Commercial Property for a Newbie- good deal?

Question

Hi everyone, I'd like advice on how to proceed.

Its a commercial condo on a downtown mall in a small city. Prices are generally high here, and cap rates don't get too high.

The tenant (long time coffee shop manager has been there 7 years) signed a 10 year lease 1.5 years ago paying first 6,500 (0-60 months), then 7,000, then 7,500 (90-120) a month. Tenant pays taxes, utilities, condo fees, repairs (I think, although I'm sure some damages get pushed back to owner) etc. (I will have to do some research to make sure there isn't anything else I might be responsible for).

This gives the property a cap rate of first 7.8%, then 8.4%, then 9.0%. And this is with his posted asking price.

What else do I need to look at, who should I talk to, and how do I find out if this is good deal?

(I also need to find some MAJOR financing :P)

ANY advice is welcome!

Account Closed · Answer

You are buying NOI NOT cap rate.  What are investors paying for similar property's NOI.   NOI is net operating income.  If your unit has a NOI of $20,000 and say the other units have NOI of $25,000 and $30,000 and sold for $277,775 and $341,000 then you could say the NOI's sold for 8,8% and 9% cap rates.    Lets say the first sale is more like your unit.  Then market price would be about $25,000 / 8.8% market cap rate or about $284,000.   At your incorrectly calculated cap rate of 7.8% you'd be overypaying at $320,500.

Next year if NOI increases to $27,000 you would have to see what current cap rates are.  If they haven't changed and are still 8.8% then your VALUE would be $27,000/8.8%= $306,800.

But if you bought at the top of the market then even if the NOI increases to $27,000 but the market cap rate decreases to 10% then your NOI (property) is only worth $270,000!

Not only do you need to buy at the market cap rate but you have to anticipate the direction it is moving.

Winston Parks · Answer

Hi @James W., In your example, your ROI is 4.8%, but the cap rate is not 4.8%. The market determines the cap rate and you cannot deduct debt service as operating expenses as it is a debt expense. Imagine if you walked in with $1M cash and bought a property that earns you $80k per year. It gives you an 8% return on investment, ROI, and in the case you can say that that property was traded at an 8% cap. Your ROI on the above example is 4.8%, but that is only due to your interest rates, loan type, etc. Hope this helps.

James W. · Answer

Hi Winston,

The Purchase Price should be based on GOP - and not NOI - correct?

Because actually -  you dont know the NOI - until you first know the Purchase Price.

There will be payments due to your lender on the Purchase Price.

To show this as an example - the rental income of 78K - this should be called the GOP.

Determine Purchased Price based on GOP -

78000/8% = ~1MM.

Now if you took a loan @ 4% on 75% of this purchase price - after making 25% down payment.

Your payments are

1MM x 0.75 x 0.04 = 30,000

So the NOI is

78K - 30K = 48K.

So the effective cap rate i see is

48,000 / 1,000,000 = 4.8%

Is this the right way to think - when I take loan on this property.

Winston Parks · Answer

@Quin Weidner you need to know the lease inside and out. Also, if you have no experience then work with a seasoned broker on your first few deals to ask questions about the lease, current market conditions, etc. If you do this, work with someone you hire and not the listing broker. Regarding the CAP, basically what @Bob Bowling said regarding NOI vs CAP is one way. We look at what the Gross Operating Income (annually) divided by the market CAP and that gives us the price. In a Triple Net scenario then your NOI and GOI should be similar as your operation costs should be minimal. Research what the rates are going for in your area (Use Loopnet as a resource) and take into account size, lease terms (triple net?), available properties in the surrounding area, etc. Know what the market is asking for similar properties like Bob said. Do not think about what the CAP will be after the rent increases as you are buying it today. So, $6,500 * 12 = $78,000 / 8%mkt cap = $975,000 asking price.

James W. · Answer

I see what you mean - thank you.

The thing is - Its generally very important for me to have a back-of-napkin calculation to quickly see the monthly returns or liability, you see. The closer the better.

My understanding is that its easy to estimate the monthly returns very accurately - simply by taking the Cash on Cash from Cap Rate - and deduct the Debt Service from it.

Of course it doesnt consider all expenses - but given that debt is the biggest expense - its very close.

