Canadian Money Forum banner

1 - 20 of 34 Posts

·
Registered
Joined
·
2,054 Posts
Discussion Starter #1
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%
 

·
Registered
Joined
·
3,423 Posts
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).

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.
 

·
Registered
Joined
·
450 Posts
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.
 

·
Premium Member
Joined
·
2,686 Posts
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 :)
 

·
Registered
Joined
·
240 Posts
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.

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.
 

·
Registered
Joined
·
2,054 Posts
Discussion Starter #6
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.
 

·
Registered
Joined
·
2,925 Posts
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.
 

·
Registered
Joined
·
2,054 Posts
Discussion Starter #8
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.
 

·
Registered
Joined
·
420 Posts
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.

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?
 

·
Registered
Joined
·
240 Posts
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.
I was just pointing out that it doesn't beat "every" REIT.
I have been screwed over on real estate three times , all seemed like real bargains at the time , once thru a messy divoce , once thru bad renters , and once thru a failed local economy.

I had a lot less into them than the example you quote , I shudder to think what could happen if I were to shell out $450,000 as a down payment.

The fact of the matter is people who have invested in real estate over the years have absolutely destroyed stock investors.
I know from experience that this is not true for everyone , or even for the majority (unless you have some stats to prove me wrong) , I have aquaintances who have lost big time in RE as well , especially during the last crash.

I have however , done very well in REITs , but when it comes to real estate , I am probably a little overly cautious.
 

·
Registered
Joined
·
546 Posts
Don't care how "everyone else does it". I think basic finance applies to all financial decisions.

I don't think either the principal OR the interest should be factored into the basic equation of profitability. Evaluate the property's rate of return first. Then compare that to the rate you will pay for the debt. Detail.

Very, very few people calculate the return they earn from real estate properly, with all the costs. So of course they think they make a killing. And concluding that the last 5 years is 'normal' is also wrong.
 

·
Premium Member
Joined
·
2,686 Posts
Don't care how "everyone else does it". I think basic finance applies to all financial decisions.

I don't think either the principal OR the interest should be factored into the basic equation of profitability. Evaluate the property's rate of return first. Then compare that to the rate you will pay for the debt. Detail.

Very, very few people calculate the return they earn from real estate properly, with all the costs. So of course they think they make a killing. And concluding that the last 5 years is 'normal' is also wrong.
I was about to comment that mortgage payments should not deducted from the gross rental income to compute the cap rate. My understanding of cap rate is it is the net rental yield from a property owned free and clear.

In your case, the cap rate is $145K/$1.7M = 8.53%.
 

·
Registered
Joined
·
2,054 Posts
Discussion Starter #14
Don't care how "everyone else does it". I think basic finance applies to all financial decisions.

Well you should care how everyone else does it because in income producing real estate if you don't understand this nothing anyone says will make any sense to you. When the real estate agent says this property has a 5% cap rate you had better know what that means and be able to examine their equation and make sure all expenses are accounted for including vacancy allowance and maintenance expense. Otherwise you are being screwed on the price and may end up in hot water. All expenses including the cost of servicing the loan are included.

Also the link you sent is for homes not income property. This is a formula used in the industry and is information anyone investing in real estate needs to know.

It is a start like reading financial statements is to buying stock. Some people don't include goodwill or other things they don't like according to their criteria but as a general rule they don't say hey I wish accountants did not include debt servicing charges in their calculations about the worth of the asset.
 

·
Registered
Joined
·
2,054 Posts
Discussion Starter #15
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?

When you are buying your own home it is different than if you are buying for income. There are many difference variables that you have to take into account when buying for yourself. For example your spouse and children, work proximity etc. I also believe the mortgage should be paid off as soon as possible on your personal residence in case of illness or lay off etc.

I'll use myself as an example when I purchased this house I had a construction company. I was very concerned with space I wanted a large lot. I used my garage and shed for extra storage. The house itself was a series of small rooms and there was one kitchen cupboard, the one under the sink. So everything went in a bookshelf. There was also a one bedroom basement apartment which was a great help to pay off the mortgage.

Now my situation has changed I no longer have the same husband :) I have a 2 year old child and I work from home and drive around renting houses for a living. I might want to sacrifice the space for proximity to the downtown core.

Since I bought this house I have moved the laundry room outdoors to allow for a two bedroom apartment instead of a one bedroom apartment, I have removed almost all the walls and made it a open concept.

If I were to buy again in my current life situation with the hubby I have now and a 2 year old running around I would not be able to buy this house. I would buy at least a 4 bedroom to allow one room for my office instead of being stuck downstairs and room for a family expansion.

But still I could buy a house that is undesirable to a lot of people. One thing that really affects people on an almost subliminal level is smell. Air it out or paint and the smell is gone. I could buy in a strategic area one that I think is undervalued etc. Having said this I would also have to satisfy my spouse who likes new construction.

