How to properly evaluate income property

Berubeland · 01-20-2010, 11:35 AM

Income property value determined the same accepted way.

First you must determine what your Gross Income for the property is. Then you must substract all actual expenses for the property. Then you substract a maintenance allowance. Then you substract the vacancy allowance. Then you substract a management fee.

The result of this is your Net Operating Income or NOI

For Example

200,000 gross income
-20,000 property taxes
-60,000 mortgage payment
- 5,000 insurance
-10,000 vacancy allowance (200,000 x 5% for Toronto)
-10,000 property management (200,000 x 5%)
-20,000 maintenance allowance (200,000 x 10 %)

85000 Net Operating Income or NOI

So capitalization rate or cap rate as usually called is determined by dividing the net operating income by purchase price.

85,000 / 1,700,000 = 5% cap rate.

So what does a 5% cap rate mean for the investor? For my example above the purchase price being 1,700,000 the down payment is 25% or 425,000. This is the money you actually take out of your pocket to buy the building

What is your return on that? 85,000/425,000 = 20% this also does not count the mortgage capitalization that you make every year from paying the mortgage.

That's a heck of a lot better than Dundee REIT or any other REIT.

My example is a 5% so when people start telling me that they wouldn't buy a 14% Cap Rate in Toronto they absolutely don't understand what they are talking about unless they have brain damage and can't add and substract.

Your cash on cash return in a 14% cap rate would be almost 60%

Four Pillars · 01-20-2010, 12:35 PM

Great post.

Question - shouldn't you only subtract the interest portion of the mortgage payment? The part going to pay off principal is income I believe.

When you calculate the return you are using the downpayment as the denominator - but shouldn't the equity in the property increase over the years as the mortgage gets paid off? This would mean this number should be increased over time (and the return % might go down).

Quote:

Originally Posted by Berubeland

That's a heck of a lot better than Dundee REIT or any other REIT.

Kind of apples and oranges isn't it? The amount of time involved in shopping around for and caring for a REIT is miniscule compared to an income property.

Potato · 01-20-2010, 12:55 PM

Berubeland, I'd quibble with just one point: the mortgage. Since part of the payment is principal repayment, I wouldn't consider it an expense (though it is a cash flow issue).

The other point with the mortgage is that I wouldn't use it to find the cap rate, because the mortgage is going to be interest rate sensitive (and sensitive to how much leverage you decide to take on). If you leave it out and find the cap rate without any leverage, then you'll quickly see how high interest rates can go and still be able to stay afloat.

So, if we back out your $60k mortgage figure, the NOI line becomes $145k, for a (cash purchase) cap rate of 8.5%.

Then you can start seeing what happens with leverage. If you can borrow at X%, and leverage 4:1 (25% down), then you make 8.5% on the first 25%, and 8.5-X% on the other 3 quarters, for 8.5+3(8.5-X) return on cash invested.

So at 6.5% interest (which is my understanding of what multi-unit borrowing costs are based on what the REITs have to pay to borrow), that would be 14.5% after the magnifying effect of leverage. The tolerance limits for interest rate hikes is also apparent: much above 8.5% and the investor starts to hurt.

CanadianCapitalist · 01-20-2010, 01:15 PM

A 5% cap rate isn't bad at all in this interest rate environment considering rents are likely (hopefully) to keep pace with inflation and 5% is equivalent to a real rate of return (in the long run). I know people who invest in real estate here in Ottawa but they don't get anything like a 5% cap rate. Their gross rental yield is only 6% or 7%.

I do agree with Potato that I won't count it as a 20% return on my cash investment especially if the mortgage is variable rate and tied to current interest rates.

While REITs may not be a bargain today, they were trading at attractive prices last year. And who knows? Maybe they'll trade down again in the future

furgy · 01-20-2010, 01:19 PM

Quote:

That's a heck of a lot better than Dundee REIT or any other REIT.

If you had bought Retrocom REIT in March when at alltime lows , your current return on investment would be around 35% , (and in all probability , going higher as unit prices increase) , not to mention 200% in capital gains on unit price.

Quote:

Kind of apples and oranges isn't it? The amount of time involved in shopping around for and caring for a REIT is miniscule compared to an income property.