So you see - you come across a listing that says 1MM @ Cap Rate 5%.

You know right away this yields 50K a year.

You realize you're going to take a loan on 75% of 1MM - at 4 %.

Your payments are now 3% of 1MM ( 750K x 0.04) = 30K.

Principal is around a third of interest - so 10K.

You may have other expenses - 10K.

Total expenses 50K.

You know right away - the deal doesnt yield anything for you every month.

If this had a cap rate of 8% - i know i can simply deduct 3-4% - and it yields 4-5% annually.

You see - i did the above without using any term - NOI, GOP, or anything like that. To say that a quick calculation is a must. And can simply be done by knowing to reduce the debt payments from the yield that Cap Rate suggests.

Now - if my calculation is wrong above - i can use correction.

Thank you.

Jon Raccah · Answer

@James W.

The Purchase Price should be based on GOP - and not NOI - correct?

Purchase price should be calculated on value, market cap rate divided by NOI can help you get and idea of what the market would expect the price to be. Also, GOP is not a term commonly used in real estate (in my experience) because there is no real cost of goods sold (COGS), I think the term you're using would be gross potential rent (GPR) which is essentially your gross income before factoring in your vacancy.

You must take it down to NOI because every property has different expenses and while the GPR (what youre calling GOP) can be the same for two properties they can have 2 completely diffent set of expenses. So lets run through an example:

you have 2 properties, PropA and PropB,

theyre both 1000sqft and both get $10psf in rent. So $10k a year in GPR, if you only looked at this you would assume both properties have the same value

Now lets say PropA is in a condo assoc. and PropB is not. Thats an additional expense of lets say $1,000 per year that affects your NOI, so now PropA has an NOI of $9k and PropB has an NOI of $10k. See the difference?

There will be payments due to your lender on the Purchase Price.

Keep in mind that debt service is never factored into NOI because every investor structures their deals differently.

To show this as an example - the rental income of 78K - this should be called the GOP.

Again I think you're referring to GPR here

Determine Purchased Price based on GOP -

78000/8% = ~1MM.

This calculation should be made on NOI

Now if you took a loan @ 4% on 75% of this purchase price - after making 25% down payment.

Your payments are

1MM x 0.75 x 0.04 = 30,000

So the NOI is

78K - 30K = 48K.

This is not NOI is actually your Net Cash Flow (NCF) and you can calculate your return on investment % (ROI)

So the effective cap rate I see is

48,000 / 1,000,000 = 4.8%

This would be your ROI

Is this the right way to think - when I take a loan on this property.

Try to keep this format in mind (and if you'd like to see a spreadsheet shoot me an email id be glad to share one with you.

Gross Potential Rent (GPR) aka Gross Potential Income (GPI)

-Vacancy & Credit Loss

---------------------------

Net Rental Income

-Expense reimbursement income

--------------------------

=Effective Gross Income (EGI)

-Operating Expenses (OpEx)

-Reserves (some ppl don't keep reserves)

-------------------------

=Net Operating Income (NOI)

- Annual Debt Service (ADS)

-------------------------

=Net Cash Flow (NCF)

Return on Investment (ROI) = NCF / Total amount invested (equity+debt)

Cap Rate = NOI/Value (if you don't know value, plug in cap rate and solve for value)

@Quin

Cash on Cash would be NCF / amount of CASH invested (i.e. down payment)

Sorry for the length of the post, hope it clears some things up.

JR

James W. · Answer

ok. let us know what your loan and purchase figures come to be.

my guess is your net ROI should be ~3% less than the projected cap rate.

i say 3% because thats your yearly payments on 75% loan on purchase price, at 4%.

Quin Weidner · Answer

@James W. I did not make an offer- the cap rate was kind of low, even though I had a hard time making a comparison.

I was planning on finding a partner. If that didn't work out, I'd go commercial loan.

I also thought maybe my first property shouldn't be 1 million :P

James W. · Answer

just curious - are you buying this mill dollar property cash?

if not - what kind of down payment are you putting down and interest rate are you getting?

Quin Weidner · Answer

@James W. I've heard people call that "cash-on-cash return"

Commercial Property for a Newbie- good deal?

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