The following is link to an article that discusses the impact on Commercial Real Estate Professionals by the new Wall Street Reform and Consumer Protection Act signed earlier this week by President Obama.
Financial Reform Will Test Patience of Commercial Real Estate Professionals.
Which tool will give me the right answer?
I apologize for taking so long with this post, sorry business comes first.
Recently, I analyzed an investment for a client and as I was going over the analysis with him and I felt some of my comments might be interesting to readers of this blog. In a previous post we discussed Cap Rate as a measure of an investment well quite frankly it is only one of a number of metrics I like to use. The following are some of the metrics along with their formulas you can consider in evaluating an investment.
Loan to Value Ratio (%)
LTV = Loan Amount x 100 ÷ Market Value
Debt Service Ratio (DSR)
DS = Net Operating Income ÷ Debt Service
Capitalization Rate (Cap Rate)
Also called Broker’s Yield
Cap Rate(%) = Net Operating Income x 100 ÷ Market Value
Cap Rate (%) = NOI x 100÷ MV
or Market Value = Operating Income x 100 ÷ Cap Rate (%)
MV = NOI x 100 ÷ Cap Rate (%)
Return on Equity (ROE)
A.K.A. Cash on Cash Return
Also called: Equity Dividend Rate (EDR)
Where: Equity = Market Value – Mortgage and Debt Service = Principal & Interest Payment
ROE(%) = (Net Operating Income – Debt Service) x 100 ÷ Equity
ROE (%) = (NOI–DS) x 100 ÷ (MV–Mtge.)
Potential Gross Income Multiplier (PGIM)
Also called Potential Gross Rent Multiplier (PGRM)
PGIM = Market Value ÷ Potential Gross Income
PGIM = MV ÷ PGI
Effective Gross Income Multiplier (EGIM)
Also called Effective Gross Rent Multiplier (EGRM)
EGIM = Market Value ÷ Effective Gross Income
EGIM = MV÷ EGI
Default Ratio (Break-even) (%)
Using Potential Gross Income
DR = (Operating Expenses + Debt Service) x 100 ÷ Potential Gross Income
Using Effective Gross Income
DR = (Operating Expenses + Debt Service) x 100 ÷ Effective Gross Income
Loan to value ratios are decreasing due to the market conditions and the banks’ caution regarding falling property values, bankers have told me they are generally looking at 75%, 70% or lower for most commercial real estate deals if the property fits their risk profile. Yes, the banks will not entertain some properties because they are to risky, restaurant properties is one example.
Banks use the Debt Service Ratio (DSR) in their loan decision process, historically a minimum of 1.20 DSR was considered. The higher the DSR is the better.
In our last post we discussed cash flow as an investing goal, Return on Equity (ROE) or Cash on Cash Return measures the return on the cash invested versus the cash flow received from the property. Most investors give this measurement metric a greater weighting in their investing decision. As we previously discussed accuracy of financial information is critical to this metric.
Potential Gross Rent Multiplier (PGRM) or Effective Gross Rent Multiplier (EGRM) generally can be used to evaluate similar properties, obviously the lower the multiplier the better. The class, location and risk level of the property effects the multiplier value. Just as with Cap Rate this metric should not be used alone to make a property buying decision.
My favorite metric is the Default Ratio or Break-even (%) it measures the relationship between income, expense and debt. I will repeat, it is subject to the accuracy of the data you receive from the seller. This metric basically tells you if the property can support the debt placed on the property. The magic number is 85%, if the default ratio is greater than 85% this investment may be risky. Using the effective gross income will introduce the vacancy rate into the formula and would be the recommended method. When used in conjunction with the other metrics discussed, a more reasoned investing decision can be made.
In any market a complete analysis of the investment is always the wise choice.
That’s question every buyer wants answered when they invest in real estate, but that begs the question; cash flow or appreciation. Many investors in California and Las Vegas in the last couple of years purchased property for the appreciation; properties were doubling in value in 6 to 12 months. Cap rates were extremely low and cash flow was questionable but heck if you could double your money in a short period of time who cares. Well just as the gold rush ended so did the land rush come to a screeching halt and those investors that held too long are now upside down with little or no cash flow to support the investment. You’ve heard of the importance of Location, Location and Location when buying real estate, well when in investing in commercial real estate you can add Cash Flow, Cash Flow and Cash Flow. Cash flow however has to be computed for the duration of your projected holding period, and your financial calculations must include a capital reserve to cover expected capital expenditures to maintain the property over that time period. The amount of risk in the investment will affect the returns expected, generally higher risk properties yield a greater return and conversely lower risk yields a lower return. I can’t repeat this enough do your homework before you make that commitment.
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NAR Chief Economist Lawrence Yun sounded a downbeat note on the state of the commercial real estate market over the next few years in an address Friday afternoon at the 2009 REALTORS® Conference & Expo.
Yun said the most immediate problem for this sector is simple: There aren’t nearly enough buyers.
“Who is buying? The answer is no one,” he explained. “The level of transactions is way down. We’re looking at an almost 90 percent decline from peak to current levels.”
One particularly hard-hit area of commercial is the office sector: Vacancy rates are getting precariously close to 20 percent and sales volume has fallen as far as 93 percent from its peak just a few years ago.
