do I put in my pocket when all is said and done? And, just when is all said and done? Well, not for a while yet. There is more to learn and understand.
*Please note that the numbers used herein are for illustration only, and are not reflective of any current market.
EMAIL JACK CELL: 415-518-7036 OFFICE: 415-479-2298 FAX: 415-472-3101
HOME PAGE
****************************************************************************************************************
OTHER PEOPLE'S MONEY and CASH FLOW
When you contemplate purchasing an investment property your first concern is how to pay for it. One way is to use all cash and pay for it in full. Or, you can, as most investors do, use Other People's Money (OPM). How do you get Other People’s Money? Usually, by borrowing it. Who are these other people? You may be one. If you have money in a bank, credit union, S&L pension fund, etc., and they pay interest, you are most probably among the “Other People.” Lenders need to put the OPM to work in order to pay the interest, and loans are the employment market for money. The amount of interest paid is the cost of borrowing money and is called “debt service.” This is simply the cost of hiring (borrowing) the money, and reflects two things: cost of funds and risk.
“Cost of Funds” is what the lenders have to pay for the money. They loan it to you for more than it costs them, of course. “Risk” is the chance the lender takes that the loan may not get re-paid. Lenders often mitigate their risk by using what is called the Debt Coverage Ratio (DCR). Simply put, this means that the lender doesn’t allow you, the borrower, to use all of the NOI to qualify as the amount available to service the debt. For instance, they may only allow you to use 95 % of the NOI.
Keep in mind that when purchasing investment property, it is primarily the property that must qualify. You, the borrower may have to qualify too, but it is the income from the property that determines how much money can be borrowed.
Here’s where the Net Operating Income (NOI) becomes important. Remember from the previous post, the NOI is the money that is available to the investor after all of the operating expenses have been deducted from the rental income. If you pay all cash then the NOI is your actual return. But, if you borrow the money, the NOI becomes the source of cash to repay the debt. What is left after you pay the debt from the NOI is called the cash flow.
Cash flow can be either positive or negative. Positive means the property puts money in your pocket. Negative means your pocket puts money in the property. Personally, I prefer positive.
Remember the CAP rate? Well, if you paid all cash for the property, the NOI divided by the purchase price would be your return on investment, or the CAP rate. However, when you borrow seventy or eighty percent of the funds, you are using what is called “leverage” and the CAP rate is no longer a determinant of your the actual return. Your actual return is now the cash flow divided by the amount of money you have invested in the property. This is called your “cash on cash” return.
Remember, there are many factors that are important to successfully investing in real estate. You don’t need to do all the math. Your real estate broker should do that part and bring you the properties that satisfy your criteria.
LEVERAGE
This is what it is all about in real estate: LEVERAGE. The word is defined as “the mechanical advantage of a lever.” A lever is defined as “a means to accomplishment.” When I use the term in real estate, it refers to one’s
ability to control a large amount of asset value (money) with a small amount of asset (money). Or, to simplify the whole thing, consider that you can purchase a home for $100,000 using $20,000 of your own dollars. (The dollar amounts are a bit dated, but the idea is easier to follow using these numbers.) The other 80% is OPM. You remember that as “Other Peoples Money.”
In this case you are controlling 100%, the whole asset, with a fraction, 20%, of the value of the asset. Next, consider the mechanical (financial) advantage of the leverage position. If the property increases in value by 10%, using our example, the property is now worth $110,000 or $10,000 more. Because your investment was $20,000 you have just gotten a 50% return on your investment ($10,000 divided by $20,000 equal .50 or 50%). Not too bad, eh?
Of course, this is somewhat simplified and there is more to the equation than just those figures. However, the principle remains: with leverage you control a large amount with a small amount. Well, you may ask, can’t I do that in the stock market? And the answer is yes. You can. It is called buying on margin. That means you are borrowing your stock broker’s money to purchase the stock. The same value principle applies. If the stock goes up you make a larger return. Now, the stock purchase margin is limited to 50% rather than the 20% for the real estate example I used. Using the above ratios you would have made a 20% return on a 10% increase in the value of the stock. Still, not bad. Not bad at all.
Before I forget, there is one little catch in the stock purchase on margin. If the stock value goes down, there could be a margin call. This means you have to come up with the balance owed to pay your stock broker. If you can’t, the broker may sell the stock to recover his loan. If you meet the margin call, and you often have as long as three days to do this, you only lose the amount the stock went down. A bit too risky, it seems to me.