My thoughts exactly 4pillars , not to mention that REITs are probably more liquid.

Berubeland · 01-20-2010, 09:06 PM

I agree with some of your points about the mortgage and capitalization on the mortgage and the interest rates, however this is still the way income producing real estate is evaluated. This is the standard.

Also income producing real estate is evaluated at today's prices not "potential" income. So vacancy is not included in the purchase price. Commercial tenants also pay taxes, maintenance and insurance so your expenses become very low.

So if you are a smart buyer you look for some of the things I tell people to look for in a house. Bad management is a sign of opportunity for me. I see dollars where other people see problems. Stinky, peeling, bad repairs and plaster it's all cheap.

I am just absolutely sick of people saying there is no opportunity in real estate in Toronto. There is tons of opportunity. The properties I discuss here are listed on the MLS for crying out loud. I don't have to leave my desk for these.

I'm not even adding in other opportunities such as turning apartments into condominiums, turning larger industrial space which is vacant into smaller industrial condos, vendor take backs on the down payment (higher cash on cash), properties that are rented undervalue and have rents that can be increased as units turn over

As for the mortgage rates on income properties we just got a 4.5 % fixed mortgage rate for 10 years on a 24 unit townhouse complex in Oshawa.

If you had bought Retrocom REIT in March when at alltime lows , your current return on investment would be around 35% , (and in all probability , going higher as unit prices increase) , not to mention 200% in capital gains on unit price.

Right and if you had bought Huntington REIT instead you would be crying. When you buy stock all you hold is a piece of paper that says it's worth what other people are willing to pay for it. If they are cooking the books or mismanaging their properties you will never know until your share price goes through the floor. If conversely you own a piece of actual real estate a visit will tell you a lot about what is going on and you are the captain of your own ship.

[B]So, if we back out your $60k mortgage figure, the NOI line becomes $145k, for a (cash purchase) cap rate of 8.5%.

This is like saying if apples were oranges then x=y. The only person I have ever heard of who thinks that buying real estate with cash is good is Rickson9. No one else does this. If they have extra cash they buy another building and increase their cash flow.

So at 6.5% interest (which is my understanding of what multi-unit borrowing costs are based on what the REITs have to pay to borrow), that would be 14.5% after the magnifying effect of leverage. The tolerance limits for interest rate hikes is also apparent: much above 8.5% and the investor starts to hurt.
[/b]

As mentioned up above a 10 year fixed rate mortgage was negotiated with TD for 4.75% this January on a 24 unit townhouse complex in Oshawa. If the REIT is paying more I wonder who is getting the pay off on it because it isn't you the investor.

I know people who invest in real estate here in Ottawa but they don't get anything like a 5% cap rate.

They need much better advice. 5% cap rate is common here in Toronto. I am not talking about a pie in the sky here. Right now today on the MLS you can get this.

Kind of apples and oranges isn't it? The amount of time involved in shopping around for and caring for a REIT is miniscule compared to an income property.

Right and so is the return (miniscule) compared to wise investment in actual real estate.

Let me give you an example a very wise owner in Oshawa hired me a year and a half ago to manage his property. It was on the MLS for $1,900,000 but he told me that he wanted to sell it for $1,700,000. At the time there were 8 of 24 townhouses vacant. We fixed then up and rented them out. We raised the rents $75 on the townhouses we fixed up and rented out some parking spots instead of giving them away. So this month the same building sold for $2,300,000 an increase of $600,000 from one and a half years ago. Plus he got to collect rent for 18 months. Improvements cost about $100,000 and I got him a grant for $60,000.

You'll never beat that with any REIT. That is just one owner I have worked for. When you factor in the leverage, what improvements will pay off in increased rents, and what that brings you on resale, the profits are just incredible.

dogcom · 01-20-2010, 09:40 PM

Berubeland you have to understand that people who invest in stocks always try to show that they can do better then people who invest in real estate no matter if they talk about dividend stocks or REIT's. The fact of the matter is people who have invested in real estate over the years have absolutely destroyed stock investors. Of course throwing out the flippers and short term stock and real estate investors. Also their are a few examples where people have done better with stocks but they are gifted and are not the norm by a long shot.

