Apartment Investing

Why To Take Care When Calculating Cap Rate

cap rateThe Cap Rate being what it is, a ratio combining Net Operating Income and Value/Cost, two pretty important aspects of any property, is just as easily misused by certain parties as it is used legitimately. Following are three ways Cap Rate can be misused that you should be aware of.

1. Cap Rate With Pro Forma Numbers: Given that we as humans tend to seek pleasure while simultaneously avoiding pain, we are susceptible to overestimating the upside, and underestimating the downside. Brokers and smart sellers know this, so when we ask for information about the property they ply us with Pro Forma numbers; the “best case” scenario after all the hard work and improvements have been made, knowing we will go directly to there in our imaginations and conveniently skip over all of the annoying planning, supervising, managing, and flat out hard word involved with making it that way.

The obvious problem with this is by not focusing on the current condition of the property, all the repair work and cost cutting needed, or current income of the property, the Cap Rate is distorted, as you assume it reflects the future (higher) income of the property that isn’t yet there. This leads to you not acknowledging how little the property is worth now, and consequently not negotiating as hard and giving the Seller the beating he/she rightly deserves in order to get the price down to where it makes sense.

The upshot is you pay too much for the property, and only realize it after you have taken possession and face the mountain of hard work involved with turning the property around, all the while knowing there is only a trifling reward waiting for you at the end of it all. This only has to happen to you once before you give Pro Forma numbers the contempt they deserve when provided to you by a Broker or a Seller. It’s a standard negotiating gambit on their part, and you need to be aware of it. Accept Pro Forma numbers at your peril.

2. Inaccurate Income And Expense Figures: One of the figures used to calculate the Cap Rate is Net Operating Income. The Net Operating Income is arrived at by subtracting Operating Expenses from Gross Rents. When the expenses, or rents, are not accurate the Cap Rate is not accurate, and it gives you a flawed picture of how much return the property generates, and how much risk there is associated with owning the property. Read more…

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Using Cap Rate To Value Apartment Deals

Cap RateWhen looking at apartment deals to buy one of the most basic things you need to achieve is an understanding of what the property you are looking at is worth. If you are buying through commercial brokers, you’ll have the list price, and then there will be all kinds of ratios and measurements they throw at you to supposedly help you analyze the investment.

Any given ‘offering memorandum’ will contain Gross Rent Multiplier (GRM), Cash-On-Cash Return (COC), Internal Rate Of Return (IRR), Capitalization Rate (Cap Rate), and even more if they are really zealous.

If you are buying direct from the Seller you are confined to what you know about valuing apartment buildings, and what the Seller tries to convince you the property is worth in order for you to feel justified in paying the price he/she wants.

It’s helpful to be able to cut through waffle and get to the point, because apartment buildings are income property, and income is measured in numbers, making the analysis of them very concrete. Out of all the ratios a person throws at you to value a property, the only one that is really of any use to use is the Cap Rate, which stands for Capitalization Rate.

You calculate the Cap Rate for an apartment building by taking the Net Operating Income (NOI) and dividing it by the value of the property.

NOI / Value = Cap Rate

So if you have an apartment building that is being marketed at $7,950,000, and the actual NOI is being presented as being $650,000, the Cap rate the Seller is telling you the property generates is as follows:

$650,000 / $7,950,000 =  0.0818 x 100 = 8.18%

What this 8.18% is actually tells you is that if you had $7,950,000 of investment capital and you used it to buy this property, all cash, after twelve months had gone by and you received $650,000 of Net Operating Income, your return on investment from income in the first year of ownership would be 8.18%. If the price is decreased, or the NOI increased, the Cap rate goes up. If the price is increased or the NOI decreased, the Cap rate goes down.

How Is Cap Rate Used?

1. To Value Income Property: Due to the Cap rate being the quotient of the Net Operating Income and the Value, it is used when you analyze a property for possible purchase. When you have the “market” Cap rate, the Cap rate that like properties (same property class, area, condition) are selling for at the current point in time, you can use that to calculate the current value of the property, based on actual rents being collected on and expenses being incurred by the property (This is a number that is essential for negotiating price with the Seller). And you can calculate the future retail value of the property; the value of the property after all repairs have been made and it has been fully leased up and stabilized. With these two values you will now see the spread in the deal and know your buy and sell target values.

