An active real estate investor may have multiple offers cross his or her desk in any given week. Since time is our most precious resource, we need to have a method to quickly eliminate those deals that have no chance to become part of our portfolio. Here’s how I do it.
The most critical number needed to rapidly evaluate a property’s potential is the Net Operating Income, or NOI. This is simply the difference between the gross annual income and the expenses paid to operate the property that year. Mortgage payments are not included in calculating the expense total, nor are capital expenses, those large one-time outlays, such as a new roof or heating system.
Getting accurate numbers from the seller can be problematic at times, but I generally take what’s offered at face value. If I decide to move forward, confirming the income and expense values is an important part of the due diligence process. However, we can learn a lot from the actual numbers they give us.
The NOI combines with the going local cap rate to determine the sale price. You can poll your local commercial real estate brokers to get their take on the going cap rate for each class of apartment. You can also monitor sales yourself and figure the range of cap rates that apply to recent sales (or offering prices) in your chosen category. In the examples that follow, we’ll assume that C class apartments in Colorado Springs are selling in the 8-9% cap rate range.
Sample Deal #1
- 16 units, all 2-beds
- Asking $759,000 or $47,400 per door
- Income $98,634
- Expenses $51,493 (52.2%)
- NOI = $98,634 – $51,493 = $47,141
- Cap Rate = 47,141/759,000 = .062 = 6.2%
This cap rate is obviously way below the market rate. Changing it to a more reasonable 8.4% creates a sale price of $559,000, or $200,000 below what the seller is asking.
Besides being overpriced, the property, built in 1962, still has the original windows and kitchens (including the stylish turquoise and pink metal cabinets). According to the property manager, it also needs both flat roofs replaced. The out of state owner is out of touch with the Colorado Springs market and is unlikely to sell anytime soon.
Sample Deal #2
- 12 units, all 1-beds
- Asking $464,900 or $38,700 per door
- Income $60,240
- Expenses $20,024
- NOI = $60,240 – $20, 024 = $40,216
- Cap Rate = 40,216/464,900 = .082 = 8.2%
The cap rate is reasonable, but the expense percentage is on the low side, especially considering the owner pays for all the water and trash. This probably indicates that the owner has not put much into the upkeep of the property. Again, original windows from 1967. Also, since fewer people are looking for a 1-bed apartment, it’s not as easy to raise the rent as much as with 2- or 3-bed units. We’ll pass on this one.
Sample Deal #3
- 22 units 1 3-bed, 4 2-beds, 15 1-beds and 2 studios
- Asking $1,075,000 or $48,900 per door
- Income $119,760
- Expenses $24,109 (20.13%)
- NOI = $119,760 – $24,109 = $95,650
- Cap Rate = 95,650/1.075,000 = .089 = 8.9%
The expense percentage is too low to be believed. If we double it to $48,000 and bring it to a more reasonable 40% expense ratio, the NOI drops to $71,760 and the cap rate moves to 6.7%, way too low for the market.
Changing the cap rate to a more reasonable 8% moves the price to $897,000 (71,760/.08).
Two other factors working against this one are the less than desirable location of South Nevada Avenue and the fact that the owner felt it needed to be enclosed by a high fence and security gate.
Sample Deal #4
18 units 16 2-beds, 1 1-bed, 1 studio
Purchased for $800,000 or $44,400 per door
Expenses $52,648 (42.3%)
NOI = $124,577 – $52,648 = $71,929
Cap Rate = 71,929/800,000 = .0899 = 8.99%
This one has a good unit mix, expenses just about where they should be and a cap rate that indicates we got a good price. In addition, within the last five years, both roofs were replaced, new windows, doors and kitchens were installed, and 16 decks had been rebuilt. Oh, and it was full.
As these examples have shown, once you know a full year’s income and expenses, you can use those numbers with your knowledge of the local cap rate to analyze a property in less than five minutes. Then you only spend real time on those worth pursuing.