But when you buy income property the whole ball game changes. The whole purpose of buying it is to generate enough rent to pay the cost of the mortgage plus some cash flow plus capital appreciation.

So here are my criteria in order of things I like to see when buying

1 - Positive cash flow or potential for positive cash flow if there are vacancies due to neglect or bad management.

2 - Up and coming area, Look where they are putting in big box stores such as Home Depot, Lowes, Loblaws and other types of development.

3 - Building itself is structurally sound. Drywall, paint, bad smells bad kitchens, anything cosmetic. When you start replacing main beams on structures you can kiss your wallet good bye unless of course you know how to do it yourself.

4 - Bad smells - Air it out and paint it with vapor barrier primer sealer with the exception of mold which is more involved and expensive.

5 - Neglect and bad management, garbage laying around no landscaping, vacancy. Dirt.

So basically when you are going out to buy a property use your cognitive mind rather than your emotions. The first thought at the forefront of your mind should be how can I make money off this? It's disgusting well good how many $$ worth of disgusting is it? Feel free to walk away be committed to the money rather than the property. There are a lot of properties and you and your money will live to make a better deal the next day.
 

·
Registered
Joined
·
31 Posts
This is not correct.

When evaluating an income property for purchase (Market Value) you must consider the numbers this way:

Gross Income (Annual Base Rent)
Less (allowance for vacany) - say 3% retail, 10% office
Less (Allowance for managment exp) - say 5% retail, 10% office

= NOI

IF you have Triple net or net leases this is the best method. If you have gross leases, or the market uses gross leases, then you would also subtract Property Tax, Insurance, etc.

Most property markets operata in Triple Net Leases so the above is correct.

From there you take your NOI and divide by the cap.

To arrive an an appropriate cap you need to find sales of comparable properties and divide those sale prices by the expected NOI of those properties.

From a market perspective you do not use actual income since some leases may be above or below market rates and when renewed will come in at the actual market rates.

NOI/cap = market value. Obviously market value should technically have a range.
 

·
Banned
Joined
·
4 Posts
Smac, you are more correct then the others but still this is the way it should be calculated:

This is based on a fictious annual income of $20,000, triple net.

Potential Gross Annual Income $20,000
Less: Vacancy & Collection @ 3% $ 600
Effective Gross Annual Income $19,400
Less: Structural Repairs & Maintenance @ 2.5% $485 (based on the EGAI not the PGAI)
Less: Management @ 3% $582 (also based on the EGAI not on the PGAI)
Estimated Net Annual Income $18,333

The vacancy and collections is calculated first then management and repairs/maintenance are caculated off of the Effective Gross Annual Income. You then subtract these for the Net Annual Income and divide this number by the capitilization rate. The appropriate cap rate would be determined by comparable sales that help indicate the appropriate risk associated with the property. The higher the cap rate the higher the inherent risk assoicated with the property usually is.

If you are dealing with gross rents then you have take off all of the other expenses that are not paid by the tenant.

Another way to caculate a value is by using the effective gross annual income and multiplying it by a gross income multiplier or GIM. The relationship between capitalization rates and GIMs is inverse, where the factors that influence one have the opposite effect upon the other. Stated differently, as capitalization rates decrease, GIMs generally increase and vice versa. This can be usefull when you are dealing with gross rents and you don't know what the expenses are.
 

·
Registered
Joined
·
60 Posts
Interesting thread...some reason this quote came to mind
"To a man/woman with a hammer, everything looks like a nail."-Mark Twain

If you understand real estate stick with it, but don't be giving advice that other investment are inferior, if you don't truly understand it.
 

·
Registered
Joined
·
2,054 Posts
Discussion Starter #19
If you understand real estate stick with it, but don't be giving advice that other investment are inferior, if you don't truly understand it.

There is a direct comparison to be drawn between REITs which are Real Estate Investment Trusts such as Dundas REIT and actual real estate in that they are actually exactly the same investment.

The difference being that in a REIT there is a heck of a lot more people between you and income (CEO's, Accountants, Property Managers, and even the cleaners) All these people get paid first. Where do the dividends come from? They come from the rental income.

In an actual building as the owner you have the control and you also earn a lot more of the income. In a sense you are cutting out the middle man and putting the money in your pocket.

They are in fact the exact same investment REIT's are just one step removed.
 

·
Registered
Joined
·
60 Posts
We sense a conflict of interest.

A self-proclaimed Toronto Property Manger (Berubeland) advocating the merits of real-estate investment. Advocating earning 20% or more and that is without capital gains.
On the example given:
200K Gross income
10K Property management at 5%
Works out to $833 a month for the property manager.

Looks like someone is trying to drum up business. Or better yet just PM Berubeland and she can help you find these incredible deals and give you a great rate on managing your new investment property.

Nope...no conflict of interest here.
 
1 - 20 of 34 Posts
Top