The industrial part of commercial is also performing well below the norm, due in large part to warehouses, Yun said. There’s more space, but much less need for it. Rents fell more than 10 percent this year, and probably will again next year.
The prospects for retail and multifamily are somewhat better. Yun predicts that as housing prices rise, people will be more inclined to spend, which will benefit retail. In addition, young people and professionals who’ve fallen on hard times will be able to move out of their relatives’ households and into their own residences as the economy slowly recovers. This will boost both multifamily and housing, Yun said, but he added that the employment picture will have to improve first.
However, the overall commercial market will probably continue to move down—too many indicators point to more trouble. For instance, cap rates are starting to rise for the first time since the beginning of this decade. Issuance of commercial mortgage-backed securities (CMBS) actually fell to zero during a few recent months. Moreover, CMBS delinquency rates have skyrocketed over the past couple of years.
That isn’t even the worst part, though. The biggest concern in the coming years is defaults. Commercial real estate debt maturities will spike at $1.8 trillion in 2012, and much of that amount is comprised of poor-quality loans.
“The credit situation in the commercial market is very disconcerting,” Yun said. “On the residential side, there is more government backing. That’s not the case for commercial real estate. In commercial, there will be another letdown before things improve.”
However, he also expressed confidence that the federal government would try to prevent a large collapse in the commercial sector. The Federal Reserve and Treasury Department have extended the Term Asset-Backed Securities Loan Facility (TALF), a federal relief program intended to increase credit availability, through 2010.
Yun said he expected to see more relief efforts in the future.
“The policy makers clearly understand that commercial real estate is the next shoe to drop, so they’re looking at things they can do. That doesn’t mean they have the policy to implement yet,” he said.
—Brian Summerfield, REALTOR® magazine
Here are some thoughts on getting the answers you need to determine if it’s a good deal or loser.
Since Cap Rates are dependent on NOI (Net Operating Income) it is critical you are certain the bottom line is true. Whenever possible request a copy of the schedule E tax return or a certified income / expense statement. This is part of your ‘Due Diligence’.
After you have confidence in the financials you can then determine a price you are willing to pay for the returns expected.
Remember the old adage ‘If it looks to good to be true, it probably is’.
Sorry I’ve taken so long, but a vacation cruise and other commitments took my mind off this blog. Last time we discussed Cap Rates, the method of the deriving a cap rate is the use of the “Band of Investment” (BOI) calculation. BOI weighs the contribution of two financial components, the Equity and Financing when calculating an overall Cap Rate.
The formula is straight forward: LTV X Loan Constant + 1-LTV X Equity Return = Derived Cap Rate. Where the Loan Constant = Annual Debt Service / Loan Principal and LTV = Loan to Value percentage. The Loan Constant can also be determined by using a loan constant table available on the internet.
As an example: A 25 year loan term @ 7.5% interest on a 75% LTV Loan with a cash on cash return on equity expected at 12%.
(.75 * .08868) + (.25 * .12) = .06651 + .030 = 9.65 Derived Cap Rate
You can use the Band of Investment Calculation to solve for the equity returns for current market cap rates and financing. So let’s look at what investors might expect on an overall 10.5% cap rate with a 25 year, 70% LTV loan at 6.5% interest rate.
(.70 * .08102) + (.30 * X) = .105 (10.5%) = (.105 – .05671) / .30 = .1609
In this example the cash on cash return on equity equals 16.09%
As property values and loan terms change the Band of Investment calculation offers a tool to measure the impact on the deal.
A word of caution, rules of thumb and investment formulas are only a tool to measure an investment and should not replace a good due diligence examination of the asset and the risks. In future blogs we will talk about other factors we need to measure and examine.
The number one topic that always drew the most questions during my presentations of NAR’s Fundamentals of Commercial Real Estate course was always “Cap Rates”. Cap Rate or capitalization rate is a simple calculation and is easy to compute. If you know the net operating income of the investment property you can calculate market value from the Cap-Rate. Here is the formula:
Market Value = Operating Income x 100 / Cap Rate (%) or MV = NOI x 100 / Cap Rate (%)
As an example $50,000 NOI divided by a .095 (9.5%), Cap Rate = $526,316 market value, easy right, the problem is where do you get the Cap Rate value?
That is where this simple rule of thumb gets complicated, the Cap Rate value is actually a measure of risk. A low risk investment like a 20 year leased Walgreen Store property might have a cap rate of 7% or lower, while a 100 year old tenement building with a high vacancy rate, deferred maintenance and located in a depressed city or town could have a cap rate of 13%, 14% or higher. As with any investment, risk determines the price investors are willing to pay. With real estate the location, quality of the leases, credit worthiness of the tenant, age and condition along with the economic status of the market and many other factors influence the amount of risk in ownership of the property. Generally cap rates for a given property can be derived by researching comparable property sales in similar condition located in the same market. Adjusting the cap rate for qualitative or quantitative differences in the properties can zero in on market value cap rates. Keep in mind it is only a rule of thumb to be used in the comparison of potential properties. Due diligence requires considering other investment metrics which we will discuss in future blogs.
Welcome to Real Estate Related. This our first post. We are hoping to post relevent discussions about commercial & investment real estate! We will try to explain the terms and calculations used in the process of investigating a property’s value and investment return.