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Buying An Apartment Building For The Rapid Appreciation Ride

Class A Apartment BuildingOne of the great strengths of the strategy of buying Class C apartment buildings with value plays and then executing the turnaround to stabilize the property and capture the upside is that it is market cycle neutral. It doesn’t matter where you are in the real estate market cycle, up, or down, there is always demand for Class C units. In fact, the demand for Class C housing increases in a downturn and Class C values remain unaffected while office, retail, and residential values are tumbling left and right.

But the fact remains, there is a lot of work involved in a Class C property turnaround. There is installing new management, overseeing the rehab, managing the managers during the lease up, and a good eighteen months worth of keeping everyone in your turnaround focused on rehabbing units and getting them leased until you have filled up the property. In the end though, after you have all the work completed and you pull six/seven figures out of the property with your refi, you know it was worth it.

If you have the taste for a strategy with slightly more risk though, you can buy a Class A or Class B apartment building during the upswing in the market cycle, in a Momentum Market like Los Angeles or San Diego.

A momentum market is a high dollar market that has rapid price appreciation in periods of expansion, and then steep falloffs in values after the peak has been reached and the market contracts. The chief feature of a momentum market is the volatility; the highs are ridiculously high, and the lows are painfully low.

For an apartment investor willing to track the market cycle and manage his/her risk, momentum markets can bestow huge fortunes on you without a whole lot of work.

The strategy is very simple. Instead of buying Class C properties, whose great advantage is the consistency of demand, you buy Class A properties, whose great advantage is being new and highly desirable properties, they are great containers of value. When the real estate market starts appreciating, Class A properties increase in value at a higher rate than Class C properties.

You start buying Class A apartment buildings when market appreciation breaks out of the downturn and starts solidifying itself into an upward trend. You buy the biggest apartment apartment buildings that you can manage, and you continue buying until you near the top of the market.

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The Master Lease Option: Minimum Risk, Maximum Reward

 

Master Lease OptionOne of the most awesome strategies to use as an Apartment Entrepreneur is a Master Lease Option. Lease options are common place in the quick-turn “pretty house” arena, but lease options when used on single family homes don’t reflect anywhere near the profit potential that is really possible using this powerful piece of creative financing. When you move from single family to multi-family in your use of the lease option, the risk/reward tilts dramatically in your favor and your profit potential shoots straight up, in hockey stick style increase.

When applied to a multi-family property, the lease option becomes a “master” lease option. The distinction is you are leasing from an individual party, the Seller, but have the right to sub-lease to multiple parties, the Tenants. Hence you have the “master” right to sub-lease … Master Lease Option.

All of the benefits associated with a lease option you have heard about, apply to the Master Lease Option as well:

  • less risk; you are not taking title, the deed, mortgage, and tax bill stay in the Seller’s name.
  • less money required down; option consideration is at a maximum 5%, but often closer to zero.
  • no qualifying; no 3rd party has to approve you, this financing is between you and the Seller.
  • fast close; how long it takes to get a title search done and the agreement drawn is how long it takes to close, anywhere from a few days to a month at the outside.
  • easy exit; if after running the property for 6 months or so you realize the deal is not as good as you thought it was and you want out, it is simply a matter of canceling the agreement with the Seller. In case of default, the Seller simply cancels the agreement for you and just keeps the option consideration as his/her sole remedy.
  • control; you get all the benefits of managing and profiting from the property as though you own it, by merely controlling it.
  • huge profit potential; you get an option to buy the property at a price based on what the property is worth today, that spans years into the future, allowing you to increase the value of the property over time and then sell it based on its new increased future value.

When the lease option becomes a Master Lease Option though, there appears another dimension that adds two or three more zeros to a deal’s profitability.

That is, unlike single family homes, apartment buildings are valued based on the income they produce. The value of a property with 30% vacancy and below market rents is dramatically lower than if it was 90% occupied with tenants paying market rent. For mid-sized apartment properties in the mid-west this difference can be in the hundreds of thousands of dollars. For larger apartment complexes in high dollar markets, the difference can be millions.

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