In the end if I had to bet on someone I would bet on you to beat these guys even though I believe they are smart and know what they are doing.

The thing is the stuff you mention like finding properties easy to fix and so on is from the view of a professional. Could you also spot the problems in automobiles and decide if they are a good price. We do not have the same background as you do so we couldn't spot the opportunities that you do.

Berubeland · 01-20-2010, 10:59 PM

I feel like I should apologize for some reason.

I feel very frustrated these days and this happens periodically whenever I get sucked into looking for investment property for investors who can't see a good deal when it hits them in the face. Then they turn around and go buy something absolutely idiotic that does not offer them half the return on investment.

I on my part cannot manage to scrape up the capital to invest on my own. Partly because I work in property management which pays absolutely crap money. I'll never forget when I started in property management, the guy who was my boss had to put a cardboard under his car to catch the oil. He could not afford to either fix his car or buy a new one. The contractor who worked for him drove a brand new Jag. So that's how it goes.

Because I work almost exclusively with high vacancy property I seem to find myself working for people so cheap they won't even pay to keep their own property to an acceptable standard. It's unbelievable but most of the work I do consists of arguing with owners to maintain their own property for their own benefit.

In any case the formula I gave you is the correct one for determining the value of an income property. There is a lot of screwing around with this or that to increase the cap rate mostly by leaving out vacancy rate percentage or maintenance etc. Especially by real estate agents who make hundreds of thousands in commission on these large sales. The point is that you make your own calculation and that's what you use to make your offer. This formula is also the one used by the bank to approve financing.

If you are investing in real estate this is the cornerstone formula for determining property value.

MoneyMaker · 01-20-2010, 11:20 PM

excellent post, keep up the good work

Dana · 01-21-2010, 08:42 AM

Quote:

Originally Posted by Berubeland

I feel like I should apologize for some reason.

Don't apologize, this is a great post. To bridge the gap between stock investors and real estate investors (I am in each category) the cap rate of a property would be the equivalent of a dividend yield on a stock.

Quote:

Originally Posted by Berubeland

I on my part cannot manage to scrape up the capital to invest on my own. Partly because I work in property management which pays absolutely crap money.

Have you considered joint-venturing? Many novice/retired/semi-retired real estate investors look for experienced partners for JVs. You certainly seem to offer a lot of insight and experience into the market. I have met quite a few investors who started out with no capital, but were able to offer practical knowledge and experience.

I have a question for you, Berubeland: I don't usually give the cap rate a lot of weight when considering a single unit family residential investment. I usually give cash-on-cash and cash-on-cash-plus more consideration because I assume that when I re-sell the property, the purchaser would likely be an individual owner and not an investor, so they would more likely not be purchasing for the return but for personal/emotional reasons. How important do you think the cap rate is for single-unit-residential investment?

01-20-2010, 11:35 AM	#1
Berubeland Senior Member Join Date: Sep 2009 Location: Toronto Posts: 775	How to properly evaluate income property Income property value determined the same accepted way. First you must determine what your Gross Income for the property is. Then you must substract all actual expenses for the property. Then you substract a maintenance allowance. Then you substract the vacancy allowance. Then you substract a management fee. The result of this is your Net Operating Income or NOI For Example 200,000 gross income -20,000 property taxes -60,000 mortgage payment - 5,000 insurance -10,000 vacancy allowance (200,000 x 5% for Toronto) -10,000 property management (200,000 x 5%) -20,000 maintenance allowance (200,000 x 10 %) 85000 Net Operating Income or NOI So capitalization rate or cap rate as usually called is determined by dividing the net operating income by purchase price. 85,000 / 1,700,000 = 5% cap rate. So what does a 5% cap rate mean for the investor? For my example above the purchase price being 1,700,000 the down payment is 25% or 425,000. This is the money you actually take out of your pocket to buy the building What is your return on that? 85,000/425,000 = 20% this also does not count the mortgage capitalization that you make every year from paying the mortgage. That's a heck of a lot better than Dundee REIT or any other REIT. My example is a 5% so when people start telling me that they wouldn't buy a 14% Cap Rate in Toronto they absolutely don't understand what they are talking about unless they have brain damage and can't add and substract. Your cash on cash return in a 14% cap rate would be almost 60%