In the case of real estate, you have borrowed the money on a long term basis and even if the property value goes down, you’ll not face a margin call. And, you can have up to thirty years to pay off the balance. A bit less risk, I would say. Yes, property values do go down and you may be “upside down” in the property. “Upside down” means that you owe more money than the property is worth. However, in the real estate world, you have a much longer time to recover from a downturn. I point this out simply because there is some risk involved in almost every transaction. Your job is to know what the risks are and only engage in the level of risk you can tolerate.
* Please note that the numbers used here are for illustration only, and are not at all reflective of any current market.
EMAIL JACK CELL: 415-518-7036 OFFICE: 415-479-2298 FAX: 415-472-3101
HOME PAGE
While the valuation of a single family home is most often established by the sales of comparable homes in the same area, larger commercial property is usually valued by the income it produces. The more money it makes, the more it is worth. Simple, right? Well, sort of. Let’s start with an explanation of the general process of real estate valuation. Keep in mind that what an appraiser says is defined as “an opinion of value based on supportable evidence and approved methods.” It is important to understand that the appraiser does not establish a property’s worth but rather verifies what the market indicates.
There are three processes of valuation an appraiser will use to determine the value of any piece of real estate.
1. COST – The cost to build a similar piece of real estate.
2. MARKET – Based on the closed sales of similar properties in similar condition and areas. This is called the comparable or market value.
3. INCOME - The property value based on the Net Operating Income (NOI) the property produces. An appraiser will use all three processes, but select only the one (or, at most two) that most accurately reflects the market value. They are never averaged.
Net Operating Income (NOI)
As an investor in real estate, you will be particularly interested in the Net Operating Income (NOI) in order to determine a property’s worth to you. Simply put, the NOI represents a property’s profitability. It is the money that is available to the investor after all of the operating expenses have been deducted from the rental income. Important? Sure! It’s “money in the bank” or money to pay the mortgage. If you paid all cash for the property, the NOI would be the “return” on your investment just as if you had deposited your money into a savings account.
Here is an easy way to compute the Net Operating Income:
Start with the total income that would be generated if the property is fully occupied. Then subtract any money lost due to vacancies, uncollected rents or other credit losses. The remainder constitutes the money available to operate the property. From this figure, subtract all operating expenses, such as routine maintenance and property taxes. What is left is called the Net Operating Income (NOI).
Now let's look at the NOI as it relates to the process of choosing an investment property, along with its two commonly used shirt-tail cousins, the CAP Rate (Capitalization Rate) and the GRM (Gross Rent Multiplier).
CAP Rate
With a savings account, the money you earn is called the “interest” and is expressed as a percentage rate. In Real Estate, the return on an investment is also expressed as a percentage and is called the CAP rate or Capitalization Rate. So, how do we get the CAP rate? Well, the cap rate is derived by dividing the NOI by the asking price of the property. For example, if the asking price of a property is $1,000,000 and the NOI is $100,000, you would compute the CAP Rate as follows:
(NOI) $100,000 ÷ (Asking Price) $1,000,000 = .10 or 10%
This just means that if you were to pay all cash for the property your return on that investment would be 10%. In general, the higher the CAP rate the better the deal. As an investor you may decide not to look at any properties with less than a certain CAP rate, thereby concentrating your search efforts on the most viable investment opportunities for you.
Gross Rent Multiplier (GRM)
Another handy tool that can help you decide which properties should get your attention is the Gross Rent Multiplier (GRM). This calculation estimates a property’s value as a multiple of its annual gross rental income. The relevance of the GRM is dependent on knowing the average GRM’s of recently sold similar properties in the same area. You can quickly figure the GRM of any property by dividing the selling price by the annual gross income. It goes like this:
(Selling Price) $750,000 ÷ (Annual Gross Income) $65,000 = GRM of 11.5.
Unlike CAP Rates, the lower the GRM the better. If you know that the average GRM in a specific area is around 11.5, you wouldn’t spend your time looking at properties with higher GRM’s. Both of these calculations help to narrow the field of potential properties to fit the investor’s specific criteria, especially during the
initial phase of looking at income property. They do not, however, tell the complete story. A more detailed analysis of all the variables will be important as the search process goes forward.
So what, you ask? How much money do I put in my pocket when all is said and done? And, just when is all said and done? Well, not for a while yet. There is more to learn and understand.
*Please note that the numbers used herein are for illustration only, and are not reflective of any current market.