01-20-2010, 12:55 PM	#3
Potato Member Join Date: Apr 2009 Location: London, ON Posts: 87	Berubeland, I'd quibble with just one point: the mortgage. Since part of the payment is principal repayment, I wouldn't consider it an expense (though it is a cash flow issue). The other point with the mortgage is that I wouldn't use it to find the cap rate, because the mortgage is going to be interest rate sensitive (and sensitive to how much leverage you decide to take on). If you leave it out and find the cap rate without any leverage, then you'll quickly see how high interest rates can go and still be able to stay afloat. So, if we back out your $60k mortgage figure, the NOI line becomes $145k, for a (cash purchase) cap rate of 8.5%. Then you can start seeing what happens with leverage. If you can borrow at X%, and leverage 4:1 (25% down), then you make 8.5% on the first 25%, and 8.5-X% on the other 3 quarters, for 8.5+3(8.5-X) return on cash invested. So at 6.5% interest (which is my understanding of what multi-unit borrowing costs are based on what the REITs have to pay to borrow), that would be 14.5% after the magnifying effect of leverage. The tolerance limits for interest rate hikes is also apparent: much above 8.5% and the investor starts to hurt. __________________ "Yes, mad scientists. Some are angry, some are insane. Many are both!"

01-20-2010, 01:15 PM	#4
CanadianCapitalist Administrator Join Date: Mar 2009 Location: Ottawa, Ontario Posts: 886	A 5% cap rate isn't bad at all in this interest rate environment considering rents are likely (hopefully) to keep pace with inflation and 5% is equivalent to a real rate of return (in the long run). I know people who invest in real estate here in Ottawa but they don't get anything like a 5% cap rate. Their gross rental yield is only 6% or 7%. I do agree with Potato that I won't count it as a 20% return on my cash investment especially if the mortgage is variable rate and tied to current interest rates. While REITs may not be a bargain today, they were trading at attractive prices last year. And who knows? Maybe they'll trade down again in the future __________________ Canadian Capitalist -- A Canadian Personal Finance Blog

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01-20-2010, 09:06 PM	#6
Berubeland Senior Member Join Date: Sep 2009 Location: Toronto Posts: 775	I agree with some of your points about the mortgage and capitalization on the mortgage and the interest rates, however this is still the way income producing real estate is evaluated. This is the standard. Also income producing real estate is evaluated at today's prices not "potential" income. So vacancy is not included in the purchase price. Commercial tenants also pay taxes, maintenance and insurance so your expenses become very low. So if you are a smart buyer you look for some of the things I tell people to look for in a house. Bad management is a sign of opportunity for me. I see dollars where other people see problems. Stinky, peeling, bad repairs and plaster it's all cheap. I am just absolutely sick of people saying there is no opportunity in real estate in Toronto. There is tons of opportunity. The properties I discuss here are listed on the MLS for crying out loud. I don't have to leave my desk for these. I'm not even adding in other opportunities such as turning apartments into condominiums, turning larger industrial space which is vacant into smaller industrial condos, vendor take backs on the down payment (higher cash on cash), properties that are rented undervalue and have rents that can be increased as units turn over As for the mortgage rates on income properties we just got a 4.5 % fixed mortgage rate for 10 years on a 24 unit townhouse complex in Oshawa. If you had bought Retrocom REIT in March when at alltime lows , your current return on investment would be around 35% , (and in all probability , going higher as unit prices increase) , not to mention 200% in capital gains on unit price. Right and if you had bought Huntington REIT instead you would be crying. When you buy stock all you hold is a piece of paper that says it's worth what other people are willing to pay for it. If they are cooking the books or mismanaging their properties you will never know until your share price goes through the floor. If conversely you own a piece of actual real estate a visit will tell you a lot about what is going on and you are the captain of your own ship. [B]So, if we back out your $60k mortgage figure, the NOI line becomes $145k, for a (cash purchase) cap rate of 8.5%. This is like saying if apples were oranges then x=y. The only person I have ever heard of who thinks that buying real estate with cash is good is Rickson9. No one else does this. If they have extra cash they buy another building and increase their cash flow. So at 6.5% interest (which is my understanding of what multi-unit borrowing costs are based on what the REITs have to pay to borrow), that would be 14.5% after the magnifying effect of leverage. The tolerance limits for interest rate hikes is also apparent: much above 8.5% and the investor starts to hurt. [/b] As mentioned up above a 10 year fixed rate mortgage was negotiated with TD for 4.75% this January on a 24 unit townhouse complex in Oshawa. If the REIT is paying more I wonder who is getting the pay off on it because it isn't you the investor. I know people who invest in real estate here in Ottawa but they don't get anything like a 5% cap rate. They need much better advice. 5% cap rate is common here in Toronto. I am not talking about a pie in the sky here. Right now today on the MLS you can get this. Kind of apples and oranges isn't it? The amount of time involved in shopping around for and caring for a REIT is miniscule compared to an income property. Right and so is the return (miniscule) compared to wise investment in actual real estate. Let me give you an example a very wise owner in Oshawa hired me a year and a half ago to manage his property. It was on the MLS for $1,900,000 but he told me that he wanted to sell it for $1,700,000. At the time there were 8 of 24 townhouses vacant. We fixed then up and rented them out. We raised the rents $75 on the townhouses we fixed up and rented out some parking spots instead of giving them away. So this month the same building sold for $2,300,000 an increase of $600,000 from one and a half years ago. Plus he got to collect rent for 18 months. Improvements cost about $100,000 and I got him a grant for $60,000. You'll never beat that with any REIT. That is just one owner I have worked for. When you factor in the leverage, what improvements will pay off in increased rents, and what that brings you on resale, the profits are just incredible.