EMAIL JACK CELL: 415-518-7036 OFFICE: 415-479-2298 FAX: 415-472-3101
HOME PAGE
****************************************************************************************************************
OTHER PEOPLE'S MONEY and CASH FLOW
When you contemplate purchasing an investment property your first concern is how to pay for it. One way is to use all cash and pay for it in full. Or, you can, as most investors do, use Other People's Money (OPM). How do you get Other People’s Money? Usually, by borrowing it. Who are these other people? You may be one. If you have money in a bank, credit union, S&L pension fund, etc., and they pay interest, you are most probably among the “Other People.” Lenders need to put the OPM to work in order to pay the interest, and loans are the employment market for money. The amount of interest paid is the cost of borrowing money and is called “debt service.” This is simply the cost of hiring (borrowing) the money, and reflects two things: cost of funds and risk.
“Cost of Funds” is what the lenders have to pay for the money. They loan it to you for more than it costs them, of course. “Risk” is the chance the lender takes that the loan may not get re-paid. Lenders often mitigate their risk by using what is called the Debt Coverage Ratio (DCR). Simply put, this means that the lender doesn’t allow you, the borrower, to use all of the NOI to qualify as the amount available to service the debt. For instance, they may only allow you to use 95 % of the NOI.
Keep in mind that when purchasing investment property, it is primarily the property that must qualify. You, the borrower may have to qualify too, but it is the income from the property that determines how much money can be borrowed.
Here’s where the Net Operating Income (NOI) becomes important. Remember from the previous post, the NOI is the money that is available to the investor after all of the operating expenses have been deducted from the rental income. If you pay all cash then the NOI is your actual return. But, if you borrow the money, the NOI becomes the source of cash to repay the debt. What is left after you pay the debt from the NOI is called the cash flow.
Cash flow can be either positive or negative. Positive means the property puts money in your pocket. Negative means your pocket puts money in the property. Personally, I prefer positive.
Remember the CAP rate? Well, if you paid all cash for the property, the NOI divided by the purchase price would be your return on investment, or the CAP rate. However, when you borrow seventy or eighty percent of the funds, you are using what is called “leverage” and the CAP rate is no longer a determinant of your the actual return. Your actual return is now the cash flow divided by the amount of money you have invested in the property. This is called your “cash on cash” return.
Remember, there are many factors that are important to successfully investing in real estate. You don’t need to do all the math. Your real estate broker should do that part and bring you the properties that satisfy your criteria.
LEVERAGE
This is what it is all about in real estate: LEVERAGE. The word is defined as “the mechanical advantage of a lever.” A lever is defined as “a means to accomplishment.” When I use the term in real estate, it refers to one’s
ability to control a large amount of asset value (money) with a small amount of asset (money). Or, to simplify the whole thing, consider that you can purchase a home for $100,000 using $20,000 of your own dollars. (The dollar amounts are a bit dated, but the idea is easier to follow using these numbers.) The other 80% is OPM. You remember that as “Other Peoples Money.”
In this case you are controlling 100%, the whole asset, with a fraction, 20%, of the value of the asset. Next, consider the mechanical (financial) advantage of the leverage position. If the property increases in value by 10%, using our example, the property is now worth $110,000 or $10,000 more. Because your investment was $20,000 you have just gotten a 50% return on your investment ($10,000 divided by $20,000 equal .50 or 50%). Not too bad, eh?
Of course, this is somewhat simplified and there is more to the equation than just those figures. However, the principle remains: with leverage you control a large amount with a small amount. Well, you may ask, can’t I do that in the stock market? And the answer is yes. You can. It is called buying on margin. That means you are borrowing your stock broker’s money to purchase the stock. The same value principle applies. If the stock goes up you make a larger return. Now, the stock purchase margin is limited to 50% rather than the 20% for the real estate example I used. Using the above ratios you would have made a 20% return on a 10% increase in the value of the stock. Still, not bad. Not bad at all.
Before I forget, there is one little catch in the stock purchase on margin. If the stock value goes down, there could be a margin call. This means you have to come up with the balance owed to pay your stock broker. If you can’t, the broker may sell the stock to recover his loan. If you meet the margin call, and you often have as long as three days to do this, you only lose the amount the stock went down. A bit too risky, it seems to me.
In the case of real estate, you have borrowed the money on a long term basis and even if the property value goes down, you’ll not face a margin call. And, you can have up to thirty years to pay off the balance. A bit less risk, I would say. Yes, property values do go down and you may be “upside down” in the property. “Upside down” means that you owe more money than the property is worth. However, in the real estate world, you have a much longer time to recover from a downturn. I point this out simply because there is some risk involved in almost every transaction. Your job is to know what the risks are and only engage in the level of risk you can tolerate.
* Please note that the numbers used here are for illustration only, and are not at all reflective of any current market.
EMAIL JACK CELL: 415-518-7036 OFFICE: 415-479-2298 FAX: 415-472-3101
HOME PAGE
RSS Feed