01-20-2010, 09:40 PM	#7
dogcom Senior Member Join Date: May 2009 Posts: 281	Berubeland you have to understand that people who invest in stocks always try to show that they can do better then people who invest in real estate no matter if they talk about dividend stocks or REIT's. The fact of the matter is people who have invested in real estate over the years have absolutely destroyed stock investors. Of course throwing out the flippers and short term stock and real estate investors. Also their are a few examples where people have done better with stocks but they are gifted and are not the norm by a long shot. In the end if I had to bet on someone I would bet on you to beat these guys even though I believe they are smart and know what they are doing. The thing is the stuff you mention like finding properties easy to fix and so on is from the view of a professional. Could you also spot the problems in automobiles and decide if they are a good price. We do not have the same background as you do so we couldn't spot the opportunities that you do.

01-20-2010, 10:59 PM	#8
Berubeland Senior Member Join Date: Sep 2009 Location: Toronto Posts: 775	I feel like I should apologize for some reason. I feel very frustrated these days and this happens periodically whenever I get sucked into looking for investment property for investors who can't see a good deal when it hits them in the face. Then they turn around and go buy something absolutely idiotic that does not offer them half the return on investment. I on my part cannot manage to scrape up the capital to invest on my own. Partly because I work in property management which pays absolutely crap money. I'll never forget when I started in property management, the guy who was my boss had to put a cardboard under his car to catch the oil. He could not afford to either fix his car or buy a new one. The contractor who worked for him drove a brand new Jag. So that's how it goes. Because I work almost exclusively with high vacancy property I seem to find myself working for people so cheap they won't even pay to keep their own property to an acceptable standard. It's unbelievable but most of the work I do consists of arguing with owners to maintain their own property for their own benefit. In any case the formula I gave you is the correct one for determining the value of an income property. There is a lot of screwing around with this or that to increase the cap rate mostly by leaving out vacancy rate percentage or maintenance etc. Especially by real estate agents who make hundreds of thousands in commission on these large sales. The point is that you make your own calculation and that's what you use to make your offer. This formula is also the one used by the bank to approve financing. If you are investing in real estate this is the cornerstone formula for determining property value.

01-20-2010, 11:20 PM	#9
MoneyMaker Member Join Date: Jun 2009 Posts: 85	excellent post, keep up the good work